Financial leverage is using borrowed capital (money) for an investment, expecting the profits made to be greater than the interest payable. The most common instrument of leverage for most of us is the mortgage note. We expect to buy a house with a mortgage, pay interest, and at some point in the future sell the house for more money and benefit from the tax breaks. We are told by the experts that these benefits will far exceed the cost of interest expense as well as upkeep. On the other hand, renters do not participate in leverage. They simply pay each month for the right to live in the dwelling. The risk of investment is placed on the owner.
The Federal Reserve perpetuates the path of inflation by increasing the money supply. This supports those who use leverage in their investments. In the past, leverage was held at bay by the lender’s restriction of loan to equity ratio. How much money does the borrower have at risk as a percentage of the entire investment? Historically a 20% down payment was preferred. This meant that your leverage was 5 to 1. A 5% down payment meant your leverage ratio was 20 to 1. High leverage meant that borrowers must pay mortgage insurance added to their monthly payment to insure the borrower against losses. As long as house prices continued to climb, everyone was happy.
What happens when real estate prices begin to drop due to lower demand? Suddenly you owe more on the house than it is worth. You are now paying interest on “nothing”. In the last real estate bust, many just left the keys and walked away from the loss. They lost their perceived equity but were no longer paying for something of less value. When enough people do this, the lender becomes insolvent because the lender also utilized leverage to loan the money. If the lender is a bank, the money lent may have been depositor money, assumed to be stable deposits. The system has been based on the perception of stability. The lender looks for stable and reliable borrowers. Depositors look for stable and reliable banks. You get the picture.
Relaxing lending requirements allows the leverage ratio to increase thus increasing the overall risk to the lender or investor. The Regulator’s job is to insure prudence in this area. Guidelines are established to protect the parties in question. However, Bill Clinton wanted more people buying houses so he pressured the regulators to allow greater leverage ratios and at the same time virtually eliminated the creditworthiness requirements of borrowers. The “no money down” loans began to spring up. “No income required” loans also came into the picture. The large banks were given a blank check to invest in anything that would stimulate the economy.
The current leverage ratio of paper gold investment to the actual physical metal is reported as being about 100 to 1. For every one ounce of gold there are 100 ounces of paper claims against it. This is one aspect of the “derivative” bubble we are now in. Once people decide to demand physical gold for their paper, the price of gold will skyrocket. This happens when the investor decides to de-leverage and reduce his “paper” exposure.
What would happen if all investors decided to move to cash and out of their leveraged paper investments? A massive implosion. If you hold a claim on an asset, that does not necessarily mean you really own the asset. This is actually true of your money in the bank. They are not actually holding your particular cash in a box for you, you hold a claim to an asset. You are an unsecured creditor of the bank. If things go too badly, you may not receive all your money back. If you too are leveraged, you may get stuck in the middle of an implosion.
Seek Our Heavenly Father on your particular situation. HE is the only One who is certain about the future. For everyone else there are three questions due to uncertainty:
1. When will the current unsustainable path of leverage implode?
2. What will the chaos be like?
3. How do I position myself for the chaos and the resulting system?
If each of us places our trust in Our Heavenly Father and follow HIS Wisdom, we will do just fine for HE will navigate us through the muck and mire. Those that don’t will suffer.