o word of the day : LEVERAGE

Leverage is the ratio between an initial cash (debt) investment and the total notional value of the underlying asset. Leverage magnifies both gains and losses.

For example, suppose you only have $5,000 to use as a down payment for a house. Let's assume a bank issues you a $500,000 mortgage to buy the house you want. With a 1% down payment, you are able to buy a $500,000 house. By loaning you the amount you needed to purchase the home, the bank willingly enables you to leverage yourself 100:1! What's wrong with this scenario? If the housing market keeps rising and the value of the house appreciates to $600,000 in value, on paper you've made $100,000 profit on your $5,000 down payment. However, if the value of the house drops below the outstanding interest balance of the mortgage, the rational economic decision for the homeowner is to walk away from the house and default on the loan. When leveraged to these extremes, banks and mortgage owners become engaged in a high stakes game of roulette placing huge directional bets on the future price of real estate.

In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value. If a corporation can’t afford the risk of being highly leveraged, or even if the CEO and board of directors are uncomfortable with the level of risk, the only sound advice is don’t take on so much risk.

In the current market environment, not only are banks giving formal consent for consumers to be leveraged 100:1, banks themselves are leveraged 40:1 in the broader institutional market place. Therefore a bank that is dealing with a highly leveraged consumer is actually placing their leverage at 140:1. That's unconscionably high.

The housing crash should not just be the end of a bubble, it should be the end of a business model based on extravagant leverage. In future, set the down payment on residential homes to 20% of the value of that asset. Do not allow commercial banks to be leveraged more than 10:1 as a ratio of assets controlled on their books versus cash on their balance sheets.