MONEY 8 - REAL ESTATE #3

THIS IS MY EIGHTH POST ON UNDERSTANDING MONEY TOOLS

Money! Money! Money!  Now let’s discuss some basics of industrial real estate.  We will break this category down into two types, light industrial and heavy industrial.

Industrial real estate is down the totem pole in real estate from commercial that we have talked about already.  Most cities with proper planning have designated areas for light industrial and heavy industrial, being away from residential areas and many times tucked in behind commercial/retail or on its own where it can’t be easily visible.  There are examples where cities wish they could plan all over again.  A good example of very little transition in zoning is in older Houston.  You have prime River Oaks and close by mixed zonings.  I have seen this in some towns including the Mid-West where you have commercial, then residential, then industrial and then back to residential as they didn’t think ahead and plan for town/city expansion.

Industrial is also associated with transportation, manufacturing and storage.  With transportation to and from these sites extremely important these zonings are common to railroad lines and road arterials, state and interstate , highways for trucking access.  These days well planned cities also require an industrial park to be set back from the road, and many times landscaped nicely with an attractive entry.

Light industrial is clean, no manufacturing/processing and normally has an office in conjunction with warehouse for assemblage, storage, etc.  Rents per square foot are considerably less than commercial for obvious reasons, the income per square foot generates far less.  Light industrial usage can include, pool supply companies, small newspapers as most have gone to paperless, auto body shops, mini-storage units, etc.  This type of industrial creates less noise, less light disturbance and less traffic than commercial/retail and it is more destination types of businesses.

Heavy industrial will be in city designated areas at even a lower level of real estate.  This has manufacturing as well as distribution.  The Environmental Protection Agency watches the pollutants carefully.  When buying a property that has, or has had known heavy manufacturing make certain soil tests are completed.  If the soil is contaminated the EPA can hold you, the owner, accountable for cleaning the dirt, and that cost is not easily determinable.  I have seen several properties that are not salable because of the question of costs and liabilities are not definable.  The government can hold any past owners liable going back to the original grant for the land.

Financial analysis for these properties is basically the same as we previously discussed in commercial.  It’s all about location, age, quality of the building and construction, and cash flow.  One difference in analysis would include looking at cubic footage rather than just square footage.  If a building has 30 foot ceilings it is perhaps more valuable than a building with 20 foot ceilings.  The same with loading docks, and other requirements for today’s higher standards for shipping, computer usage/electronics and storage.

As with all real estate, don’t forget the real estate broker representing the sale of the property represents his client, the owner, and is trying to get the highest price for that person or entity.

MONEY 7 - REAL ESTATE #2

THIS IS MY SEVENTH POST ON UNDERSTANDING MONEY TOOLS

Money! Money! Money!  Let’s talk about commercial real estate and investing in that industry.  Books can be written on the subject, therefore we will only touch upon the investment.  We will look at existing property  versus new builds. Commercial real estate comes under the “C” designation of municipal zoning.  There will be a number after the “C” as to what is permitted and each city might use a different designation.  Commercial/retail can vary from a small one unit building to a very large shopping center. 

The big property owners including Real Estate Investment Trusts (REIT’S), many of which are publicly traded stock companies, want the large properties.  There is also economy of scale. All costs of operating a company need to be amortized into their holdings.  One type of real estate ownership would be to buy publicly traded stock in a REIT.  It can be a nice diversification in a stock portfolio and many times yield a return higher than corporate stocks. However, in weakened economic times vacancies will play a big part, thus lower revenues and lower values to the fund,  and yields will come down.

As with all investment real estate the larger properties having more tenants spreads the investment risk with vacancies.  Also, economy of scale comes in with property managers, maintenance, city tax benefits, bank financing, etc.

When buying a commercial building it is best to work with experts in the field, e.g. real estate agents who specialize in commercial property. As with all real estate purchases consult with a lawyer who specializes in real estate law….best money spent! If you are not a cash buyer, consult with your bank on financing possibilities ahead of time.

Now, let’s look at age of building.  Old buildings may be sold because they have been depreciated on the books and an accountant has advised a sale or trade of the property.  The possible benefit of a trade is that taxes are deferred to a future date of sale.  If you think capital gains taxes will be going up, it is probably wise to pay taxes now (long term Federal capital gains tax is 15%).

