Leverage 101: The Real Cause of the Financial Crisis 22 comments
-
Font Size:
-
Print
- TweetThis
Much of the current financial market crisis is blamed on two main factors – poor risk management by company executives and the ultra-depressed housing market. Company management is paying the penalty with the most failed CEOs fired and years of lawsuits and regulatory probes ahead for implicated senior executives. The second factor, a depressed housing market, in itself is not new. Housing is cyclical and every 10 years or so we have a downturn followed by a boom. Despite this being a much more severe downturn, you also have to remember prices almost doubled (boomed) before the collapse.
What really caused the magnitude of the current financial crisis, in my opinion, was the amount of leverage used in the housing market and mortgage backed securities derived from it. Leverage is a double-edged sword that is a powerful ally during boom times, but can quickly become your worst enemy during the ensuing bust. The collapse or bailout of some of our most highly regarded financial institutions – Fannie Mae (FNM), AIG (AIG), Lehman Brothers and Merrill Lynch (MER) - was squarely due to leverage.
What is leverage and how does it work? Below is a simplified example using three scenarios:
- (No leverage) Assume I purchase outright (in cash) a home valued at $100,000. If that house increases in value by $10,000 in one year, my rate of return (appreciation) against my $100,000 cash outlay (down payment) is 10% ($10,000/$100,000). Not bad.
- (Partial Leverage) Now assume that I purchase a home valued at $100,000 and only contribute $10,000 as a down payment and finance the remaining $90,000 at 6% (equivalent to $5,400 in annual interest). If the house increases in value by $10,000 in one year, my rate of return (appreciation) on my outlay (down payment plus the interest costs) is $10,000 / ($10,000 + $5,400) = 65%. So, through leverage of about 10 to 1, I was able to increase my rate of return significantly compared to scenario one where I had no leveraged debt.
- (Maximum Leverage) Now assume that I purchase the same home valued $100,000 and only put down $1,000 as a down payment and finance the remaining $99,000 at 6% ($5,940 annual interest). If the house increases in value by $10,000 in one year, my rate of return is (appreciation in value) divided by (the down payment and the interest costs), $10,000 / ($1,000 + $5,940) = 144%! So through leverage of about 100 to 1, I was able to increase my rate of return by triple digits. Picture doing this for several years and as long as values rise, I would accumulate tens of thousands of dollars on an investment of $1,000 + interest costs. See how this could be so enticing for investors.
Most investment banks were leveraged by a ratio of 30 to 1, and they were dealing with billions of dollars instead of thousands. Government sponsored mortgage giants Freddie (FRE) and Fannie were using leverage closer to 100 to 1, because of their supposedly stricter lending standards and implicit government backing. As you know, when asset prices are rising, this system works like a dream, but let's look at what happens when asset prices (in this case – houses) move downward.
In scenario #1 above, if the price of the house decreases by $30,000, other than the "paper loss", as long as you don't sell, there are no problems because you have no leveraged debt. In scenario #3 above – maximum leverage, if the price of the house decreases by $30,000, here's what potentially happens:
- Let's assume the bank that lent you the $99,000 decides that the collateral (the value of the house) is no longer sufficient to cover the loan. It may ask you to come up with the difference between the current value of the home ($70,000) and the outstanding debt ($99,000). In order to protect the bank's interests, it will want you to come up with $29,000.
- Now you have two options. First, you can give the bank the $29,000. But you probably didn't have it in the first place, so this is probably not a realistic option. Secondly, you could refinance your mortgage with another bank. But this probably won't work because you already have $29,000 of negative equity. All banks are going to be reluctant to give you money without collateral.
- So you most likely lose the house to foreclosure. This is exactly what is happening to a number of homeowners today.
Now let's map this scenario from a homeowner with a single mortgage to an investment bank that invests in millions of mortgages. If the day you bought the house you had a net worth of $1,000 – the cash you put down on your house - then lets say your personal "stock" was worth $1,000. After the foreclosure you lost your $1,000 investment and now you personal "stock" is worth $0.
An investment bank may put down $1,000,000 for $30,000,000 worth of mortgages. So lets say the investment bank's stock is worth $1,000,000. As housing prices drop, the investment bank has the same problem as you, they cannot refinance because nobody will lend them more money, so they start losing their houses to foreclosure. As the houses go into foreclosure – one by one – the investment bank's value (and thereby stock) drops. In the end, the investment bank has the same value stock as your personal stock value – zero. Unlike you, the investment banks go hat in hand for a Federal bailout because they failed to manage their downside risk from leveraged debt.
So, the lesson of this story is not that leverage is bad; it just has to be understood for both the upside AND downside impacts. If the individual or investment bank were leveraged 3 to 1, they would have enough equity in the house(s) to either refinance or more likely, the bank would not have called-in the loan in the first place. Remember if you are leveraged 3 to 1, you have put down 33%. Therefore, the house(s) would have to fall more than 33% to become an issue. Plus, even if the house(s) eventually fell a total of 40% at the market bottom, and the bank called-in the loan, you would only need to come up with $7,000 ($67,000 mortgage - $60,000 in current value), which is much more manageable for an individual or an investment bank than the $39,000 that would be required if you were leveraged 100 to 1 and the house dropped in value by 40%.
