Leveraged Losses. What Does Panic Feel Like?

One of the big deals about owning real estate, when it comes to financial motivations, is the concept of leverage. If you buy a 100 dollar asset with 10 dollars of your money, and 90 of borrowed money, when your asset increases by 10%, your return on investment is 100%. Thus, your leverage is 10x.

$100 * 110% = $110 ; Sell the asset and pay off the $90 loan, and you've doubled your money by owning an asset that went up 10% in value. That's leverage.

Real Estate appreciates on average at about 6% a year. Supposedly this is true dating all the way back to the 1626 purchase of Manhattan Island by Dutch settlers for a whopping $24 USD. I don't know if this is accurate (even wikipedia calls it a 'legend'), and I have not calculated the ROI on $24 USD in 1626 relative to the value of Manhattan today. In fact, I don't really know what Manhattan is worth today. This is just an anecdotal story I picked up somewhere. But 6% on average isn't a bad figure to use, on a very general basis.

But leverage can work against you as well. If that $100 asset lost 10%, you still owe a bank the other $90, so if you sold the asset, you pay the bank off, and you have zero. 10x the loss = 100% of your investment. That's also leverage.

Leverage isn't just a game played by homeowners with mortgages. It's the concept behind borrowing on margin to purchase securities. And it's a major component to investment strategy employed by commercial banks, investment banks, hedge funds, and pretty much anybody in the investment game.

When it comes to mortgage dollars, it can take a lot of leverage to make a big profit. The interest rates banks receive on the money they lend is pretty low. So they borrow more money to lend, and keep a few nickels on the "spread". The more they can borrow and lend out, the more nickels they collect.

Well we all know by now that the mortgage market came to a screeching halt last summer, a few months after home values started to come down, and loans at the shakier end of the spectrum started to default. As illustrated above, just a 10% asset value decrease can lead to 100% investment loss when you're sitting at 10x leverage.

A new report out of the University of Chicago offers quite a lot of insight into the anatomy of this bubble, explains how the negative feedback loop of dropping asset values in mortgage bonds and real estate create a web effect that has worked to assure that this "subprime meltdown" would NOT remain contained, and goes on to illustrate how 400BN in bank losses equates to an estimated 900BN in business contraction, and corresponds to an estimated GDP reduction of 1 to 1.5%. The role of leverage is central to the paper. Its a long read, but critical if you wish to understand this market.