Is the property needing work and has general maintenance been neglected?  Use a well-known contractor for an inspection report before buying.  Do a market report for yourself or have one done.  This would include demographics of population growth or decrease, traffic count, income levels of people, growth of residential living to bring more buyers into area, etc. Is there an anchor or major tenant?  Lease expirations?  You want a balance of leases coming up for renewal.  A person should also look at the balance of types of stores, what industries do they come from, are they small owner operated or national chains. Try not to overlap, or offer that a tenant has exclusivity against other competitors coming in.  For small stores seeking to be a tenant, or if you are buying the building ask for the retailers Dunn and Bradstreet (D&B) or ask the realtor representing them.  Also, obtain a credit report on the owners of the small stores.

Most stores have a national association that will release or discuss the norms as to what a store is capable of paying per square foot in relation to gross income.  It is better to decline a tenant than end up with a vacancy needing a lot of refurbishment and an eviction of premises.  Here is an example of square footage to gross rent. Let us assume that a tenant’s rent should be in the 10-12% of their projected annual gross sales income, and the tenant believes the store can gross $250,000.  He only needs 1,000 square feet.  You can be comfortable in this illustration charging rents of about $20./square foot.

Most retail stores will need a build out to their specifications.  Most owners allocate a certain dollar amount up front to assist the new owner, this may include drywall, electrical, plumbing, lighting, etc.  Make certain that everything is done under construction code with the city or county.  Require a copy of the contractor’s Workman’s Comp Insurance and Liability Insurance. Retail stores will also need storage area for inventory which can be very utilitarian.

In today’s lower market rents in some areas of the country I have seen people buy buildings, especially small medical buildings, and the owners cannot afford the cost to build out the space for a tenant.  I know of one dental building, space for two operations within the structure.  A build out of one side would cost about $70,000 for a doctor or dentist and the market rents are only in the $15./square foot range.  In this case, they are sitting with empty space until the market returns as the economics aren’t there.

There are several types of leases for tenants.  One common lease is a triple net where the tenant pays for most of the build out of the space to their specifications, electric, air conditioning, (unless it is common interior), and a percentage of exterior maintenance expenses inclusive of real estate taxes (the latter here known as CAM charges or common area maintenance charges).

There are a couple commonly used methods for quick financial analysis on commercial properties, these being determining a capitalization rate (CAP rate) and the other being a gross rent multiplier number (GRM). To determine a CAP rate:

1)    Find properties that have sold in the area and an average comparable, or the value of said property

2)    Obtain net operating income.

3)    Divide the net operating income by the estimated value of property.  The result is the cap rate.

Illustration would be:

-       Net operating income: $33,000

-       Value of property: $500,000

-       $33,000 divided by $500,000 equals .066 the cap rate or 6%

This is the projected return on investment for one year on a cash on cash basis. If there is a mortgage in this case the net income would come down and the CAP rate would adjust accordingly.

To determine a GRM or gross rent multiplier:

1)    Determine the value of a property

2)    Divide the property value by the annual gross rent. The result is the gross rent multiple.

Illustration would be:

-       Value of property: $500,000

-       Annual gross income $70,000

-       $500,000 divided by $70,000 equals 7.1 the GRM.

Conversely if you know the gross rent multiple common to an area, let’s say this 7.1 and the gross rent of a building is $70,000 then the asking price or value of a property should be about $500,000.

There are other ways of determining value:

-       Price per square foot on a general market basis

-       Replacement cost basis if the property is fairly new

-       Internal rates of return

-       General market value, but this is most common for residential properties

MONEY 6 - REAL ESTATE #1

THIS IS MY SIXTH POST ON UNDERSTANDING MONEY TOOLS

Money! Money! Money!  Let’s talk real estate.  This is a broad topic. We will cover it in several pieces and only the basics,  hopefully make some sense guiding you to better investment decisions.

I’ve been in the real estate arena in almost all aspects and I can tell you the industry “ain’t” rocket science, but it does have fundamentals that if followed can cut risk. In my opinion two of these is money and it’s availability at a low interest rate, and market….location, demographic changes, etc.

RESIDENTIAL REAL ESTATE:  Most people think of their home when it comes to this type of real estate.  It will be, to most people, the most expensive decision you make.  Residential real estate means living within the improvement so can encompass single family, duplexes/flats, and multi-family such as apartment buildings and conversions of large homes to serve more than one family under the same roof. Land or lot costs can vary greatly depending on area, location, desirability, demographics, etc.  Construction costs can vary greatly, too from well under $100/sq. ft. to over $1,000 sq. ft. for top luxury.

