Investment and loans

Technology and market

admin — Wed, 22 Jul 2009 14:28:27 +0000

Advancements in technology can expand the economy’s production possibilities. Technology determines the maximum amount of output an economy can produce given the resources it has. New and better technology makes it possible for us to get more output from our resources. An important form of technological change is intention the use of science and engineering to create new products or processes. In recent years, for example, inventions have allowed us to develop photographs faster and more cheaply, process data more rapidly, get more oil from existing fields, and send information instantly and cheaply by satellite. Such technological advances increase our production possibilities, shifting our economy’s entire production possibilities curve outward.
An economy can also benefit from technological change through innovation -the practical and effective adoption of new techniques. Such innovation is commonly carried out by an entrepreneur-a person who introduces new products or improved techniques to satisfy consumers at a lower cost. To make a profit, an entrepreneur must convert or rearrange resources in a way that increases their value. This also pushes the production possibilities curve outward.
Take, for example, Henry Ford, an entrepreneur who changed how cars were made by pioneering the assembly line. With the same amount of labor and materials, Ford made more cars, more cheaply. Another entrepreneur, the late Ray Kroc, purchased a hamburger restaurant from Richard McDonald and built it into the world’s largest fast-food chain. Kroc revolutionized fast food by offering attractive food at economical prices. He also developed a franchising system that resulted in uniform quality across the many different McDonald’s restaurants worldwide. More recently, entrepreneurs like Steven Jobs (Apple Computer) and Bill Gates (Microsoft) helped develop the personal computer and software programs that dramatically increased their usefulness to businesses and households. It is interesting to think about how a few famous entrepreneurs have improved our productivity and changed our lives so much.

Production possibilities curve

admin — Wed, 22 Jul 2009 14:26:50 +0000

People try to get the most from their limited resources by making purposeful choices and engaging in economizing behavior. This can be illustrated using a conceptual tool called the production possibilities curve. The production possibilities curve shows the maximum amount of any two products that can be produced from a fixed set of resources, and the possible trade-offs in production between them. Admittedly, this is an oversimplified model because economies obviously produce more than just two products. Nonetheless, the production possibilities curve can help us understand a number of important economic ideas.

Private ownership and markets

admin — Wed, 22 Jul 2009 14:26:06 +0000

Private ownership and competitive markets provide the foundation for cooperative behavior among individuals. When private-property rights are protected and enforced, the permission of the owner must be sought before anyone else can use the property. Put another way, if you want to use a good or resource, you must either buy or lease it from the owner. This means that each of us must face the cost of using scarce resources. Furthermore, market prices give private owners a strong incentive to consider the desires of others and use their resources in ways others value.
F. A. Hayek, the winner of the 1974 Nobel Prize in economics, used the expression “the extended order” to refer to the tendency for markets to lead perfect strangers from different backgrounds around the world to cooperate with one another. Let’s go back to the example of the property owner who has the choice of leaving her land idle or building housing to benefit students. The landowner might not know any students in her town nor particularly care about providing them housing. However, because she is motivated by market prices, she might build an apartment complex and eventually do business with a lot of students she never intended to get to know. In the process, she will purchase materials, goods, and services produced by other strangers.
Things are different in countries that don’t recognize private-ownership rights or enforce them. In these countries, whoever has the political power or authority can simply seize property from whomever might have it without compensating them. In his book The Mystery of Capital, economist Hernando DeSoto argues that the lack of well-defined and enforced property rights explains why some underdeveloped countries (despite being market based) have made little economic progress. DeSoto points out that in many of these nations, generations of people have squatted on the land without any legal deed giving them formal ownership. The problem is these squatters cannot borrow against the land to generate capital because they don’t have a deed to it, nor can they prevent someone else from arbitrarily taking the land away from them.
Private ownership and markets can also play an important role in environmental protection and natural-resource conservation. Ocean fishing rights, tradable rights to pollute, and private ownership of endangered species are just some examples. The accompanying Applications in Economics feature, “Protecting Endangered Species and the Environment with Private-Property Rights,” explores some of these issues.

Freddie Mac and Fannie Mae

admin — Fri, 17 Jul 2009 17:37:06 +0000

When Applying to Freddie Mac or Fannie Mae, the Rule is You Need Good Credit and a lot of Cash

When the housing bubble burst this past fall and the government had to bail out Freddie Mac and Fannie Mae, getting a loan for a new home became just a little harder for homeowners. With the two largest lenders being in a government conservatorship, rules have tightened to reduce the risk to mortgage lenders. Potential homeowners should now be prepared to offer large amounts of cash for a down payment and be able to prove that they have a good credit score. This is the new reality in these hard economic times.

