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Investments where you can win but you can’t lose, or where your winnings are unlimited but your losses are extremely limited.

Posted by John T. Reed on

Pennies and nickels

I have already discussed US pennies and nickels at length. They are made of copper and nickel and zinc so inflation causes the metal to rise in dollar value. Deflation can cause the metal in the coins to fall in value, but from a financial standpoint, the coins cannot fall in value below the face value amount engraved on them.
 

Mortgaged real estate

How about mortgaged real estate? In inflation, the dollar value of a house or other property rises in value. In deflation, it falls in value. But suppose you have a mortgage?
 
You do not want debt in deflation. It is a killer. In inflation, having a house with a mortgage is a great deal. A free-and-clear house will rise in dollar value in inflation, but the purchasing power of the house may be unchanged. Its real (adjusted for inflation) value will stay the same. It’s nice to not lose, but this article is about investments where you can win, but not lose.
 

Make out like a bandit

In inflation, you make out like a bandit with a mortgaged house. The real value of the house goes up, which as I just explained is okay, but not exciting. But the real value of the mortgage FALLS. That IS exciting.
Say you buy a $300,000 house 5% or $15,000 down. Say it rises in dollar value 20% in inflation. That increases the house value to $360,000. So your $15,000 turns into $75,000 equity. That is a WIN, not just staying even.
 
But suppose there is deflation? If you have to pay the mortgage, it will likely crush you to bankruptcy. What do I mean if you have to pay the mortgage? Sometimes you do not have to pay it.
 

Non-recourse

First, there are nonrecourse mortgages. Those say that if you do not pay, the lender can foreclose, but they cannot go after your other assets or income. That is what non-recourse means and it is what the lender explicitly agreed to. Nothing immoral about invoking that agreed-upon condition.
 
Some may say well, it may be legal, but it will hurt your credit and it is dishonorable. Bulls***! That is true of a recourse mortgage, but it is not true of a nonrecourse. When you get a non-recourse mortgage, that is the deal. For the lender to complain about it, is dishonest on their part. They agreed to it.
 

Affect your credit?

After we deeded two apartment buildings back to the lenders in the savings & loan debacle in the 1980s, my wife and I refinanced our house. I wrote an article about the deeding back titled “Won’t that affect your credit?”

The answer was we had to pay 1/4% more for two years because one type of lender had a two-year rule about having a deed in lieu of foreclosure on your record. We could not use the other type of lender because my wife was a bank examiner then and she could not borrow from the type of lender that had the lower rate because she examined those banks. So the deeds in lieu would NOT have affected our credit at all if my wife had not been a bank examiner. In the event, we had to pay 1/4% more for two years, near meaningless. The question on a mortgage app asked, “Have you been foreclosed or given a deed in lieu of foreclosure in the last two years.”
 

No shame; just business

The lender may try to shame you about walking away from the loan. FHLMC gave me a partly recourse, but mostly non-recourse loan on an apartment building. When the savings-and-loan debacle happened in the 1980s, the value of the apartment buildings dropped to half the mortgage and the cash flow of each went $33,000 a year negative.
 
I paid the recourse portion of the mortgage and never made the slightest hint of not paying or renegotiating. But I told them I wanted to cancel the non-recourse portion by deeding them the apartment building. They refused to take it.
 
I said, “Well then, I will just stop paying the nonrecourse portion of the mortgage. I will put all the rent in a checking account and pay the operating expenses and give you the total in the bank account when you stop being stupid and take the property.”
 
They howled and threatened me. “With what?” “We’ll foreclose.” “Oh, really. And since the property is worth less than the mortgage no one will bid and you will end up owning the property. I will give it to you now for free. If you foreclose, you’ll have to pay legal fees and delay getting the building for months.” They said they would sue me for the legal fees. I said, “And I will tell the judge that I offered you the apartment building before foreclosure so the legal fees are a self-inflicted wound.”

They finally agreed to accept the building from me. I paid every penny of the other $95,000 that I owed recourse with interest. Never was late with any payments and paid it all off ahead of schedule.
 

Distressed Real Estate Times book

I lost about $200,000 on that property which I bought for $600,000. But as painful as it was, that was a limited loss, There was no upside limit if if we had normal times. I wrote a book about the two apartment buildings I owned and deeded to the lenders then: Distressed Real Estate Times.
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Anti-deficiency judgement and one-action rules

So how do you get non-recourse mortgages? In CA and AZ, all purchase-money, conventional, principal residence home mortgages are non-recourse because of a state law called the Anti-Deficiency Judgment Statute. A number of other states have similar laws like the “one-action rule” which says they can take the house or just go after your income and other assets but not both.
 