Single Family residences are either new homes, including custom build, or resale homes. After the “go, go” real estate years of 2003-2006 we fortunately have for the most part better quality companies remaining who stand behind their new home builds. You might pay a bit more for a new home, but you have new home warranties, a contractor who can go over things as the home is being built, have selection of interior and exterior custom changes you want and higher energy efficiency.

New home builders many times offer buying incentives for using their mortgage lending company and for options within the home. During the past 6 years there have been so many acreage/lot bankruptcies that new home prices are not much higher than foreclosed upon homes owned by banks without any warranties.  Part of this is because the builders remaining in business today are buying foreclosed lots from banks at about $.20 on the dollar and passing that savings on to you, thus you are paying mainly for the construction of the home (referred to as the improvement on the land) and not the land development costs.

If buying from a bank and the property was a foreclosure or short sale, there are no warranties, and don’t be surprised if you need to put money into the property after you take ownership.  Definitely get a real estate lawyer involved early on in the transaction.  As far as all real estate transactions go they must be in writing and it is highly recommended to be advised by legal counsel. Also, have the property thoroughly inspected by a reputable company that has been in business for a good period of time.

Many areas have Home Owners Associations, and there are pros and cons to being in one.  When the property was developed unless very old, the developer most likely needed to file with the county a “Public Report”.  Best to review that instrument.  If a condominium or townhouse purchase review the “CC&R’s” and “Declarations” for the association.

Trends:  Residential real estate has changed the past 6 years. As you are aware we started the decline in real estate in about 2006.  Prior to that we had large builders wanting tracks of land to develop in California, Arizona, and Florida of 1,000 acres and more.  The demand from baby boomers wanting to retire in warm climates created this demand along with easy financing.  “Let’s get in before things go up more” theory, and commodity prices were rising.  Those days are gone.  Now, even the large companies want small developed lot projects and are scouring the banks for bankrupt land, especially developed lots.  They want to get in and out, and limit risk. When commodity prices were rising, and home values appreciating quickly, people wanted large homes, in some places 6,000 to 15,000 sq. ft. 

Now days, baby boomers are concerned about having enough money to retire and there is deflation/devaluation in home prices so I don’t see the desire or want in the future for large homes.  Large, expensive homes have high real estate taxes, a great deal of maintenance hassle and related costs. You will always have a small segment where the expensive home is in want, but right now that is mostly confined to New York City with many foreign buyers, some in Washington D. C. and California where you have pockets of great wealth.

Also, the next generation down is struggling for employment and with interest rates expected to be low until 2015 and a poor economy that generation wants a more practical home. Families are smaller today.  Adding to this is mortgage financing.  We went from easy financing to very difficult financing and tons of paper work to support each loan.  The Federal Reserve printed money for QE 1, QE 2 and now QE 3.  This significant amount of money was to assist the real estate industry, the largest industry in the country, however the money has gone to the largest of banks and they have invested the money to make profits for themselves and their stockholders, and not given proportional aid to US homeowners, nor allocated a large amount to the real estate industry.  In addition, American wages are currently at a 50 year low as a percentage of our Gross Domestic Product. Inflation is running at a higher rate than our increase in wages, therefore people have less money to spend on housing. Thus, with all this printed money very little is in circulation helping our gross domestic product and our middle class and small companies and businesses.

Duplexes/Flats are two residential units within one structure. They can be side by side or many times in the Midwest referred to as flats stacked one on top of the other, each with a separate entrance.  Many people buy these for investments either to rent both sides or live in one side and rent out the other side, producing income and helping on a mortgage.

Anytime you rent out real estate you must depreciate the property from an accounting tax standpoint.  There are different depreciation schedules and this is where you need to be advised by an accountant.  With depreciation you take a tax deduction from income on a Schedule E Form for that year, however the case with all real estate you then need to “recapture” that deduction when you sell the property hopefully for a gain and pay taxes on that increased amount.  For instance, if you bought a $100,000 property and you rent 1/2 of it ($50,000) must be depreciated. If you select a 30 year straight line amortized depreciation schedule that would be $1666.66/year, ($50,000 divided by 30). At the end of a 5 year period your cost basis in the duplex after depreciation is $41,667 for the portion you rent ($1,666,66 X 5 equals $8333. subtracted from $50,000) plus the side you live in, $50,000 or $91,667 adjusted cost basis. 

