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
