Are you asking your clients about their liabilities? Looking only at one side of your clients’ balance sheet may put their long-term goals at risk. Great asset allocation constructed to fit the clients’ investment risk tolerance is only one part of the formula–your clients’ level of debt (or leverage) and their capacity for risk is a huge part of the equation as well.
Today, more than at most other times in U.S. history, Americans are highly leveraged. Just look at these staggering facts:
- Personal bankruptcies are on the rise, according to the Administrative Office of the U.S. Courts. Approximately 2.1 million bankruptcy petitions were filed in 2005, 50% higher than the prior year and the most ever filed in any 12-month period.
- In June 2006, the U.S. personal savings rate was again negative, at -1.5%, according to the U.S. Department of Commerce’s Bureau of Economic Analysis.
- American households’ overall debt rose to a median 108% of income in 2004, up from 78% of income in 2001, according to the Federal Reserve Board’s Survey of Consumer Finances.
- In 2005, for the first time, U.S. households borrowed more than $1 trillion. Before 2000, consumers had never borrowed more than $488 billion in one year, according to Federal Reserve statistics.
Overconfidence in Borrowing
Let’s recall the way things were as recently as the late 1990s. If a corporate executive wanted to buy a vacation home that cost $2 million, she might borrow 90% of the purchase price based on her annual cash flow of $1 million and an investment portfolio worth $25 million.
Sounded okay, but there’s a catch. The investment portfolio was heavily concentrated in one public company.
When the price of the collateral stock declined, the executive was required to make a margin call and had to liquidate assets in a depressed market. In so doing, she had to forgo any future rebound and appreciation of the stock. What might have been a temporary dip in value became a permanent destruction of her wealth, having a huge impact on her long-term goals.
In the late ’90s, many investors suffered from exuberant overconfidence and thought that the stocks they purchased had nowhere to go but up. We now know this was not true. However, could history repeat itself if our clients suffer another case of overconfidence in residential real estate?
Let’s look at the latest housing market data. Existing home sales rose to a nine-year high, but price appreciation was at an 11-year low, according to a June 2006 National Association of Realtors report. Inventories of existing homes were up 39% while sales were down 8.9% over the past year. Adding to the slower housing market is the ever-increasing range of loan choices available to borrowers. These include interest-only mortgages, longer average loan maturities, and “piggyback” mortgages, or second liens originated at the time of purchase. These choices allow borrowers to assume bigger mortgages than they otherwise could afford and take on greater risk. (See “ATM” sidebar)
With the recent cooling in housing prices and interest rates on the rise, now is an excellent time for you to add value to your client relationships. Consider reviewing your clients’ existing commitments and collateral, and to discuss with them their “personal maximum debt level.”
Your clients’ borrowing decisions should be made with the same kind of discipline applied to their investment strategy. It’s important to distinguish between leverage that’s beneficial from borrowing and exposure to outsized risk. To become wealthy, many of your clients took calculated risks along the way, but preserving wealth requires a much more balanced approach. Credit used wisely can be a potent tool for both building and sustaining wealth. You can play a key role in helping your clients to understand and embrace their “personal maximum debt level.”
We define “personal maximum debt level” as the highest level of debt that can be expected to weather future market and cash-flow uncertainties without hindering the realization of long-term goals. While your clients can use basic Internet tools to determine their debt-to-income ratio, you need to keep in mind that the real number cannot be calculated by a formula alone. You must consider your clients’ portfolios as well as their investing behavior.
p>Once you review each of their current portfolios, you need to determine the level of debt that will cause your client to make irrational decisions. Her “personal maximum debt level” is the upper limit of a client’s comfort zone.
Gauging Your Clients’ Discomfort Zones
To learn more about your clients’ comfort zones, you need to probe. Have a discussion on how much they believe interest rates could rise. Ask them what a significant decline in collateral values would mean to their ultimate goals. How much do their cash flow sources and uses vary? What are their tolerances for changes in cash flow? If a client is used to spending $300,000 a year, will he feel uncomfortable if the cash flow drops to $250,000, or $200,000? With upfront discussion and planning, you can make your clients aware of the benefits and drawbacks of leverage versus the discomfort of cash flow changes.
Asking these questions, you will gain a better understanding of your clients’ rationale–what their limitations and expectations are. Our role as advisors is to be aware of our own and our clients’ psychological shortcomings so we can help them avoid making bad decisions based on psychological factors instead of real analysis.
By discussing and evaluating the likelihood of differerent scenarios in advance, you can help your clients understand the repercussions of their borrowing and spending, which would be of tremendous value to them. As they approach or exceed their personal maximum debt levels, they will know they are entering a zone of higher risk to their long-term goals and are in a position to take corrective steps.
“Risk comes from not knowing what you’re doing,” investment sage Warren Buffett has said. While your clients may be good at their professions, they expect you to assist in protecting them from financial harm. You are the expert they look to for helping them reach their financial goals.
Borrowing can be a strategic tool that facilitates a range of activities. What is critical, however, is figuring out your clients’ personally appropriate level of debt. (See “Consider These” sidebar.)
Putting Debt to Work
So far, we have only discussed the negatives of borrowing, but there is some upbeat news about debt. As we said earlier, debt used wisely can be a potent tool for both building and sustaining wealth. It can be a powerful enabler if used correctly. There are three things that you must always discuss pertaining to debt: 1) the overall objective; 2) the definition of success, and 3) the risk involved in borrowing (i.e., personal maximum debt level).
Common objectives could be to take advantage of attractive market opportunities without disturbing the existing portfolio; to bridge a temporary funding gap; to reduce portfolio risk; to reduce or defer taxation; or to transfer wealth.
The definition of success is that returns exceed the cost of borrowing.
The risk of borrowing will always circle back to a client’s specific personal maximum debt level. Remember, there is no single formula to determine this level, nor is there a “cure” for how to manage debt. Each client is different and will have his or her own circumstances to take into consideration. A debt check-up should become a standard part of your client practice. There is no better time than now to work with clients in year-end planning. By adding this key service–and insight–to the process, you can differentiate yourself from your competitors. By adding value to your clients’ initiatives and goals, including assets and potential liabilities, you can be seen as the advisor of choice.
Susan L. Hirshman, CFP, CPA, CFA, CLU, is a managing director for JPMorgan Asset Management in New York. In that position, she develops strategies to provide wealth solutions to the affluent market. She can be reached at email@example.com.