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Subprime mortgage debacle harms financial sector stocks

U.S. stock market prices have backed up to where they were about six months ago. But things aren't quite the same as they were then. Investors are on edge. Many are downright scared. The big bad wolf that's been dogging the markets is subprime mortgages.

Everyone seems to have their own definition of subprime. It started out as a label for mortgages given to borrowers with low credit scores. But it has become a catchall that includes exotic mortgages that have negative amortization, low or no down payment, adjustable-rate mortgages (ARMs) with low initial teaser interest rates and/or other features that allow borrowers to purchase more expensive homes than they could otherwise afford.

The key phrase is purchase more expensive homes than they could otherwise afford, and you may as well delete the word otherwise.

One thing these subprime mortgages have in common with standard mortgages is that they are often bundled into bonds, called mortgage-backed securities (MBS) collateralized debt obligations (CDOs), etc., and sold to investors. These mortgage bonds run the gamut from the plain vanilla to the exotic and even the bizarre. Some of the securities pay holders normal principal and interest payments. But some pay principal only, some interest only and some give their investors (or, more accurately, speculators) payments contingent upon pre-payment levels, default rates, etc.

So, what does this have to do with the recent volatility in the stock market? Well, hundreds of billions of dollars of these subprime mortgage-backed bonds found their way into the portfolios of publicly traded firms - such as investment banks, hedge funds, commercial banks, insurance companies, mortgage underwriters, etc.  and rapidly rising default rates among the underlying mortgages are causing the value of the bonds to decline, sometimes dramatically.

Compounding the matter of declining prices, many of the investors who own the bonds employed leveragei.e., they bought subprime mortgage bonds that were paying higher interest rates with money borrowed at lower interest rates. Leverage can magnify your gains, but it works in reverse, too. For example, an investor employing 2-to-1 leverage who buys a bond that loses 1 percent of its value loses 10 percent of his capital. Some of the lowest quality mortgage bonds have lost more than half their value. Several hedge funds have lost huge percentages of their investors' assets, and at least one lost 100 percent of its investors' capital.

When it's all added up, the losses from this unraveling subprime debacle will likely be measured in the tens of billions of dollars, so it's understandable why financial sector stocks have been sagging. But stocks in other sectors have been falling due to the concern of subprime issues spreading throughout the economy.

The feared domino-effect scenario goes like this: When default rates rise, fewer people want to buy mortgage-backed bonds. As buyers for the bonds dry up, mortgages become harder to get. Less mortgage money means fewer people can buy houses. Fewer buyers mean lower prices. Lower prices can mean more loan defaults, and on and on.

Subprime sprawl could affect the stock market in another important way as well. At least some of the strength the stock market had been enjoying for the past year or so was being driven by private equity takeovers, and many of those deals were financed by issuing bonds. There have been rumors that some recently announced deals may not be able to be completed due to market liquidity issues, and this has given investors pause.

I would not downplay the risk of subprime problems spilling over into some non-financial sectors, as around 25 percent of the U.S. economy benefits from housing construction/sales in some way. But the probability is high that most of the economic carnage caused by subprime lending will be cordoned off in the financial sector. That's because defense contractors, pharmaceuticals, food/beverage makers and a host of other companies should have almost no negative impact from subprime lending.

It may be wise to avoid or reduce positions in financials with direct exposure to subprime contagion until more of the damage has been quantified and publicized. But don't be afraid to buy or add to your positions in non-financial companies whose stocks are knocked down in the bouts of indiscriminate selling triggered by subprime lending headlines.

- Scott Tapley, CFA, is a vice president/financial analyst with the Main Street Wealth Management Group. He can be reached at (217) 351-6539 or scott.tapley@mainstreettrust.com

RETIREMENT PLAN CHOICES: LUMP SUM VS. ANNUITY

Jimmy StewartJimmy Stewart
CIBM Contributor

If your employer offers a pension, you'll want to be familiar with your payout options before it's time to start taking money out, because your choice can have a big impact on your retirement income.

If you participate in a pension, upon retirement, you'll receive a specific amount of money based on your salary history and years of service. But how you take that money is up to you.

You have two basic options: You can accept the pension as a series of annuity payments, spread out over your lifetime or a certain number of years, or you can take the money as a lump sum. But not all pension plans offer the lump-sum option.

