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Dr. Kalinda Rose Stevenson
Using Leverage To Create Weapons Of Financial Mass Destruction
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Leverage creates wealth. This has been the promise behind the real estate boom. Now that the boom has gone bust, what is the role of leverage in the current financial crisis?
Greed is blamed for much of the economic crisis currently facing us. But blaming greed misses the real point. Greed needs a mechanism—a tool—to put greed to work. This tool has been touted as the magic money-making tool. What is the tool? It is leverage.
Underneath all of the complicated terms, such as “derivatives,” “leveraged buyouts,” “financial instruments,” the fundamental tool that has led us to this point of crisis is misused leverage.
What is leverage anyway? Leverage is the result of the action of a lever. When properly positioned, a lever allows you to move something you could not move with your own strength.
“A simple machine consisting of a rigid bar pivoted on a fixed point and used to transmit force, as in raising or moving a weight at one end by pushing down on the other.” “Lever” http://www.answers.com/topic/lever
In finance, leverage is primarily the use of borrowed money to buy what you could not afford to buy with your own money.
The real estate boom has been fueled by leverage. This has been the great selling point for real estate investing. You can use leverage to buy real estate with little or none of your own money. In other words, you finance your real estate purchases with debt.
Leverage is the tool that rewards greed. With leverage—whatever form that leverage takes—you can buy more than you would be able to buy using your own money.
Leverage is a tool that can and does create profit. The real estate boom is a testimony to the effectiveness of leverage as a wealth creating tool.
“People used to build wealth through building equity in their homes. Today, people prefer to speculate on the price of their house by using historically high levels of leverage.” Richard Bernstein
So why are we in the current financial crisis? Underneath the crisis is a shared belief that values will keep going up. Robert Schiller makes this point in his book, Subprime Solution.
“In Shiller’s view, the biggest dangers in financial markets come from unanimity. In Subprime Solution, he argues that what united the missteps by the Federal Reserve, mortgage brokers, Wall Street bankers and home buyers that together brought on the current financial mess was a shared belief that house prices never go down.” “Crash Master” http://www.time.com/time/magazine/article/0,9171,1838756,00.html
This is the true irrational belief behind the financial mess. In reality, real estate prices are subject to cycles, and ups-and-downs. The old adage states: What goes up must come down. Nothing continues on a continual upward path indefinitely.
Yet, from the greatest investment banks on Wall Street, to novice real estate investors, many of us operated with the belief that real estate values would continue to go up, and that leveraging borrowed money was the smart way to make money fast.
As a result of this shared belief, many real estate investors and the bankers who financed their transactions, never saw the downside of using leverage as a tool to create wealth.
Think again of using a lever to move something. Leverage is inherently risky. Think of changing your tire. As long as your car is resting on four tires, it is stable. As soon as you lift up your car with a jack, you have created a potential danger. A car on a tire jack is no longer stable. The car can slip off the jack, and you can get hurt.
This is the downside of leverage. When you use leverage, you create a potentially dangerous object that can slip off the bar. Leverage lets you go higher than you could on your own, but it also means that you can come crashing down faster and lower than you would without the lever.
“In finance, leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.” “Leverage” http://en.wikipedia.org/wiki/Leverage_(finance)
The fundamental reason that the big investment banks have failed is because they threw caution out of the window and relied on ever-increasing amounts of risky leverage. in simple terms, they used large amounts of borrowed money.
“Lehman’s fall shows the downside of using borrowed money. Even though Lehman has a 158-year-old name, it’s actually a 14-year-old company that was spun off by American Express in 1994. AmEx had gobbled it up 10 years earlier, and it wasn’t in prime shape when AmEx spat it out. To compensate for its relatively small size and skinny capital base, Lehman took risks that proved too large. To keep profits growing, Lehman borrowed huge sums relative to its size. Its debts were about 35 times its capital, far higher than its peer group’s ratio. And it plunged heavily into real estate ventures that cratered.”
“Here’s how leverage works in reverse. When things go well, as they did until last year, Lehman is immensely profitable. If you borrow 35 times your capital and those investments rise only 1%, you’ve made 35% on your money. If, however, things move against you - as they did with Lehman - a 1% or 2% drop in the value of your assets puts your future in doubt” in “How Financial Madness Overtook Wall Street” http://www.time.com/time/business/article/0,8599,1842123,00.html
The current economic mess is tremendously complicated, but the basic mechanism behind the crisis is leverage created by arcane financial instruments that few of us have any hope of understanding. The particular form of the leverage ranges from subprime mortgages, to derivatives with fancy names, such as “collateralized debt obligations” (CDOs) or “credit-default swaps” (CDSs)
In 2003, Warren Buffet called these derivatives “weapons of financial mass destruction.”
The reason that all of these leveraging tools worked so well for so long was because property values were going up. But when property values started to go down, these leveraging tools turned into the weapons of financial mass destruction that Buffet foresaw.
Dr. Kalinda Rose Stevenson
Do you know how banks make money out of thin air? Find out in No Money Limits For Real Estate Investors. And be sure to sign up for your Free “52 Heart Of Money Insights” at NoMoneyLimits.com.
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