You may want to run a business out of your house or home office and expensive that square footage as a percentage of the entire square footage. Keep good tax records of these deductions as that amount lowers the cost basis in your home and you will need to recapture that when you sell the house and pay taxes on it. A benefit here is that long-term capital gains tax for holding assets in excess of one year is 15%, versus perhaps a higher ordinary income tax. 

One drawback from renting a duplex and relying on the income is that one or two months of vacancy really hurts cash flow. You are only spreading the loss of rental risk to one unit.

Some counties and municipalities have a tax on rental income separate from income taxes.  Best to check, or have your lawyer or accountant advise you before purchasing.

Multi-Family Residential has been a strong industry through our recession years.  As people have been foreclosed upon, done short sales and walked from homes their credit has been hurt and yet they need a place to live, thus renting. For buying this type of investment property like all real estate, location, location, location is all important.  Buying around hospitals and schools can be good. Risk/reward for student type housing.  The students you rent to may be harder on the property, but incomes are normally higher.  Purchasing near hospitals is usually good as you have a solid employment base of administrators, nurses, doctors, etc.

One last comment:  There is no “free lunch”!  Buying real estate is easy, but maintaining the property, placating to tenants wants and needs, the maintenance costs all can be wearing. With economy of scale you can have a management company manage your properties, but that also lowers your return on investment.  Real estate is not very liquid in most cases, like stocks, and hitting a bad market may place you in a position where you need to hold the real estate for several years before you can sell.

I have found that on a “cash on cash basis” and properly maintaining a good property returns are about the same as most conservative investments, or perhaps slightly higher.

MONEY 5 - FINANCIAL STATEMENTS

THIS IS MY FIFTH POST ON UNDERSTANDING MONEY TOOLS

Money! Money! Money!  When you are looking into a company to invest in or talking with an investment advisor it might be good to have a very fundamental understanding of an income statement and balance sheet.

An income statement/profit and loss statement gives you an idea of how the company is performing income and expense wise on a monthly or yearly basis.  Let’s look at the very basics with an income statement and balance sheet. With a balance sheet you have assets of the company and its liabilities. The assets must equal liabilities plus shareholder equity.

Income Statement:

The first line will be Gross Sales or Revenues

Less cost of goods sold (material costs/expense item if buying goods from a manufacturer as retailers do)

Thus, we get to Gross Income

Now, we need to deduct all expenses for running the company including, but not limited to, salaries, rent/mortgage expense, marketing/advertising, bank financing charges, entertainment, travel, hotels, rental cars, leased cars, etc. etc.

Then, bottom line we have net earnings profit, or loss pre-taxes.

Balance Sheet:

The first part contains the assets of the company including cash, machinery, real estate, accounts receivables, etc. etc. Tally up all assets.

Then, you have liabilities, and they are broken apart into long term and short term.  Liabilities are obligations of payment, or debt, like accounts payables, lease obligations, mortgage, etc.

Short term obligations might be a problem for a company if cash on hand is short and bank borrowing is not available, as is common in this current economic market.

Then, you have shareholder equity.

Again, the total of your asset column needs to equal all liabilities plus shareholder equity.

Now, let’s take a look at some other useful techniques for analyzing companies. 

1)    Price to earnings ratio (P/E Ratio) is one of the most common as you can then compare the ratio to other possible stock purchases or historical averages of the stock market in general. To get this ratio merely divide the price of the stock by the earnings, if there are positive earnings. There is also a PP/E or projected price to earnings ratio, that analysts have come up with projecting what should happen financially to the company.

2)    Liquid asset test.  Divide the assets by the liabilities and you will get a ratio.

3)    Beta test.  The beta of a stock is a number determined by several factors given out by analysts.  A beta of one is the average or a baseline determined from many stocks (e.g. S&P 500). A number higher than one is more volatile and thus a higher risk.  A number lower than one is less volatile and more conservative, less risky. These numbers are based upon past performance and don’t necessarily reflect future performance.

