Tuesday, April 20, 2010

Passion Party #199 - Leverage, Part 2

One basic area of financial leverage available to many people
is Real Estate.
It is common practice in the US to be able to buy a house or a condo with 20% down.
(You can buy a $500,000 house with $100,000 down).
In this way, you have just created a 5 to 1 leverage of your money, buying a $500,000 asset for $100,000, and borrowing the rest. If, let's say, the house increases in value to $600,000 and you sell it, you have just doubled your investment (minus closing costs, of course), so a 20% increase in value gives you a 100% return on your initial investment.

At the peak of the Mortgage Mess, people were buying property with 5% down, or 3% down, or even NO MONEY DOWN, in essence creating leverage of...Infinity?
In addition, people that already owned houses were being offered Equity Lines of Credit (HELOCs). These were, in a way, "margin accounts" based on the current value of their house. If kept as an emergency account it was a good thing, but many people used them for vacations or investments or to buy other houses. People were leveraging their home in California to buy multiple rental properties in Las Vegas, or Florida, or wherever real estate seemed "cheap".

When the "margin call" came - when the banks started closing the HELOCs due to falling property values - many people were in trouble, especially when they discovered that they could not rent out the property they bought to cover the various mortgages they had taken on.
The "great de-leveraging" of real estate had begun, which brought us a 40% drop in home prices nationwide.

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