Understanding Debt, Risk and Leverage

I don’t understand all the dominoes in the financial crisis. In situations like this, it’s helpful to step away and look at general principles: never mind the pieces, what’s the “gravity” that makes them fall? And fall so hard?

This is a companion discussion topic for the original entry at http://betterexplained.com/articles/understanding-debt-risk-and-leverage/

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Thank you Kalid!!! I thought I understood the leverage model but after reading this article I found out that I really didn’t get the how sever the ‘leverage’ is in the negative direction. It all stems from leveraging homes mtgs. to people who had no chance to pay them back (balloon payments, ARMS etc.). Factor into your leverage model the loss of jobs such as high tech in Ma. , manufacturing country wide and you can see how a small ripple becomes a financial tsunami. Capital injections won’t solve this problem alone. It is confidence. It goes back to money over a period of time which means jobs. A national program such as FDR did to end the great depression comes to mind. Repairing the infrastructure in the U.S would help in the short term but the final solution is high paying jobs here over time.
Take care

[…] November 17, 2008 at 8:53 am (General nonesense) The ‘Better explained’ blog has a great article on ‘understanding debt’: http://betterexplained.com/articles/understanding-debt-risk-and-leverage/ […]

Very Good article. You also haven’t taken into consideration the interest while borrowing from banks. Assuming we borrow 90k with an interest-rate of 8%, wouldn’t just 2% fall in housing rates wipe out our whole investment. Yes, there are certain economies which have close to 0% interest rate, which i think you have used as an example.

Good to see you back! Explained in a nice and easy to understand way, as usual.

Very very good article.

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@Mr. Rose: Thanks for dropping by! Yeah, I was pretty surprised by how much a negative swing can get multiplied into a huge loss – and the inability to pay back loans definitely kicked off a tidal wave. You’re right, there is a crisis in confidence right now, as banks are afraid to lend, making the problem even worse.

@Azhar: Thanks for the comment. Yes, I thought about mentioning interest (I may go back and add it briefly), but the key point of leverage is the multiplying effect (interest acts like a fixed cost in a way – the interest you owe isn’t tied to your gains or losses). But definitely appreciate the comment.

@Aditya: Glad you enjoyed it – yep, it’s nice to be blogging again :slight_smile:

@Ranga: Thanks!

This video is perhaps a little melodramatic but it does a reasonable job of explaining how the banks leverage essentially creating money:

I did need some leverage to understand the concept and you provided just the right amount of push to increase my knowledge gain!.. Thanks again for a wonderful post!

Its inspiring to read your posts! Keep posting!

@Yeroc: Thanks, I’ll take a look.

@Prateek: Appreciate the kind words! I’ll try to keep posting :).

Not only is the negative leverage a tsunami but the greed as well. It worked so well for so long that the risk factor started to be ignored. Instead of taking profit and paying off debt, they took the borrowed money, borrowed more and leveraged the whole package. What would that be, factorial??

Thanks for the article, and the links to the podcasts. A lot of this appears to be uncharted territory, so brushing up on some basic economic principles is a big help.I’m afraid this is going to get a lot worse before it gets better, and unfortunately, it will be the people struggling to make ends meet that suffer the most. I don’t have any sympathy for Wall Street, if anything there should be some criminal investigations. It’s strange how we will spend millions of dollars investigating a blowjob, but reward gross financial incompetence with more money. Its amazing to watch all these corporations start lining up at Wasingtons door now, trying to get their share of the loot before it dries up. Maybe I am old school, but I’ve always felt corporations and financial institutions should take responsibility for their own stupidity, and/or greed, and suffer the consequences accordingly. Instead, astonishingly, some of these companies are still paying out huge bonuses and other perks. No-one will ever be able to convince me why or how some ceo of a company that is failing deserves a $5 million dollar bonus in addition to all the other pay, perks and benefits. At what point does absolute greed bother these people, and if it doesn’t ,they must not have a conscience, and should be dealt with accordingly.

This was a very good read. Even after taking multiple finance courses in college leverage was a murky subject (but I got very good at filling in formulas). Thanks!

Hi anh. Another great article! =) It shed light upon some things we talked about briefly during the economic crisis & the election. It becomes more concrete when you put key words into context, such as leverage, return, and equity into the equation, and even bringing in examples of everyday mistakes people make into tangible realities. Makes me want to explore into the unknown territories of… drumroll please…FINANCE… the dreaded word that is becoming more of a friend lately. Thanks for the inspiration dear.

Thanks for the informative article Kalid !

Thanks for the great article - to the point and enlightening!

@Mr. Rose: Yeah, that was definitely a problem. People used leveraged investments to buy more leveraged investments… on and on. You’ll get insane gains and destructive losses… pretty much exponential I’d say (depending on the leverage factors in between – I’d have to multiply it out).

@Peter: Yes, one giant problem with leverage is if you can get bailed out if things go sour, you have incentive to make things as risky as possible. Imagine going to the casino and your rich Uncle Sam saying he’ll cover your debts if things go south. Why not bet $1M on red?

@Anonymous: You’re welcome, I was in the same boat as well. I’m always surprised by how revisiting the so-called “basics” can shed light into more complex matters.

@Valerie: Thanks Em – yeah, I find many articles in the media will just mention “leverage” but without concrete examples it can be tough to see why it’s so dangerous. You’re welcome for the article :).

@Arun: Glad you enjoyed it!

@Anonymous: Thanks!