4)    Alpha test.  The alpha number is what a portfolio manager adds to the investment performance including mutual fund managers. This may also be used in a particular industry sector.  Similar to a Beta test one is used as a baseline, less than one, less volatility; and more than one, more volatility. As an illustration a 1.2 Alpha for a portfolio would be 20% more volatile than a portfolio reflecting a 1.0 Alpha.

5)    Standard deviation.  This is similar in ways to a Beta test.  It is a statistical measurement of how far a variable quantity moves above and below an average price.  The wider the range over a given period of time, the greater the risk.

6)    Sharpe Ratio.  Created in 1966 is the Sharpe ratio another tool for measuring risk in investments.  It is not used and referred to as often as the above tests.

7)    Company capitalization.  To determine a company’s financial size.  This is determined by multiplying a company’s outstanding shares of stock by the market price of one share of stock.

Next we will head into other types of investments and start off with real estate.

MONEY 4 - STOCKS

THIS IS MY FOURTH POST ON UNDERSTANDING MONEY TOOLS

Money! Money! Money! Where do we buy stocks?  As we talked about previously, the Glass Steagall Act regulated more closely the financial industries and kept each type separate.  This Act disintegrated over a 20 year period from the late 1970s until 1999. Institutions within the financial industry all started looking the same.  The insurance companies, commercial banks, trust companies, brokerage firms and others provide similar services.  It’s the Walmart mentality that has occurred with the “financial big companies” drowning out the little guys and family businesses.  The little guy can’t afford the expenses.

Let’s discuss the management of your money in stocks.  Fee based money managers are many times preferred as their income doesn’t grow unless your portfolio grows.  Some money managers have a larger minimum account to open, let’s say $500,000 or more. 

At work you might have a 401-K Plan or one of the ERISA retirement plans that offer “mutual funds”.  A mutual fund spreads your investment risk amongst a partial ownership of many stocks, and you can even select what types of stock investments you want, e.g. higher risk when you are younger and won’t need the money for years, but perhaps will have greater growth, mid or large cap stocks, higher yielding stocks, or perhaps stocks that do good for humanity, oil and gas, high tech, foreign stocks, etc. 

There are many types of “sector” stock funds and you should work with a counselor or broker when making these selections. These sectors may be global stocks, a particular industry, “green” companies, companies that help people, etc. Mutual fund fees also vary and that should be considered although history and performance of the fund is most important.

Bonds and bond funds are another investment opportunity.  These instruments are safer with lower risk, very appropriate for troubled economic times and older people. Portfolios for older individuals might hold 50% or more in various bonds.  Nothing is 100% safe! A bond is an instrument of indebtedness paying an interest rate, versus a stock that perhaps pays a yield.  In the risk pecking order bonds are the safest, preferred stock next and then common stocks. There are different types of bonds, the most popular being Federal, State, County, City (municipals) and corporate.

How is risk created on these?  Default is one and interest rate fluctuations number two. If you need to go to the secondary market to sell the bond before maturity it will sell at market value.  US Bonds have the least risk. The US government stands behind the bonds and can print money or increase taxes if needed to pay off maturing bonds, therefore the interest rate is the lowest. Most US bonds are 10 to 30 years in duration.  Shorter term instruments of US indebtedness are Treasury Bills (up to one year in length) and notes from one year on as a mid-range investment vehicle.

If interest rates go up and you need to sell your bond, you may not get face value for the bond, but a lesser amount equating to what interest rates are going for.  Conversely, if interest rates go down and you hold a bond that pays a higher interest rate, your bond is worth more than face amount.

There are different types of bond funds.  Two of note is an open end bond fund and a closed end bond fund.  If you think interest rates will go down, buy a closed end fund as the value of the fund will go up.  This type of fund is closed and will not add to the bonds thus lowering the overall interest rates. If you think interest rates are going up, buy an open end bond fund as the fund will keep buying new bonds into the portfolio at higher interest rates.

Corporate bonds are issued by corporations to raise money. Like any bond there is risk that the company will be able to pay the interest on the bond and then the face value upon maturity. Most bonds are also “callable” which can disturb your financial planning.  If interest rates go down, corporations and municipalities may call their bonds in and pay off the bond, and then refinance the debt at a lower interest rate. Of course, brokerage firms are all too happy to assist as they make fees in so doing.  Like stocks you can buy bonds through your broker or bank.

