Using the lever principle in physics, one pound of weight can lift a load many times its weight over a fulcrum. Analogously, using a down-payment of 20% to buy a home thus represents a 100/20 = 5X leverage. During the US housing boom in the 90’s, Merrill Lynch, an investment bank, used $30 billion of equity capital to incur debt of $1 trillion, a 33X leverage. Goldman Sachs, another investment bank, had a 25X leverage. (Economist 3/22/2008). Bear Sterns went as high as 42X (WSJ 5/6/2010)

Using leverage to acquire financial assets is very seductive in a bull market. At 42X leverage, a 10% increase in price of a debt-financed asset can bring in a 320% (42*1.1 – 42 – 1 = 3.2) gross return on capital. When interest rates were as low as 1% after the dot com bust, using leverage seemed like a sure way to make a lot of money. The capital gain could then be used as collateral to borrow more money to buy more assets. If the borrower is a home owner, he could cash out the capital gain through a home equity loan.

The downside of leveraging is equally devastating in a bear market. If the price of the debt-financed asset falls by more than (1/42 =) 2.4%, your invested capital would be wiped out and your debt-financed asset is under water, worth less than what you owe.

But in fact, housing prices fell more than 25% in the 2007 housing bust. No wonder some over-leveraged investment banks dealing in asset-backed debt securities no longer exist today as independent entities. And those who survived owed their survival to taxpayer bailout.

The degree of leveraging depends, of course, on the down-payment or margin required by lenders. The lower the down-payment or margin¹, the higher the allowed leverage. For example, from 2000 to mid-2006, lenders lowered the average down payments on riskier home loans to less than 4% from about 14%. (WSJ. 11/3/2009). In other words, the leverage of home loans increased from (100/14 =) 7X to (100/4 =) 25X.

Leveraging up is an inexorable positive feedback process in a bull market with excessive liquidity. Amidst low domestic interest rates and a flood of foreign money, lenders lowered the down-payments to entice more home buyers. More home loans drove up home prices by 90%. Higher home prices in turn drew in subprime home buyers and enticed existing home owners to trade up to more expensive homes. Increasing home prices also increased home equity to borrow from. Rising home prices also provided more collateral to package asset-backed securities to investors. In turn asset-backed securities are re-packaged multiple times into synthetic collateralized debt obligations. The margin requirements for buying these debt obligations were also lowered to entice yield-hungry investors. (WSJ 5/3/2010)

Deleveraging is also an inexorable positive feedback process in a bear market. When leverage is sky high, a small increase in the default rate could launch the process of deleveraging as asset prices begin to fall. Falling prices mean that the equity (asset price – loan value) of a loan can fall below the minimum margin requirement (as a percentage of the asset market price). Failure to answer the margin call could lead a forced sale of assets thus driving down asset prices even further. Falling prices might also lead lenders to raise the minimum margin requirements triggering more sales and discouraging new loans. Consumers might repay their debts instead of incurring more debts. Banks might tighten their lending standards and refuse to roll over old loans. All these can happen even when interest rates are very low as in the Great Recession starting 2007.