In my research the last few years about our late 2000’s financial troubles, time and again, I came across examples of persons or companies who were in good shape financially, but who went broke because they were suddenly required to pay a huge lump sum.
In the finance world, this is called a liquidity problem.
Roughly speaking, it is a way for people with relatively high net worths to suddenly lose everything. That happens when you have to make a lump sum payment but do not have enough cash to do so, so you have to start selling your hard assets—real estate, art, vehicles, and so on—at fire sale prices. Having to sell everything fast wipes out your life savings.
Selling slow is called an orderly liquidation. So having to sell fast could be called a disorderly liquidation. Disorderly liquidations wipe out the difference between normal market value of your assets and under-duress value.
Here is a list of such events. I hope readers will apprise me of others that I have overlooked. I strongly recommend that you absolutely refuse to agree to them:
• mortgage balloon payments; agree only to self-amortizing loans
• margin calls; these are demands for more cash or other collateral to guarantee a loan you borrowed to buy stocks or bonds or similar securities
• cross-default clauses in loan agreements; these say that a default on one loan enables the lender to demand immediate payoff of another loan
• due-on-sale clause in mortgage; you probably cannot avoid the clause, but you can usually avoid the sale; if you agree to such a clause, and cannot afford to pay off the entire mortgage at once; do not sell or sort of sell the property (for more on due-on-sale clauses see www.johntreed.com/dueonsale.html or my books Real Estate Finance Techniques, How to Buy Real Estate For Little or No Money Down, and How to Structure Your Mortgage.
• loan covenants that require you to maintain certain ratios like a debt-coverage ratio of 1.2 or a particular loan-to-value ratio; if you don’t, you have to pay off the loan in full immediately; typically, during a recession, yo would violate these sorts of clauses because of the downturn in your income and asset values
• withdrawals by investors; many businesses are organized as partnerships; many of those allow partners or investors to withdraw their money at any time or on short notice; they are most likely to do this just when you need them to be patient and wait for better times; prohibit such withdrawals except for long notice like five to ten years if at all; better still, prohibit withdrawals until the asset in question is sold off
I cannot overemphasize the importance of always being able to pay your bills and debt payments. The day you cannot, your creditors have the power to grab for your assets. That grabbing, and the resulting fire sales, usually make your assets worth far less wiping out your life savings.
That’s part of what I talk about in my books How To Protect Your Life Savings from Hyperinflation & Depression and Best Practices for the Intelligent Real Estate Investor.
