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Overuse of Financial Leverage and The Housing Crisis

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  • Overuse of Financial Leverage and The Housing Crisis

    One of the contributing factors to the collapse of the housing market is the collapse of subprime mortgages. After a steady rise in real estate prices even unqualified applicants without a good credit history and cash for down payment in their pockets were able to get subprime mortgages to own a decent house. With the help of poorly regulated financial lending system it was so easy to get subprime loans with low interest rates and literally no down payment at all.

    When these loans matured their fixed interest rates turned into fluctuating form and the homeowners couldn't afford to pay their high interest mortgages. This triggered a lot of foreclosures in different parts of US. These foreclosures of the houses brought down the value of the other houses in their neighborhoods. All of a sudden many homeowners found themselves in a situation where they owe more than the market value of their homes.

    Besides subprime mortgages' defaults oversupply of new house constructions added fuel into the flame which spread into the whole country. The mortgage lenders and banks created so much diverse and complex mortgage options to be able to appeal more customers, neither the borrowers nor the mortgage brokers fully understood these options and their terms. These factors triggered the demand which caused a big jump in median home prices in the last decade. When we compare historical median home prices it clearly explains the whole picture. The increase in median home prices between 1997 and 2007 is 74% whereas the increase between 1987 and 1997 is 52%. The bubble in the last decade is unprecedented.

    June 1987: $85,900

    June 1997: $131,400

    June 2007: $229,200

    This seemingly national housing crisis turned into a worldwide economic crisis as the lenders of these default mortgages were the investors from all over the world, a bank from Australia or an investor from Taiwan. The burst of the ever inflating house bubble caused a domino effect and created a big worldwide economic downturn. Many banks and financial institutions having big amount of mortgage backed securities in their balance sheets, a.k.a. toxic assets, went out of business. This also created a credit crisis, i.e. the banks slowed the lending activity. Credit crisis affected everybody who needs a loan to start up a company, go to college or purchase an automobile.

    We can explain the root cause of this crisis as exploiting and excessively using of financial leverage. The investors were investing in US treasury bills since it was the safest harbor until when they found out that there was a better return in investing mortgage backed securities. After the dot-com bust and September 11 Federal Reserve Chairman Alan Greenspan lowered the interest rates to only 1% to keep the economy strong. This low percent interest repelled the investors while appealing the banks.

    As the banks could borrow more money with low interest rates, they could use that money to buy mortgages from mortgage lenders and sell them to investors and make money out of this deal. The investors were also happy as they were gaining more return than the Treasury bills. This is practically called financial leverage which means basically borrowing money to amplify the outcome of a deal. High financial leverage put the banks into a higher riskier position. Everything went well as long as the homeowners were paying their mortgages. But when mortgage defaults started excessive use of financial leverage put these money making banks into a bad situation.

    When someone buys "too much house" or refinances, as this means higher fixed cash outflows to support a higher mortgage payment, we can view this as higher fixed cost impacting the homeowner's budget. If, compared to fixed costs, variable costs form a relatively smaller portion of the household's total costs; this puts the homeowner into a risky situation due to high operating leverage. The definition of the operating leverage is the ratio of fixed costs to total costs. The higher fixed cost means the higher operating leverage.

    Due to high operating leverage, a small decrease in household income can jeopardize the financial position of the homeowner which may eventually end up with a walk away from the house or i.e. foreclosure. The families having this issue will try to cut the other costs to be able to cover the high fixed costs with their decreasing incomes. Per the "Greater Risk, Greater Return" rule this also means more income or equity if everything goes fine with the housing market and no concern of unemployment or no decrease in household's income.

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