At Barry Ritholtz’s place a blogger writes
Example of 5 times leverage:
When we buy a house and put 20% down, we buy a house worth 5 times as much as the down payment. If we put $100 thousand down we can buy a house worth $500 thousand. $500 thousand divided by the $100 thousand we put down equals 5 times leverage.
100 times leverage:
By the same calculation ZERO down mortgages were suffice it to say, 100 times leverage, it’s actually more but that’s a discussion for later. Repeat after me, no money down mortgages equal 100 times leverage.
. . .
100 times leverage on the borrowers side times 30 times leverage on the [Too Big To Fail] banks’ side is 3,000 times leverage ON house prices.
Now there is the obvious issue that 100% down is not 100 times leverage but infinite leverage. I think the author knew this but thought that 100 would make more sense and make the numerical demonstration easier.
However, that’s a bad idea, because using INFINITY would have shown you that your numerical example is doesn’t really make sense or at least isn’t telling you what you think.
In particular, since 30 times INF is still INF, the leverage at the bank side is irrelevant to the calculation. Yet, the author set out to show how excessive bank leverage contributed to the crisis. Thus, something went wrong if these measures tell you bank leverage is irrelevant.
The second issue is the phrase ON house prices. Yet, its not on house prices at all. Its on houses. In particular, if you like your house, want to keep it, can afford the payment, etc then movements in its price are not necessarily important to you.
They certainly don’t bankrupt you. They don’t make the house any less house-y. They don’t make the roof stop keeping out the rain, etc.
Leverage has important properties. And, leveraging purely for the purpose of speculating on the market value of some asset is relatively dangerous for the creditor – though not necessarily for the borrower.
This is why creditors are typically loathe to let you do this. However, for the most part neither banks nor home buyers were speculating on the price of houses. They expected both the loans and the homes to produce yield and that yield to exceed the cost of funding.
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Saturday ~ December 31st, 2011 at 6:36 pm
q
> However, for the most part neither banks nor home buyers were speculating on the price of houses. They expected both the loans and the homes to produce yield and that yield to exceed the cost of funding.
“for the most part” is not relevant here. large amounts of the money funding the home finance system was sold as super-safe AAA – both rolled into CDOs, tranched out, and insured – then those products were in turn heavily leveraged. they were heavily leveraged because they they were “proven” safe – by faulty maths which failed to take into account the possibility of many things, among them liquidity issues and house price declines.
Saturday ~ December 31st, 2011 at 6:37 pm
q
and to be clear on this, if a bank takes 20% down, they aren’t taking much risk on the house price. if the owner defaults there’s a very good chance over history that they will get paid back – they can take possession of the house and resell it. if a bank takes 0% down, they are taking a lot of house price risk.
Saturday ~ December 31st, 2011 at 7:42 pm
scharfy
That poster is George Washington AKA (alex floum).
Truther, nutbird, conspiracy crackpot.
Here’s a taste of his work:
http://georgewashington2.blogspot.com/2011/01/humans-have-been-modifying-weather-for.html
Alex Jones cites him frequently, and I think he pays big money to post at respectable sites.
But you used his wackiness to make a valid point. Well done