 

Seller mortgage

If the seller takes back a mortgage, he can and may agree to make it nonrecourse.
 

RAMs

The misnamed reverse annuity mortgage (RAM) called a Home Equity Conversion Mortgage is an FHA non-recourse mortgage. AAG advertises one a lot on TV with Tom Selleck. You can take the loan proceeds in the form of a lump sum, and you should, you can then put the cash into inflation hedges or two-way assets (like a free-and-clear house). If there is deflation, you can walk away from the RAM and owe nothing on it.
 
Or you can keep living in the house as you would have during the depression. Not only is the mortgage non-recourse, they cannot foreclose. You get to live there as long as you want. The loan only has to be paid off and only from the proceeds of selling it, when you die or move out for a year. You can also sell it yourself if it appreciates and you want to move. The lender gets their principal and interest and you get to sale proceeds above what is owed to the RAM lender.
 
The mortgage also has NO MONTHLY PAYMENTS! If they ever sell the house when you die or move out for a year, any sale proceeds above the mortgage loan balance go to your heirs or you.
 
Like I said, you can win, but you cannot lose. If there is inflation, you get 100% of it. If there is deflation, you have no payments to make and you can live there until you die with no rent or mortgage payment.
 

Unlimited homestead exemptions

Then there are the states and a territory with UNLIMITED HOMESTEAD EXEMPTIONS for your principal residence if you go bankrupt. They are AR, DC, FL, IA, PR, SD, TX. In those states and PR, you can go bankrupt and keep your home equity. There are acreage limits, but they are large. For example, in TX, you urban area home can be up to an acre and your rural home can be 200 acres for a family.
 
So in effect, conventional principal home mortgages in those states are non-recourse if you file bankruptcy or are forced into an involuntary bankruptcy by your creditors. I am not sure, but I suspect FHA and VA mortgage lenders may be exempt from the homestead exemptions. They ARE exempt from the anti-deficiency laws in CA and AZ.
 

Insolvent = non-recourse

Finally, suppose you have a mortgaged home, but you do not have a pot to pitch in, and you are unable to make the payments, there are no other assets or income for the mortgage lender to go after. That is a non-recourse mortgage as a practical matter if not a legal matter. You can’t get blood out of a stone.
 

No gain from forgiveness if you are insolvent

There is actually a federal income tax law that says if you walk away from a mortgage when you are insolvent, you do not have to pay tax on the gain. If you are not insolvent, you do have to pay tax on the difference between the mortgage balance, which is considered a sale price, and your basis which is generally your original cost.
 

High-leverage home purchase

Generally, the formula where this would be most attractive would be if you bought a principal residence with, say, 5% down. If it goes up in value, you get 100% of that appreciation. If it goes down in value or you cannot make the mortgage payment for some reason, you will have to move out (unless it is a RAM). If it is nonrecourse, you will lose any equity you have or had, but no more. If you are in one of the unlimited homestead exemption states or PR, you can even keep the equity if you go bankrupt.
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One US court said that a non-recourse mortgage on a no-money down purchase is, in substance, a call option. A call option is the right buy a property for a fixed price for  certain period of time. In this case, the option price would be the amount owed on the mortgage. If the property in question goes up in value, you exercise the option by paying the mortgage payments on time. If not, you can walk away from a true call option losing only the price you paid for the option. You may not be able to walk away from a 100% mortgage.
 
You can win an unlimited amount, but your losses are zero in the homestead-exemption states and PR, and limited in the other states.
 

No prepayment penalty good deal

There is also a “you can win but you can’t lose” clause in the typical home mortgage. That is, the interest rate is fixed and it cannot be “called.” In corporate bonds, if the interest rates fall, the borrower can pay off the loan early—refinance to take advantage of the lower market interest rates. The lender or bond owner cries the blues when that happens.
 
But there is no prepayment penalty in home mortgages. That means if interest rates drop you can refi and get the benefit of the lower rates. But if market rates go up, you get to keep the loan until the 30 years are up. In that case, the lender cries. It is heads the lender loses; tails the borrower wins.
 

US bonds

That is also the case with US government bonds. The government cannot pay them off if rates fall except at a big prepayment penalty that equalizes the lender/bond owner’s loss of the high interest.

 

Must be government here somewhere

These asymmetrical unlimited gains, but limited loss situations are stupid for the counterparty—the guy on the other end of the deal. Who would be so stupid?
 
The government. If you read carefully, you will find that the counterparty or regulator or legislature is giving you an asymmetrical deal in these examples is the government.

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