Bob O'Brien
Head Instructor
bobrien@mywealth.com
If there was ever time to make absolutely certain that you understand financial leverage, this is the time! The root cause of this economic crisis is due to too much financial leverage! The last economic crisis that led to the great depression was due to too much financial leverage.
The main thing to remember is that financial leverage is something that “magnifies gains” and “magnifies losses.”
A lot of people really got carried away with this. Who exactly is guilty of being over leveraged?
Most Wall Street firms, banks, State governments, homeowners and consumers. That’s all!!
Let's step away from finance for a second to make certain you understand leverage. When I was in my twenties, like many young Americans, I ran up my credit cards and spent more than I had coming in. Money was no object to me!
I look back at this at this period of my life as a time when I used “psychological leverage”. I wanted to to look rich and feel rich. I really didn’t know what being rich was about. I just figured I’d spend like crazy and I would just make more money somehow to pay off the debt. I wanted to be rich, but I didn’t even really know what that even meant!
I learned a great lesson: I needed to get more scientific about my finances! That’s exactly what our courses do!
“Being rich” was costing me a lot of money (20% interest)! I couldn’t afford to be rich anymore! Flipping credit cards was a fulltime job as well.
I used leverage to magnify my lifestyle and self image! Financial leverage looks to magnify returns!
The real tragedy in this economic mess is that people that bought homes had no idea how financial leverage works. In fact a lot of them still don’t. They just thought that there was something magical about real estate. There is no magic and every cent adds up in the end!
If you bought a house for $300k and put down 10% ($30,000) and the value of the home increased by 20% over a two year period, you where up $30k. 20% X $300k = $60k minus $30k down payment.
A 100% return on your money! Financial leverage “magnified the return”. Many people got real excited when this happened between 2000 & 2006 and really felt wealthy and financially secure by this. Economists call this the wealth effect, which lead to people spending a lot of their equity out of their homes.
Then when the prices came down, we had people losing 100% of their 10% down payment only months after the purchase! This is “magnified losses” and they are underwater!
Unfortunately the real estate craze was created by more perception than actual wealth because of the leverage. If you borrowed for a $300k home at 6%, you are going to pay about $350k in interest. So really you need to get to $650k in home value before you are really making money off the house. Run the #’s yourself! This does not include all the other expenses that go along with owning a home.
Home ownership has never been nearly as good of an investment as most people think! The leverage has created this false perception.
The mortgages that where created in all this (many poorly written mortgages), were packaged together and sold to investors. These investors (Wall Street) also used leverage with these pooled mortgages assuming that they would be paid with no problem! So to be clear, Wall Street was borrowing in order to buy all the mortgages as investments in order to magnify their gains!
Isn’t this very dangerous? Yes, it leads to a financial crisis! (Good Video!)
In the above example, when the home purchaser put down 10%, they used leverage at ratio of 10 to 1. The Wall Street investors used leverage at a ratio of 30 to 1 and sometimes even 40 to 1.
This is why some people feel strongly that they should return all the big bonuses that were made with this strategy. They never really made the money. It would be like letting Bernie Madoff, get away with running a ponzi scheme!
These bonuses should be clawed back, since the strategy was not only flawed, but destructive!
Finally, I just want to say that this financial crisis is not going to cause people to wait in line all day for a stick of butter or a bowl of soup! Actually, if the soup is a really good, I might wait in line! It is not going to be that bad. I don’t believe that it is going to be like the “The Great Depression”. The worst case scenario is that some people will have to move in with family members and friends. This is not the end of the world (unless of course you have to move in with your in-laws)!
Bob O’Brien
Sr. Instructor
www.mywealth.com
