If the financial crisis taught us anything, it conveyed how crucial the credit markets are to sustain a functioning economy. In the darkest days of September – November 2008, the nation and world came perilously close to a complete and utter economic meltdown, which could have plausibly led to a widespread destruction of wealth and even massive food shortages.
To be sure, many factors contributed to the financial crisis and the subsequent economic downturn that continues to persist. The formation and collapse of the U.S. housing bubble was the catalyst that broke Bear Stearns, Countrywide, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, Washington Mutual, and AIG, among others. Government mandates on subprime mortgage origination, loose underwriting standards, shoddy diligence, excessive leverage, credit default swaps, and vast trading losses all played important roles to doom these institutions and the broader economy.
Bear Stearns, Lehman Brothers, and more recently MF Global, were each leveraged to the hilt before their collapses. In the years prior to 2008, Bear and Lehman raked in serious money as lines of business were profitable and asset values on their balance sheets appreciated. The substantial leverage enhanced profitability during the good years. Bear and Lehman held major positions in financial instruments linked to the housing market, and once the bubble started bursting, those assets lost value. If an institution with 40:1 leverage experiences a mere 2.5% write-down of its assets, the equity is wiped out – resulting in insolvency. While the business model for broker-dealers like Bear and Lehman differed from traditional banks, their fate highlights the delicate balance that companies need to strike when weighing shareholder profitability with proper risk management.
Banks
In the case of traditional banks, domestic and international regulators have taken a more conservative approach following the financial crisis. Institutions are now required to have higher capital ratios, thereby reducing leverage.
If these banks have solid business models without taking excessive risk, the more stringent capital requirements will curtail their profitability. The expectation and realization of a permanent reduction in profits serve to adversely affect bank stock prices. As a result, individual and institutional owners of bank stocks (including mutual funds and pension funds) are worse off because of reduced capital appreciation and dividends received. The companies themselves, experiencing reduced profitability and growth potential, will not seek to expand their business and hire employees to the extent they would have otherwise. In fact, many banks are contracting, with loan reduction and widespread layoffs occurring as a result. This scenario which is playing out today hardly seems like an optimal outcome.
Financial stability is paramount in a functioning economy, and some contend that the additional capital requirements are necessary to prevent another financial meltdown from occurring. In this construct, the tangible downsides of reduced profitability are outweighed by the potential increased stability that a reduction in leverage would provide. In accordance with, and separate from, the major financial reform legislation passed in 2010, banking regulators have taken a position to encourage significant deleveraging. Depending on how the economic and political climate evolves, there will be a continuing debate on what the “right” capital ratios are for banking institutions. This is certainly an important issue because either a) another financial meltdown, or b) a weakened economy and job loss caused by tepid loan growth could result from ill-advised policy.
Housing
Consumers leveraging to take on a mortgage is fundamentally different from traditional banks leveraging to underwrite loans and facilitate economic growth. Banks use leverage to increase lending and borrowing capacity, and its absence would make the business model untenable. On the other hand, consumers typically use leverage because they cannot afford to pay the full price for a house, and taking on mortgage debt allows for long-term financing.
If you purchase a home for $250k, you can finance it by placing 20% down and borrowing the remaining 80% from a mortgage lender. So you would invest $50k out-of-pocket (equity) and take on a $200k mortgage (debt), typically at a fixed interest rate for a 15- or 30-year time horizon. In this example, you would be leveraged 5-to-1 on the underlying asset.
If the home price appreciates by $25k, from $250k to $275k, that 10% increase translates to a 50% increase of your $50k equity stake. However, the same 5-to-1 leverage works the opposite way in cases of price decline. Depreciation by $50k, from $250k to $200k, equates to a 20% reduction in the home value. This translates to a 100% decline of your equity stake, resulting in the home value being equal to the mortgage debt.
Borrowers are “underwater” on a mortgage when there is negative equity; that is, when the principal balance exceeds the value of the home. Considering the fact that millions of borrowers contributed negligible down payments (< 5%), and that national home prices have fallen over 30% since 2006, it is rather obvious that more stringent down payments and less leverage will generate safer mortgages where borrowers can a) actually afford mortgage payments, b) have “skin in the game” to align incentives, and c) have more of a cushion to protect against price declines.
Keeping this thought in mind, this article highlights minimum down payment requirements for mortgages that are backed by the Federal Housing Administration (FHA) [a.k.a. taxpayers]:
While the article is from 2010, it is just as relevant today. Here is an excerpt:
An increase in down payments to 5%, from the current minimum 3.5%, would limit new FHA-backed loans by 40%, equivalent to 300,000 fewer home sales, according to testimony that FHA Commissioner David Stevens is set to deliver on Thursday.
“We share the goal of increasing equity in home purchase transactions, but determined after extensive evaluation that such a proposal would adversely impact the housing market recovery,” Mr. Stevens says in his testimony.
To protect taxpayer money, some experts have proposed the radical idea of requiring homebuyers to purchase a volatile asset using only 20-to-1 leverage (5%), rather than 29-to-1 leverage (3.5%). If the FHA is serious that 95% financing is too stringent a requirement, the housing market is in a far more perilous situation than many people realize. Ironically, many of the same people who decry excessive leverage in other financial sectors are big proponents of excessive leverage in mortgages, despite everything the housing bubble and subsequent crash has taught us.
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