A recent article in the Wall Street Journal estimated that buyers need approximately 20% cash down plus a credit score of 740 to qualify for a low down payment. With a credit score and cash on hand like this, a buyer could qualify for a mortgage with an interest rate of 4.75% plus origination fees. If your credit score is lower, count on having to put down more cash plus spending a lot more in fees.

With private institutions not keen on making mortgage loans in the current financial climate, Freddie Mac and Fannie Mae may be the only avenue to turn to for a mortgage for many home buyers. Potential homeowners need to be prepared to part with a lot of cash in terms of a down payment in order to qualify for a mortgage. The FHA is still working with people who have poor credit, but there is not a lot of mortgage money to go around. The best way to get a mortgage is to have a good credit score and to have plenty of cash on hand to make a down payment and pay the fees. There’s just no way around the new rules at the moment.

The housing market collapse has created a glut of homes that are waiting for buyers, but low selling prices have scared off sellers. Economic experts have said that there is a need to balance safe lending with stabilizing the housing market. Many people are applying for mortgages and are being turned down because they do not have a lot of cash on hand to make a down payment or they don’t qualify due to bad credit. This is creating an economic catch 22 where there isn’t enough money to lend to prospective buyers and there is a backlog of homes waiting to be sold.

While things probably won’t change in the short term, there probably needs to be some loosening of the purse strings and willingness to take on more risk by Freddie Mac and Fannie Mae to get more people qualified for mortgages. People will need to realize that no matter what, good credit and a lot of cash may be the order of business for getting a mortgage and buying a home today.

Value-Based Ratios

admin — Tue, 23 Jun 2009 20:41:49 +0000

There are a large number of different ratios in use, and this post presents a potpourri of some popular ones. The list is not exhaustive, as indeed only the imagination limits the quantities that can be used in the denominator. Two ratios that are relatively similar to the P/E ratio discussed in the previous post are :
Alternative Price-Earnings or Cash Flow Ratios Earnings can be deﬁned in a variety of ways:
with or without extraordinary items, diluted, etc. There is no right or wrong way: the goal is to ﬁnd a ratio that makes the comparables ﬁrm appear to be as similar as possible. For example, one measure of earnings is EBITDA (earnings before interest and taxes, depreciation, and amortization). The rationale is that accounting depreciation is so ﬁctional that it should not be subtracted out. But EBITDA has problems with leverage (interest expense) and capital expenditures—if you use it, please subtract these. Of course, if you do, you will de-facto use a price over cash ﬂow ratio, which can suﬀer from the shortcomings that capital expenditures are very “lumpy.” This is why we used earnings rather than cash ﬂows in the ﬁrst place.
Price/Book-Value-of-Equity Ratios This ratio is commonly used, and often abbreviated as the market/book ratio. It should not be recommended for valuation purposes. The reason is that the book value of equity is often close to meaningless. Accountants use the book value of equity to balance assets and liabilities, in accordance with all sorts of accounting conventions (such as depreciation). As a result, this measure is especially diﬀerent across ﬁrms with diﬀerent ages of ﬁxed assets (such as buildings).
However, sometimes neither earnings nor the book-value of equity are meaningful. For example, biotech ﬁrms may need to be valued even before they have meaningful, positive earnings. The idea is to substitute another, more meaningful quantity for earnings. In biotech ﬁrms, a better (but still very bad) measure than earnings may be the number of scientists. An analyst might ﬁnd that biotech ﬁrms are worth $1,000,000 per employed scientist. In principle, the comparables valuation method remains the same as it was when used with price earnings ratios. The alternative ratio typically still has price (either equity value or overall ﬁrm value)in the numerator, but a quantity other than earnings (e.g., sales or number of scientists) in the denominator. The analyst chooses comparable ﬁrm(s), determines an appropriate typical comparables ratio, and ﬁnally multiplies this comparables ratio by the ﬁrm’s own quantity to determine its value. This may work well only if ﬁrms are comparable enough among the chosen dimensions that application of the ratio of some ﬁrms to the ratio of others oﬀers a meaningful price.
Price/Sales Ratios This ratio is especially popular for industries that do not have positive earnings. Therefore, it was commonly used during the Internet bubble, when few Internet ﬁrms had positive earnings. Presumably, ﬁrms with higher sales should be worth more.
One problem was that ﬁrms, such as Amazon during the Internet bubble at the turn of the millennium, were known to sell merchandise at a loss. Naturally, it is relatively easy to sell $100 bills for $99! So, the more Amazon sold, the more money it lost—but the more valuable Amazon appeared to be. After all, with higher sales, the Price/Sales ratio suggested that Amazon would be worth more.
Price/Employees Ratio
This ratio is popular when ﬁnancials are deemed not trustworthy. Of course, it assumes that the employees at the comparable ﬁrm are as productive as the employees in the company to be valued.
Price/Scientists Ratio
This ratio is popular for upstart technology ﬁrms, which have neither earnings nor sales. One problem is that it induces ﬁrms to hire incompetent scientists on the cheap in order to increase their valuations. After all, ﬁrms with more scientists are presumed to be worth more.
Price/Anything Else Your imagination is the limit.
This latter set of ratios only makes sense if you compute them for the enterprise value of the ﬁrm (that is, the value of all equity plus the value of all debt). If you want to obtain the value of the equity, you should compute these ratios using the enterprise value, and then subtract oﬀ the current value of all debt.