Going forward, I hope our regulators take heed of this when the next blend of investment banks emerges and Fannie/Freddie become profitable again. Hopefully the amount of leverage and actual equity is much more carefully regulated and 30:1 or 100:1 leveraging ratios are banned. Similarly, future homeowners should take this leverage lesson to heart and only purchase homes where they can afford a 20% down payment and so don't get as badly exposed when home prices fall.
Disclosure: None.
Related Articles
|
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largestSee all
increase in followers
in the last 7 days
Fastest Climbers » -
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most active
Instabloggers.-
1
TraderMark
-
2
Don Dion
-
3
Cliff Wachtel
-
4
Mike Havrilla
-
5
James Quinn
Top Instabloggers » -
1
-
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
This article has 22 comments:
But the sucker who put down 20% losses it all and has no "leverage" to re-negotiate!
!?
not that leverage malfunctioned in any way...but because it was used for self harm.
The "sucker" who put down 20% may.......gasp......ha... been acting on the old fashioned notion that he was buying a home for shelter and security instead of as an investment that was "sure" to keep going up and up indefinately.
The true suckers are those who believed that housing price increases could outpace wage increases indefinately.
Not sure why you included AIG in this list. A CDS is a totally different instrument, basically an insurance policy on debt.
A 'credit default swap' pays out when the bond or debt issuer can not repay. AIG's problem is that it sold CDS's to anyone who wanted to buy whether or not they actually were holding the bonds.
As an example, Company A sold $100M bonds on the market. Mr. Smith who didn't buy any bonds came to AIG and wanted to bet that Company A would default on the bonds. Mr. Smith bought $200M (yes, even more than the outstanding bonds!) worth of CDS coverage from AIG and paid $2,500,000. Now Company A can't repay the bond or is being liquidated etc. and bond holders receive only 50%. Mr. Smith, who never actually purchased a single bond, goes to AIG and says that on the $200M worth of CDS, real bondholders are getting only 50% so you owe me $100M! That's the problem...it doesn't take many defaults for the numbers to add up quickly.
AIG sold these 'policies' because it thought in the aggregate it would make money on the premiums. In reality, long term it might be true. However, a short term hiccup can create a serious cash outflow. AIG simply did not have enough cash reserves to cover its current obligations. This is why it needed $28B in a hurry.
CDS is insurance, not classified as leveraging though investors will use a CDS to leverage and offset - that's a different story.
CrossProfit
But lenders not only did it (too high leverage) themselves, they also encouraged you and me to do the same, with some of us (the so called fools) not being even aware of the high risk. Now we have a big bunch of people loosing their homes, investment banks going belly up, financial market in a collapse, economy at risk - and all those executives who not only knew the risk, but also orchestrated it and led us right into this mess walking away with their large 2002-2007 bonuses and golden parachutes.
Let's say you were one of these smart executives, being paid $100M to find a big bunch of fools, lead them into the ditch, then walk away with the money and not look back, ... would you?
This is the most expensive lesson about (abused) capitalism, (dis) honesty, (lack of) values and conflict of interests in modern history.
The CEOs who have committed so much fraud should be prosecuted and have all assets -- including real-estate, cars, boats, aircraft, securities, bonuses, "golden parachutes" and the like seized. Make an example of the greedy people. Let THEM pay the price for their failed schemes.
Building another federal bureaucracy to handle this mess will only cost us more in the long run, and build in another layer of society with a govenment dependency. An endless downward spiral.
> jack
I mean..how dumb was that? What were they thinking? If you can borrow at 1+% (more or less) and use that money to leverage yourself..you don't need to be Fellini to figure out that sooner or later the bubble will burst..aka..today's problems.
If the bankers who packaged these "products" can't price them..why does anybody think the geniuses in D.C. will be any better?!
In my humble opinion...let nature take it's course, so to speak, let the govt. pay as little as possible (with some form of guarantee) and let the institutions pay the price for their actions. Sure, there will be pain..but let Wall St. feel what everybody else is feeling for a change!
The problem is Fannie Mae, Freddie Mac, AIG and Wall Street all knew this but ignored it. They should have been smarter than the individual entering into this type of transaction for the first time in his life who is more worried about Clay Aiken being gay than he is about leverage and economic principles.
For Fannie - holding some $10 trillion "worth" of homes, the losses are staggering. A 10% reduction of their income stream is a humongous number.
No such business should be unhedged. They were. End of story. Except, of course the cost to taxpayers to bail them out. Heck of a way to run a business. Or a government.
Nor would you if you saw their entire balance sheet.
Flooding this market with additional liquidity for debt to financial companies is insane. It is pouring gasoline on a fire.
AND!!! Interesting post from earlier reflects a new mentality. Instead of buy a house, keep a house, the kids, the neighborhood, the schools... accept the pull backs cause it's home, not an investment... right? NOW the mentaility is that it is not smart to keep the house when it is underwater... damn the kids, damn the neighborhood, damn the schools... a house (evre since since COBRA of 1986) is an investment. Don't do the right thing, do the smart thing is apparently the new mantra.