You can obtain ratings on bonds from objective independent companies like Moody’s and Standard and Poors.  Bonds are rated with classes of A’s and B’s down to “junk bonds”.  The less risk and higher the rating the lower the interest rate.

MONEY 3 - STOCKS/INVESTMENTS

THIS IS MY THIRD POST ON UNDERSTANDING MONEY TOOLS

Money! Money! Money! We are going to explore investments in common stocks and the various aspects of “investment tools”.  In this article we will touch upon only a few parts, and then we will continue in future articles.

The first US stock exchange is dated back to our founding fathers and good, old Ben Franklin. Common stock is a vehicle in which a person can own part of a business or company.  There are several types of stock.  Some stock ownership is private, some can be bought and sold with easy liquidity, some is restricted and cannot be sold or must be offered back to other owners in the company.  There can be preferred stock, different classes of stock, stocks that render a dividend yield, small, mid and large cap stocks, and more.

Why does an owner of a company offer stock?  Money!…. to raise money for operations and growth, or to sell the company.  Most people think of publicly traded stock when talking about stocks in general, perhaps over lunch or dinner. Why would people want to take their company public and incur all the expense to go public, ongoing expenses and lose total control?  Money!  A private company if sold might fetch 2 to 3 times earnings while a public company’s stock might trade for 15-100 or more times pre-tax net earnings. 

Let us concentrate our focus here on publicly traded companies and learn a bit about how this all happens.  When incorporated a company authorizes a certain number of shares of stock by the Articles of Incorporation and then issues a certain number of shares from there to shareholders.  This may include shares for employee stock options.  The third stock is treasury stock typically held by publicly traded companies.

When a company “goes public” with an “initial public offering” or “IPO” it does so with an investment banking firm, (stock brokerage firm).  To this point they believe they have something of value to offer people interested in investing and hopefully make money.  They must go through a “due diligence” process controlled by state and federal regulations, and this needs to be done under time constraints to insure that the financial numbers, members of management, board members and material facts are current. Sometimes companies put several of their asset holdings together under one umbrella to go public, this being called a “roll-up”.

When it is time to go public so that a company’s stock can be traded freely, the process has been managed by an investment firm referred to as the “managing firm”, they will be a market maker, hold stock in their house name and select other firms to be market makers for the stock.  The managing investment firm has selected which “exchange” to be traded on, the most familiar being the New York Stock Exchange and the NASDAQ. 

The asset value and stock price plays a part of which exchange the company will be accepted on and also the company’s industry.  For instance many of the high tech companies are on the NASDAQ.  For small cap stocks including stocks trading below a certain price there is the “penny stock” exchanges and these stocks are “pink sheeted”.  The risk on these companies is much higher.  The price per share of stock can be very low such as a few cents.

Now it’s time to “go public”.  The managing brokerage firm has to date attempted to sell larger blocks of stock to institutional buyers. Then, each stockbroker within a firm has offered the stock to clients, larger clients getting a priority on the amount available to them. After this “IPO” the trading of stock is done in the “secondary” market place, and the market will dictate the price at any given time.  The corporations normally have a public relations firm do ongoing press releases.

MONEY 2 - STOCKS

THIS IS MY SECOND POST ON UNDERSTANDING MONEY TOOLS

Money! Money! Money!  Now, we are going to continue on our venture into the financial market and try to gain a better understanding of the system, then in a following blog we will go into simple analysis. 

Within the realm of common stocks there can be classes, for instance a Class A and a Class B.  An illustration here is one class might have limited voting abilities and the other class full rights.  Another type of stock is Preferred Stock.  This stock is right behind corporate bonds as to hierarchy in the financial position, perhaps receiving a guaranteed dividend at a higher yield than the common stock.  Whether a company pays a dividend or not, or the amount is not necessarily related to how the company is doing, but more in line with it’s objectives.  A dividend is the decision of the Board of Directors. Some companies like Microsoft are sitting with billions of dollars being managed short term with the goal of having plenty of money on hand to purchase other companies if they wish, and yet financially they could pay much more in dividends.

We are familiar with the New York Stock Exchange, NASDAQ and Penny Stock Exchanges, but there are stock exchanges in countries all over the world. Also, our large investment banking firms have offices in many of these countries to offer our products and to assist in selling local stocks. The regulatory body for the US exchanges and licensing is the Securities Exchange Commission (SEC).