Land Contract (Purchase Contract)

admin — Sat, 30 May 2009 18:35:54 +0000

The land contract, purchase contract, or contract for deed is recommended as a method of sale when the buyer does not have a sufficient down payment. It is an agreement whereby one party agrees to convey land to another party for a certain price, with the seller retaining legal title and the deed until some specified future date (for example, until all payments are made). Although legal title stays with the seller during the contract, equitable title passes immediately to the buyer. The land contract is becoming popular in several states among unrelated parties.
There are several variations in methods of payment under the land contract. Some are as follows:
• Fixed money price and fixed annual payments.
• Payment based on fixed amount of commodities each year. For example, the contract could specify so many bush- els of wheat each year. The value of the payment would then be determined by the price of wheat for that year.
• Fixed purchase price with yearly payment based on percentage of gross receipts. This method is sometimes used on dairy farms.
• Variable purchase price with variable payments. The payments could consist of a certain percentage of the gross income during the parents’ lifetime.
• Combinations and variations of the above may be worked out.
Advantages
• The purchase contract facilitates the purchase of a farm by a young buyer with limited funds. It is one of the few ways this can be done.
• The repayment schedule encourages a young farmer to build up equity during the early years.
• Some sellers like the purchase contract because of income tax savings due to use of the installment plan. Install- ment payments allow the gain from the sale to be spread over several years.
• An element of control is left in the hands of the seller.
• Ejection of a defaulting buyer under a contract for deed may be easier than a mortgage foreclosure. However, courts often tend to require similar procedures in each case.
Disadvantages
• The buyer has less secure title to the property, since it is an equitable title, but not the legal title.
• It may be more difficult for the buyer to sell his equity if, for health reasons, he wants to quit farming.
• If the down payment is small, the seller takes more credit risk in the early years of the contract than is taken by regular lending agencies that require a larger buyer equity.

Outright Sale, with Mortgage

admin — Tue, 19 May 2009 18:34:11 +0000

Use of a deed and a mortgage in combination is a common method of transferring the ownership of real estate between unrelated persons. The seller deeds title to the property to the buyer. The buyer makes a down payment and gives the seller a mortgage on the property to ensure payment of the balance of the purchase price.
Where this method is used in estate planning, the parents may for example deed title of the farm to the child and the child could encumber title by giving a mortgage back to the parents. This method should be encouraged, provided the child can make sufficient down payment. Often the child cannot; and, from the parents’ viewpoint, there are serious disadvantages when little or no down payment is required. Passing the title to a person who might have little incentive to increase equity involves some risk. In this type of situation, some authorities believe the child should pay at least one- fourth of the purchase price before the parents pass title. This amount could reasonably vary due to a number of factors.
Advantages
• Outright sale permits the purchasers to make permanent improvements on the land.
• A sale with a mortgage is a businesslike way of making the transfer. It is usually best to have the farm appraised to prevent family misunderstanding as to its value, especially if there is more than one heir.
• Equitable treatment of all the heirs can be separated from the problem of transferring the farm.
• The transfer may prevent the farm from becoming run down when owners become too old to maintain it properly.
• In instances where an estate tax problem exists, sale of the farm will set the value to be included in the estate for estate tax purposes.
• A sale to children makes it possible for the buying children to operate the farm during their most productive years.
Disadvantages
• The parents lose control over the property.
• The capital gains tax may be greater than the estate taxes would be. Selling by the installment sales method can be used to reduce the taxes. Installment sales must conform to certain restrictions.
• The parents may not receive enough for the farm. The parents often are tempted to sell for less than the market price; and, if their wealth is limited, this may later cause them hardships.
• If parents sell to one child for less than market price, conflicts may result with their other children.
• The estate cannot take advantage of current use valuation.