I agree about leverage, but the new mantra changes the math too... and not for the better. IMHO
Basic requirement was house be a home and a shelter. To the extent there is no monthly payment shock home owner have to live and pay rent or a mortgage. This was a fundamental assumption. As long as they can afford monthly payment they will stay. That is why home ownership is different kind of investment.
Even this bail out has this assumption. To the extent home owner can afford to make monthly payment lenders with HUD’s co-operation can do loan modification so, people can stay in home.
Unfortunately insensitive consistent prolonged reduction in interest rate and after that prolonged increase in interest rated created dramatic inflated home prices and now deflated home prices.* Just now feds have understood that old fashion monetary policies (raising and reducing interest rate) do not have precise effect. Remember conundrum? Long rates were cheaper than short and world kept on throwing money at leveraged hedge funds. In this global financial market that is loaded by sovereign funds is a different animal. It took so long to have an effect that it damaged the entire credit market. It is like doing a surgery by a chainsaw where you need a laser beam. Now our economy patient is in critical condition. This collateral damage caused by lack of leadership can cost our country a super power status.
Fierce competition and outdated regulations created a disconnect between borrower and lender. Prolonged lower interest rate and inflated home prices created a feeling of have and have-nots home owners. Toward the end 2005-2006 most of the houses were bought by these have-nots who felt left out. To make it affordable they were given teaser rate payments assuming prolonged lower rates.
The real problem was marking to market and it is still a marking to market. SEC is a sleep on the wheel hoping that two wrong will make one right. First when problem started risk pricing was done based on ‘marked to market’, based on previous five years’ experiences. Ignoring the imminent increase in market risk. That caused disaster to investors. Now second time same thing is being done ignoring ‘there is no market CDOs’ there for requiring ‘balance sheet’ and ‘Capital’. Common sense should prevail.
Two wrongs does not make on right.
No market does not mean no value it is a short term assessment bookkeeping problem. There could be a one year ‘suspense account’ valuation or a gray area valuation lead by SEC.
Instead SEC, vested interests and politics are creating shotgun weddings and winners and losers of the centuries. This is lead ‘wagon circling’ by the same people who were supposed to help. No wonder banks and lenders do not trust each other and refuse to help.
Now decentralized localized negotiated loan modifications with home owners is the only meaningful solution. Each individual mortgage has a home owner and each home owner has a family, neighborhood, township, school and communities that make this nation. Big time games on Wall Street and Washington should not ignore that.
* No one is talking about replacement cost of these houses. Material costs have gone up. These deflated prices of homes will cause another inflated response in future.
Here's my solution to the financial crisis...
1) Somehow cover the short-term credit "freeze". Short-term "crisis" solved.
2) Next, detox the debts by helping families refinance mortgages, or have the government buy foreclosed property and re-sell it...basically, get money flowing again so these debts aren't worthless. Medium-term crisis solved.
3) Slowly deleverage financial institutions. Some European banks are leveraged 30:1 (UBS is even 60:1!). Long-term crisis solved.
4) Create rules and regulations. Examples are small excise taxes on trades to discourage speculation. Reasonable limits on CEO compensation, so that we can fire a CEO who caused the company to lose jobs without having to give them millions of dollars for screwing up. The point is that we should encourage wise, long-term investments, not short-term greed.
" Now assume that I purchase a home valued at $100,000 and only contribute $10,000 as a down payment and finance the remaining $90,000 at 6% (equivalent to $5,400 in annual interest). If the house increases in value by $10,000 in one year, my rate of return (appreciation) on my outlay (down payment plus the interest costs) is $10,000 / ($10,000 + $5,400) = 65%. "
What if your interest rate was 100%? Now your first year rate of return is
$10,000 / ($10,000 + $90,000) = 10%. See your mistake?
SEC Comments. Page 6: "Envy, hatred, and greed have flourished in certain capital market institutions, propelling ethical standards of behavior downward. Without meaningful reform, there is a small (but significant and growing) risk that our economic system will simply cease functioning."
www.sec.gov/rules/prop... December 22, 2003.
and:
SEC Comments. Page 2: "Together these practices threaten the integrity of securities markets. Individuals and market institutions with the power to safeguard the system, including investment analysts and rating agencies, have been compromised. Few efficient, effective and just safeguards are in place. Statistical models created by the firm show the probability of system-wide market failure has increased over the past eight years.
Investors and the public are at risk."
www.sec.gov/rules/prop... February 6, 2006.
On Sep 25 08:14 AM john s. gordon wrote:
> the reason that the collapse occurred during the 8 yrs of bush presidency
> is that federal housing policy encouraged risky mortgages ('ownership
> society', remember?) plus white house policy told regulators not
> to regulate so that existing safeguards were discarded. shame on
> you emperor george w.
George Santayana: "Progress, far from consisting in change, depends on retentiveness. … Those who cannot remember the past are condemned to repeat it."
The moral hazard of this story is that lenders are willing to push more credits and money to borrowers that do not have the ability to repay. From 2005 to today, the accumulation of unresponsible lending send is the resulted of one law.