Why Leverage is the Primary Weapon of Financial Mass Destruction
Posted by: real estate / Category: InvestingLeverage is the primary cause of the current economic crisis. 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
In finance, leverage refers to purchases with borrowed 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.
So why are we in the current financial crisis? Underneath the crisis is a shared belief that values will keep going up. This is the 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.
The fundamental reason that 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.
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 weapons of financial mass destruction.
Dr. Kalinda Rose Stevenson. Do you know how banks make money out of thin air? This is the money secret of leverage. 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.
Kalinda_Rose_Stevenson,_PhD
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Tags: mortgage, mortgages, real estate investing