$1 Trillion

This article, written by famed bond guru Bill Gross of PIMCO, paints a bleak picture of the current financial environment.


In my opinion, banking, at least over the next generation, will be drastically different:

1) gone are the days of no-doc teaser home loans.
2) banks are now much more risk averse (less willing to lend to anyone with just a pulse).
3) many more banks will fail.

What America needs is the Leave-it-to-Beaver era of thrift, honesty and a 20% down payment. I would not lend to someone who didn't pass that filter. I don't have much faith in people not wanting to keep up with the Joneses.

Sadly, however, this crisis means Uncle Sam's place in our lives just got bigger. America will live with much of this. Remember, some of the most odious Acts and Laws were passed several decades ago (e.g., Social Security). So be leery of any measures to 'save' homeowners. Few find it politically expedient to speak the truth: the banks lied; the borrowers lied; the mortgage lenders lied. That's a scary combination. But all should pay the price before the taxpayer carries the burden.

As Buffett said: "Be greedy when others are fearful and fearful when others are greedy." There's blood in the streets now, but expect more. Nevertheless, I am optimistic about the long-term ingenuity of America's creative engines.

On Timeshares and Psychology

There's something about mostly tan, thin, vacation-theme clothed, and universally happy sales people that breeds distrust. This past weekend, my wife and I sat through our third timeshare presentation in as many years. We're not interested, but companies now dangle bigger rewards as incentives to come sit for 90 minutes; sales presentations can also be a great education in psychological persuasion and in how to see through fuzzy math. It was a 4th of July weekend well spent at a Worldmark office, a subsidiary of Wyndam (Ticker: WYN).

The picture

4.4 million US households own vacation ownership interests (a euphemism for timeshares). For Worldmark, The average age is 52 and the median household income is $74,000; this is the middle class, the I-can-feel-retirement-coming crowd. Again, this is the median number so half are older and have are younger. All are bad at math, however.

We were probably referred by a friend or acquaintance (they offer extra perks for referrals). The sales building was located in a typical office park but in an upper-middle class area of town. The parking area was newly paved and partially shaded with immature trees. The entrance was simple yet attractive and on 95 degree day, the cool office air felt almost too cold. The facilities had the disadvantage of being located off-site. There was no personal tour to entice would-be buyers with extra big jet tubs and high thread count sheets (or whatever they have). On-site tours account for 90% of Wyndam's timeshare sales though only 80% of sales close on-site.

Once settled in the office our sales rep (a twentysomething mother of two) offered us cookies and soda--an odd and unsatisfying menu given the mid-morning hour of our appointment. 10-15 couples of middle and young family age, joined us in what I'll call "why everyone needs to buy a Worldmark timeshare."

The Economics

Worldmark should make a profit, but it's how they present that bothers me.

The direct cost to the consumer are: 1) a lump sum payment, generally 10% down; financing is pre-approved at 17.9% (a stratospheric rate) though the average interest rate on 277,000 loans ($3.3 billion in total loans) is 12.5% (source: 2007 10K). This is still extremely high; 2) Maintenance fees* of $500-1,000 per year depending on the number of vacation credits (these are exchanged for days at any one of the company's 67 resorts.)

The numbers presented to us were vacation credits roughly equivalent to ten days per year for 55 years. The one time fee was $31,340 with an annual maintenance fee of $947.00, or $94.70 per day. The key factors in doing the math are the estimated average room rate increases over the next 55 years and the assumed alternative rate of return (the opportunity cost of capital) of the lump sum payment. Opportunity cost is one of the most important principles of any economics class.

Wordmark's assumed room rate inflation is 7.6% and is based on past 30 years. This number seems high and unlikely to continue. This is economic red flag number one in the presentation. Room rate inflation, according to form 10K, over the last 8 years has been closer to 4%. I make the assumption of an opportunity cost of capital based on the stock market (S&P 500) recent 30 year compounded annual growth rate of approximately 9%. 7-8% would probably be more appropriate.

In the pitch, she told us room rates averaged $150.00+; a higher hotel room rate makes it more appealing to lock in the rate today; it's also very dishonest. This is economic red flag number two. With a base room rate of $108 (the average daily hotel room rate for 2007 was $103.00 per 2007 10K) and 7.6% room rate inflation over 55 years at 10 days per year you will have paid $725k for hotel rooms assuming you 'vacation' as they say you should.

But what would you have given up (what's the opportunity cost for saying yes)? If you invested the $31,340 lump sum payment in the S&P 500 over the course of the same 55 year period, with an assumed return of just over 9% you'd have over $3.1 millions dollars. Add the yearly fixed maintenance fees of 947.00 and you'd have another $1.3 million.