Which option is better? At some point before you retire, consider some possible arguments for both choices. Here are a few to consider:

Choosing a lump sum

  • Can help you avoid the effects of inflation. In many cases, annuity payments are not indexed to inflation. Consequently, you're getting paid with dollars that are essentially worth less and less each year, while some costs, such as health care, may be rising at a rate faster than the Consumer Price Index, a common yardstick used to measure inflation. But if you take your pension as a lump sum, you're getting all the money in today's dollars.
  • Can help you leave more to loved ones. Once you and your spouse die, annuity payments from a pension may stop. However, if you take a lump sum and then reinvest the proceeds into other securities, you may have more assets available to leave to family members.
  • Can help you control when you pay taxes. Your annuity payments will be taxable. Of course, so will your lump sum, but if you roll it over into an IRA, you'll have more control over it when you take funds and pay income taxes provided you are older than age 591/2.
Choosing an annuity
  • Can give you greater flexibility in managing retirement income. If you choose to accept your defined benefit payments as an annuity, you may be able to structure your payments to match your needs and goals. Your options may include a straight-life annuity that provides a monthly payment for your lifetime or a joint and survivor annuity that covers your life and that of your spouse. Or, you may be able to choose a level income option, which provides you with larger payments before you start receiving Social Security and smaller payments after. Another option may be a period certain payout; under this arrangement, you would receive a reduced annuity over your lifetime, but if you were to die during a specified period, such as 10 years, monthly payments would be made to your beneficiary for the remainder of the 10-year period.
  • May give you more money over the course of your lifetime. If you end up living a few decades past your retirement date, you might end up with more money, in total, than if you accepted an annuity instead of a lump sum.

As you near retirement, consult with your financial advisor and tax professional to determine which option is right for you. You worked hard for your pension - so make sure it works hard for you.

- Jimmy Stewart is an Edward Jones financial advisor in Urbana. He can be reached at (217) 328-1719 or jimmystewart@edwardjones.com

REDUCE TAXES AND IMPROVE CASH FLOW

Mark ColvinMark Colvin
CIBM Contributor

Mark Colvin

CIBM Contributor

An Illinois biofuel facility saved $7 million on its federal tax bill; a real estate developer, $2.8 million; an apartment/condo complex, $334,000. All of these savings were made possible by cost segregation, a tax strategy that continues to grow in popularity nearly two decades after the IRS instituted favorable tax depreciation methods.

In spite of its widespread use nationwide, cost segregation remains somewhat of a mystery among many owners of factories, warehouses, retail stores, apartments and other commercial properties in central Illinois. Admittedly, the rules for this strategy are complicated. But with the assistance of an experienced tax professional, almost any business can benefit from the tax savings.

What is a cost segregation study?

A cost segregation study identifies and reclassifies those parts of a building that can be depreciated at a faster rate, typically 15 years for land improvements and five to seven years for various types of equipment. The standard depreciation period for most commercial buildings is 39 years.

Building components that support the structure itself don't qualify for accelerated depreciation, but those supporting the business do. These may include floor coverings, cabinetry, fixtures and specialty electrical and HVAC equipment. Identifying these components, using a combination of architectural drawings, building invoices and other documentation, is the key to determining the tax-saving benefits of cost segregation.

Benefits of cost segregation

The potential cash flow benefits, combined with positive, precedent-setting court cases, have led to thousands of filings in the past two decades. Potential benefits include:

  • Maximum annual tax depreciation expenses
  • Reduced income tax liability
  • Potential for reduced state property tax
  • Improved cash flow
  • Detailed asset listing that is useful for future management decisions

Who is eligible?

Most buildings constructed, purchased or renovated since 1986 are eligible for a cost segregation study under IRS guidelines. Properties may include, but are not limited to:

  • Corporate headquarters
  • Manufacturing facilities
  • Hotel/conference centers
  • Office buildings
  • Warehouses
  • Retail stores and shopping centers
  • Auto dealerships
  • Restaurants
  • Apartment buildings
  • Grocery stores
  • Gas stations/convenience stores
  • Agriculture/biofuel facilities

The ideal situation has a cost segregation study beginning before construction or remodeling starts. It is much easier to identify and classify building components before they are all in place. Tax savings can typically be generated regardless of whether the building was purchased, renovated or built from scratch.

IRS guidelines also allow those who purchased, built or renovated buildings since 1986 to benefit from cost segregation and claim catch-up depreciation in the current tax year

Not every cost segregation study will yield savings like those highlighted at the beginning of this article. But it is a strategy worth exploring for any business owner interested in sending less money to Washington, and more to the bottom line.

- Mark Colvin is a senior manager for Clifton Gunderson LLP Tax Efficiency Services. He has conducted dozens of cost segregation studies and assisted clients in saving millions of dollars. He can be reached at (309) 495-8754 or Mark.Colvin@cliftoncpa.com.

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