Let’s focus on how to buy stocks.  There are several ways to buy publicly traded stocks, most common are from stock brokerage firms, banks, trust companies licensed to do so and some corporations permit purchasing their stock directly without a commission involved. Brokers make their money mainly from commissions on a trade, buying or selling.  Some brokerages salary their employees so that commission incentives don’t sway the decision making process. Brokers and financial advisors sometimes receive what is called a 12b-1 fee, or “trailer fee” as part, or all of their commissions.  This is paid to the investment firm on an ongoing small percentage of money under management from a money manager, and usually on a quarterly basis. If the money manager does very well for a client the broker will receive a growing amount of money as the fee is based on a percent of the portfolio.  All parties to these trade transactions must be licensed in all states in which they are doing business, and it is strictly regulated.

Buying an “even lot” of shares, normally 100 shares at a time may have a lower commission than buying an “odd lot”, a number of shares different from exactly 100, especially if a person buys only a few shares, the commissions from a stock broker may be a high percentage of the overall costs.  Discount brokers or buying on our own over the internet with a brokerage house may be the cheapest and best avenue especially if you don’t need a broker’s advice on purchasing.

Regarding common stock there are two main ways to transact trades, buying a long position and selling a short position.  Normally, we think of buying a stock, this is a long position, and the stock certificate can be delivered to the person buying or it can be held in “street name” such as a brokerage firm and in the name/account of the buyer. You buy the stock because you believe it will increase in value. 

Another way to transact business is to sell a stock “short”.  You believe a stock is going to lose value and go down in price.  With this transaction you are selling stock you don’t own, but the brokerage firm owns in their name.  If the stock goes down you make money on “paper” and then you “buy” the stock when you deem it to be a price you are happy with. Of course, if you bet wrong and the stock goes up, the brokerage firm will want more money to protect the position of loss you are in.  In regard to this it is noteworthy that fear is a stronger emotion than greed, therefore the stock market and stocks will go down quicker than go up, however over the long term optimism has prevailed and the stock markets have risen. Staying power is important.

Stocks also have an options market.  Similar to the above only called differently are option “calls” and “puts”.  With an option you are paying an amount of money to have a right to exercise the option to buy/sell a certain amount of stock at a certain price point at a future set date in time.  Prior to that date you can sell your option.  A  “call” is buying an option on a stock at a certain price and being able to either buy that quantity of stock for that set amount within a time frame, or selling the option as it has increased. A “put option” is just the opposite, you believe the stock will go down and that is your position.  You make money if the stock goes down and the option reacts accordingly within a certain period of time. It is of note here that option prices don’t necessarily parallel the actual movement in the price of the stock. An option is normally on 1,000 shares of a stock.

These instruments and strategies can get very complex.  For instance, you can sell a “call” option versus buying it.  One use of options is to hedge your buying/selling position on a stock.  In this, you might buy a put option to hedge your long position on a stock you just bought. If the stock would go down, you have the put option price that should be going up. In the commodity markets many farmers use options to hedge their crops for the season.  The farmer could buy “crop loss insurance” which is very expensive, or hedge the loss of their plantings with options on the commodities market, corn for instance where the prices have gone up significantly across the US because of lack of rain the summer of 2012 and many crops were lost.

As a client of a major brokerage you may have the ability to borrow money from the “house”.  This is a regulated percentage backed by your stock holdings, and is referred to as buying on “margin”.  If your long position should go down in price you may have a “margin call” by the brokerage firm.  If you are in a short position and your stock goes up and you are losing money you may be asked to put more money into your account to cover the losses.

MONEY 1 - U.S. ECONOMY

THIS IS MY FIRST POST ON UNDERSTANDING MONEY TOOLS

Money! Money! Money! 

Let us take a look at a couple very important things that helped create and destroy finances in our country.  Of course, there are many to recall, but I am going to cover a few briefly here.  One is the Glass Steagall Act of 1933 that kept separate our institutions of brokerage, insurance, and commercial banking. 

A second is the Bretton Woods Agreement. In 1944 it put into place a functioning international system of rules and institutions to regulate international monetary policy, including the International Monetary Fund and World Bank. On August 15, 1971 the United States terminated the convertibility of the US dollar to gold, thus going off the gold standard, and went to a “fiat” currency.

Thirdly, we’ll discuss briefly the destruction of an old institution, the Savings and Loan industry, and how that came about.