The Title Company at Work

admin — Sun, 08 Mar 2009 11:06:09 +0000

The title company is an integral part of the mortgage loan process. The title search and title insurance commitment certify that the borrower or buyer will truly own the subject property clearly and cleanly. To accomplish this certification, the title company will examine the ownership and lien records about the property:
1. Analyze the description. The title company will analyze the legal description to the property to ensure that the property actually does exist where it claims to exist. More to the point, the title will serve to assure the buyer or lender by confirming the subject property.
2. Trace the succession of ownership. The title company will also examine how ownership of the land has been transferred from the first legally recorded owner of the property down to the current owner. This is often called the chain of title. The title company will ensure that there were no questionable breaks or interruptions in the succession of ownership—which may jeopardize the real ownership status of the current owner.
3. Review the restrictions against the property. The title company will then review and report all unreleased restrictions against the property, such as recorded encumbrances, easements and liens. Once the title company has completed its search and examination of public records, it will describe its findings to the person or company who ordered the title search. The title company will then issue a commitment to insure its discoveries. The title insurance does not go into effect until the title insurance premium is paid, which usually occurs during the loan closing. In most mortgage transactions, the title insurance company usually issues two separate types of insurance coverage:

Owners policy. With most purchases, the seller will pay for this portion. With refinances, it is normally the buyer’s responsibility.

Lenders policy. With both purchases and refinances, the borrower will normally be responsible for the cost of the lender’s title insurance coverage.

The title insurance premium is a one-time charge and varies according to the title company. The title insurance protects the owner and lender against possible losses from title-related problems. For example, consider the hypothetical situation of a Native American tribe winning a claim in court that a person’s house is on top of their ancestral burial grounds and the court orders the homeowner to surrender the property. The title insurance would protect the homeowner by either (1) paying the tribe for the land or (2) paying the original mortgage amount plus down payment and losses to the current owner.

Local Records Office

admin — Sun, 08 Mar 2009 11:04:42 +0000

Throughout most of the United States, property titles are recorded and maintained by the local county government. The records office primarily records four title elements with every property:
1. Transfers. Whenever the property is sold or the ownership identification is altered, the records office will update the title ownership.
2. Liens. Claims against the property, such as mortgage, tax and contractor liens, are recorded against the property—with proper documentation that the lien can be recorded.
3. Restrictions. The ownership and use of the property can be restricted with legally recorded encroachments, easements, lease agreements and covenants.
4. Releases. Liens and restrictions against a property can be legally removed with a formal release, properly authorized by the lien holder or legal authority behind the restriction. For each instance of recording any of the above items, the records office will normally charge a recording fee. This fee will vary from county to county. For more information, see the “Recording” article in the “Real Estate In- Depth” section.

Claims

admin — Sun, 08 Mar 2009 11:03:32 +0000

Lenders and property buyers have the same concern with regard to the title. They want to make sure that it is clean and defect-free, or at least reasonably clear. Mortgage lenders and property buyers will seek to avoid all encumbrances that may affect their interest in the title. The first mortgage lender wants to be sure that it has the first lien position (after the real estate taxes) on the title; the second mortgage lender wants to ensure that it has the second lien position. Liens, easements, deed restrictions and other encumbrances against a property restrict how property can be handled, owned and transferred. Thus, if the property owner owes taxes or has defaulted on a loan, a lien for that debt can be recorded against the property. The “Marketable Title” article discusses this issue in depth. If the current owner does not or will not eliminate these liens, he or she may still be able to sell it. But it would be difficult. The new buyer would have to agree to accept the existing liens and encumbrances. If the new buyer will be using a mortgage loan to buy the property, the first mortgage lender will normally require that all liens be paid off before or at the closing. Claims against the property, such as liens, follow certain rules:

Legal recording of liens
Legitimate liens are legal regardless of whether they are recorded or not. However, liens will not carry any weight against the property unless recorded with the local governing authority, which is usually the county records office. Moreover, there are often time limits as to how long a unrecorded lien is valid and recordable. Anyone may record a lien against another person’s property, as long as the current property owner has legally agreed to the lien. For example, most home improvement contracts contain a clause allowing the contractor to record “mechanics & materialmen” lien if the home owner fails to pay the bills.
Order of liens
Property liens are normally recorded and satisfied in chronological order: “first come, first serve.” A first mortgage loan, for example, holds the first lien position against a property. A second mortgage loan is recorded in the second lien position. When a property is sold, all the funds will pay off the first lien debt; any funds remaining will then be used for the next lien, etc. The exception, of course, is the government. Taxes owed to the government normally take primary lien in effect, the government always cuts to the front of the line. First mortgages always want to be first in line—i.e., they want to have first lien. If other liens already exist when a homeowner applies for a first mortgage loan, the borrower must satisfy or subordinate the other liens.
Thus, if a homeowner has both a first and junior mortgage but refinances only the primary mortgage, the junior mortgage must be subordinated to the new first mortgage. The lien subordination agreement (issued by the junior mortgage to be subordinated) will then be recorded into the county records so that the new order of liens becomes official.