The pitch compared future dollars to present dollars (the lump sum payment you'll make up front)--an apples to soggy watermelon comparison. This is economic red flag number three. Clearly $725k in future hotel bills looks cheap next to the $4.4 million opportunity cost. (This assumes the $31k lump sump payment is made in cash; to finance 90% of this and to add the 12.5% rate financing to equation would look even less favorable from the consumers perspective.

Securitizations

After too many cokes, the opaque math and bombardment of vacation imagery, a middle age couple decides to go for it. Of a motley group of 15-20 or so couples, they are perhaps the only to buy. The others will either sleep on it (rarely a bad policy), or just say it's too much money.

A check for 10% down is cut, the contract is signed and the couple walks with gifts equal to some reimbursement of their time. The salesman smiles looking for approval from his now content supervisor, while other sales reps curse that others were too cautious and rational.

When a deal is closed the firm sells the loan within 30-90 days as part of a receivables securitization (loans packaged and sold to investors). With a spread of 7.1% (WYN borrows at 5.4%--per 2007 10K--and lends at 12.5% for vacation ownership loans) over the standard 10-15 year period for such a loan, banking becomes the bread and butter of the business.

The present value of such a loan is worth 33% more than if the lending were done at 3.00% above borrowing costs (more reasonable given the credit of timeshare owners).

Over the last three years, securitization of customer receivables has generated $1.5 billion in gains for Wyndam, the parent company. The pursuit of profit is hardly shady, but free cash flow (what the company makes from it's core business of hotels, vacation rentals, and timeshares) over the sames period has netted a mere $148 million. To sell pools of loans is 10 times as profitable as the company's general operations. This helps to understand the motivation of receivables financing.

The psychology

So why would someone buy a timeshare if the numbers look so bad for the consumer and so great for the company?

As we proceeded through the sales pitch, I took down mental notes of some of the principles touched on in Cialdini's book, Influence: The Psychology of Persuasion. I also jotted down numbers, as the sales rep nervously observed, since this drives the rationale for accepting or rejecting decisions of this kind.

Every sales experience is deeply rooted in human psychology. Cialdini's book is so influential that upon reading it, Charlie Munger of Berkshire Hathaway, gifted the author one Berkshire Class A share. I've recommended this book to no fewer than 10 people. I've outlined some key points used in the timeshare sales-pitch.

Social Proof

Everyone is doing it. A common refrain from high school, this is ubiquitous in the world. When I said that this didn't make economic sense, she replied: "If this didn't make sense, we wouldn't be in business."

Reciprocation

There's a powerful example from the book: In a WWI battle situation, a German surprised an enemy soldier in no-man's land while the enemy was eating a sandwich. The enemy soldier surprisingly reached out and gave the German some of his food. The stunned German soldier, under command to bring back any captors for interrogating, returned alone to face the wrath of his superiors

Worldmark offers free cookies, coke, two or three nights in a resort, gas cards, and $100.00 restaurant gift card: the least you could do is become a "vacation ownership" member as a return for all these favors.

Scarcity

We received a call the day before wanting to push back our time 2 hrs. When we declined they offered us a $50.00 gas card. We kept our original reservation. They tried to create the aura of scarcity. Panicky financial decisions are rarely good ones.

Liking

We like others like us. Timeshare pitchers are young, attractive, tan, and tend to favor Hawaiian shirts over more traditional dress since we all like the idea of worry-free vacationing.

Authority

Worldmark uses AAA as the authority source for future room rate inflation. But you should ask: Is this authority truly an expert? And, are these statistics misstated or cherry picked?

How can we say no?

The easiest was to say no is avoidance. If that's not an option, then we must accept offers only for what they fundamentally are. Hence, the focus on the economics. Timeshares at best are a ripoff, at worst, sales associates (or sales executives as they may be called to inflate the importance of their jobs) present a skewed view of the world through contemptibly misleading numbers.

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Disclosure:

None

Notes:
*"These fees generally are used to renovate and replace furnishings, pay operating, maintenance and cleaning costs, pay management fees and expenses, and cover taxes (in some states), insurance and other related costs. Wyndham Vacation Resorts, as the owner of unsold inventory at resorts, also pays maintenance fees to property owners’ associations in accordance with the legal requirements of the states or jurisdictions in which the resorts are located. In addition, at certain newly developed resorts, Wyndham Vacation Resorts enters into subsidy agreements with the property owners’ associations to cover costs that otherwise would be covered by annual maintenance fees payable with respect to vacation ownership interests that have not yet been sold."

Some thoughts concerning timeshares

There's something about mostly tan, thin, vacation-themed clothed, and universally happy sales people that breeds distrust. This weekend, my wife and I sat through our third timeshare presentation--not because we're interested, but because companies dangle bigger carrots as incentives to come sit for 90 minutes, and it can be a great education.

I'm compiling some industry and company specific figures on the economics of timeshares to share with friends, family, and eager readers. Results will post within a few days.

The verdict: don't buy one (this shouldn't be a giveaway for most).