The Glass Steagall Act was created during our “depression years” to keep separate the financial business of insurance, commercial banking and stock/bond brokerage.  Lack of regulations in the financial industries helped promote the Great Depression and the US tried to prevent the same from happening again.  Also, competition was welcomed.

An important part of the Act was the creation of the Federal Deposit Insurance Corporation, to insure deposits backed by the US Government.  The banks were to buy US Treasury’s so there was money in case of bank defaults and customers’ deposits in jeopardy. Up and above the guarantee of bank insurance was the US Government. In 2007-8 the FDIC went negative from bank deposits and the Government needed to step in.  One of the first major changes to the Act was in 1977 when banks’ holding companies could establish security affiliates/subsidiaries.

In 1978 mortgage backed securities entered the brokerage field, and foreign banks buying US banks put pressures to bear to be able to diversify. President Ronald Reagan was a proponent of deregulation and in 1982 mutual fund companies entered the investment field as “non-banks”. Major investment banking firms soon followed in offering mutual funds.  It is a worthy note here that Federal Reserve Chairman, Paul Volcker, was against this.  In 1987, Alan  Greenspan became head of the Federal Reserve and he believed in deregulations. With deregulations in the financial industry corruption escalated; junk bond sales to institutions from Charles Keating, Michael Millikan and others quickened the downfalls of “thrifts” and banks.  Mortgage derivatives and mortgage backed securities were sold to Savings and Loan Banks. 

These very complex structured mortgage backed securities developed in the early 1980s by Wall Street investment banking firms like Solomon Bros. could rarely be analyzed except by those who created the instrument and were sold to institutions, eventually taking down about 1/4 of the Savings and Loans.  At about this time interstate banking was permitted,  the large banks bought up many of the small and family owned banks, thus less regulation and competition. By 1995, with political pressure coming from the large banks and institutions Glass Steagall was about dead.  In 1998, Citicorp and Travelers Insurance merged. 

On November 12, 1999 the Gramm, Leach, Bliley Financial Modernization Act was signed into law putting the final “nail into the coffin” on the Glass Steagall Act.  One last comment here, when during the Clinton years and the undoing of the Glass Steagall Agreement banks could use depositor monies to invest for their own profitability.  If the investments turned out positively the banks made money, if the banks lost money through these investments, the Government’s FDIC bailed the banks out.  In 1933 the Glass Steagall Agreement authorized US Treasury notes to be issued not backed by the gold standard, but by the United States.

Another very important act impacting our money was the Bretton Woods Agreement of 1944. The US had been increasing its debt mainly from the Viet Nam War escalating during President Kennedy, even more during President Johnson and inherited by President Nixon. The US needed to pay  debts and needed to print money to do so beyond the backing of the gold supplies.  Therefore, on August 15, 1971 we went off the gold standard backing our United States currency and went with what is known as “fiat” currency, which concisely means that our currency is not backed by anything but the good faith and strong economy of the United States.

This was the end of the Bretton Woods Agreement. The printing of money and increase of US debt has been growing significantly since then, except for a couple of years at the end of the 1990s when we cut our defense budget, had a strong economy, and no expensive wars taking our dollars outside the country.

 Lastly, we will briefly talk about a lost industry that had been around for many years, the Savings and Loan business, sometimes referred to as “thrifts”.  These S&L’s were important players in the money industry as they dealt primarily with mortgage loans even though they lent money for cars and personal items. In August, 1979, Paul Volcker became Chairman of the Federal Reserve System.  Inflation was heading upward, primarily because of OPEC and the pass through of expensive oil, and oil is used for many products. 

To slow inflation Paul Volcker went against free market decision making and raised interest rates to very high levels crushing the home building, real estate industry and especially small business. When this happened people weren’t financing homes and thus Savings and Loans were not making enough loans to stay in business. The Tax Reform Act of 1986 had a major impact on investing, changing tax rates such as capital gains and knocking out tax favorable products such as partnerships, thus lowering values of assets.

Unsound lending practices were common with deregulations especially in real estate, and then mortgage derivatives took down many S&L’s when the Federal Government stepped in and forced S&L’s to sell the derivatives they carried on the books.  Sound familiar?  Happened again in 2003-2007 and collapsed many banking institutions around the world.

Next we will talk about stocks, bonds and your investing.