The asset, liability and net worth balance sheet: a financial yardstick

Before a homeowner and agent can gain an understanding of whether the owner’s property is underwater (and if so, by how much), the homeowner and agent must examine the financial solvency of the homeowner.

A balance sheet is a worksheet used to list in dollar amounts all the homeowner’s assets and liabilities to set the homeowner’s net worth (formula: assets minus liabilities equals net worth). It is an ideal tool to decipher a homeowner’s, and by extension the family’s, financial health. [See first tuesday Form 207-1]

Editor’s note – Current first tuesday students can access a fillable and saveable version of this form from their first tuesday Forms-on-CD 4.2 or in the “first tuesday Forms Downloads and Updates” tab within their Student Homepage.

A balance sheet distinguishes the relation between two basic financial things, assets and liabilities. Assets are tangible and intangible property rights of value held by the homeowner. Among them are liquid assets which take the form of cash or something easily converted to cash and include money held in a savings account or tradeable stocks and bonds. [See first tuesday Form 207-1 §1 and 2]

Generally, the largest dollar-valued asset a homeowner will ever own is his home. It is historically considered an illiquid asset as its equity, if positive, cannot quickly be converted to cash. However, with a positive equity stake in the home, the homeowner properly treats it as a valued asset and thus maintains and improves it. Over time, the property’s equity buildup can be cashed-out by either further financing or sale, time consuming and uncertain in amount.

Liabilities are the flipside of the financial coin. Together, liabilities and net (or negative) worth are equal to the total value of all assets. Liabilities included in a balance sheet are financial obligations – debts – owed to others, including real estate mortgages and auto loans, charge accounts, credit card balances, one year’s amount of alimony/child support/lease payments and loans collateralized by stocks, bonds or notes. [See first tuesday Form 207-1 §11 through 15]

A homeowner’s net worth is revealed when his total liabilities are subtracted from the current FMVof his assets. The net worth is a primary determinant of financial wealth and should be known by all individuals, homeowners and otherwise. When net worth is positive, the homeowner is “worth” more than he owes to creditors – he is solvent.

However, this balancing act is immediately upended when a high-value asset, such as the homeowner’s residence, takes on a negative equity (the mortgage debt exceeds the home’s fair market value (FMV)). If the negative equity is large enough, say 125%, let alone 162%, the homeowner’s value of other assets is overwhelmed; his net worth appears as a negative figure. Instead of a positive measure of wealth, the negative net worth becomes a measure of insolvency. [For more information regarding the negative equity condition and the options available to an insolvent, negative equity homeowner, see the April 2010 first tuesday articles, The underwater homeowner, his future and his agent: a balance sheet reality check – Part I and Part II.]

A competitive and high-functioning agent may assist homeowners complete the balance sheet by providing information about their home’s current market price and implicit rental value.

A competitive and high-functioning agent may assist homeowners who complete the balance sheet by being available to provide information about their home’s current market price and implicit rental value, all as a part of his standard farming practice. The confidential financial discussions between the homeowner and agent that result from a review of a completed balance sheet build long-term good willbranding – which the agent will reap the next time the homeowner considers or hears about a real estate transaction.

The rational decision to walk

With lenders and Congress collaborating to deliberately refuse to provide legitimate solvency assistance to negative equity homeowners, only one rational choice exists for the negative equity homeowner. He must first get his short-term credit needs in order. Next, he defaults on his purchase-assist mortgage, exercising his contract rights under the put option in the trust deed and forcing the lender to buy the property for the amount of the loan. The negative equity owner will reside (payment and rent free) until the foreclosure sale some 12 months hence (at the current average pace), then vacate and hand the keys to the lender – but only in exchange for key-money cash.

Strategic defaulting will save tens of thousands of individual California homeowners hundreds of thousands of dollars. With the savings, they will be able to help the real estate market rebound by soon reentering the homeownership market, as other lenders besides the moralistic and political Fannie Mae will certainly finance them. The increased spending of these born-again homeowners will also assist California’s consumer economy. Both are positive results of a prudent business decision by homeowners – if done en masse, neighborhood by neighborhood, city by city. [For more information regarding strategic defaults, see the January 2010 first tuesday article, “To default, or not to default: that is the question.”]

Of course, these curative steps can only be taken once the homeowner, with the counsel of an informed real estate agent, understands his legal options and has a firm grasp on the dollar value of his assets, the total amount of his liabilities and the resulting net worth or insolvency derived by a simple balance sheet analysis. [See first tuesday Form 207-1]