An investor who primarily uses third (3rd) party money from sources such as banks, investment banks, private money groups, margin loans, credit lines, or other sources can be both a positive or negative option, depending upon the current state of the economy. In “Boom” economic times, when assets are rapidly appreciating in value, leverage can be an exceptional financial and investment strategy. This is partly true since the owner gets to keep all of the profits as we have seen more over the past year as it relates to rapidly increasing stock and real estate prices, even though the 3rd money source typically puts up the bulk of the capital in order to purchase the asset.
What is Leverage?
Per the financial website entitled “Investopedia”, some of the root definitions for the word “Leverage” translate as follows:
“1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
2. The amount of debt used to finance a firm’s assets. A firm with significantly more debt than equity is considered to be highly leveraged.
3. Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a home.”
Leverage Can be Good or Bad Depending upon the Financial Cycles
When assets are appreciating in value such as stocks or real estate, then using third party money sources (i.e., margin loans, mortgages, credit lines, etc.) to buy the assets can be a very wise and prosperous investment option. It is almost akin to being on a “hot streak” at the local casino in which a gambler is using the “house’s money” (or the winnings earned from the casino) in order to try to create even higher winnings with the gambler’s compounded parlays or bets.
For example, the $100,000 home that a homeowner purchased in 2012 using just $5,000 down (excluding closing costs or potential seller credits) may now be worth $125,000 in 2013. As a result, the property owner generated a potential $25,000 gain in appreciated value off of just a $5,000 cash down investment (excluding monthly mortgage payments, of course).
However, leverage can be a very bad thing if that same $100,000 property listed above now sells for $80,000. If true, then that same $5,000 cash down payment investment is now worth a whopping negative $20,000 (- $20,000), excluding closing costs and monthly payment obligations.
Leverage and Derivatives
The almost six (6) years of our ongoing Credit Crisis (www.thecreditcrisis.net), which began back in the summer of 2007, is primarily related to the collapsing derivatives markets worldwide linked to convoluted, complex, and nonsensical financial and insurance hybrid investments such as Credit Default Swaps and Interest Rate Options.
Many of these financial investments are akin to glorified “bets” in a figurative “casino” (or the world’s financial markets) in which one party bets on the future directions of things like the future direction of interest rates, or the values of underlying stock, bond, or real estate assets. In a “bet”, somebody typically wins, and somebody also usually loses. With most casino bets, the losing party may lose anywhere from a few dollars to a few hundred or thousand dollars for some of the more aggressive and wealthier gamblers. In derivatives investments, the losing party may literally lose hundreds of millions or billions of dollars to as much as trillions of dollars, tragically.
The global derivatives exposure in 2013, according to some analysts, is allegedly at least $1.5 Quadrillion (or $1,500 trillion) as valued in U.S. Dollars. The top twenty five (25) U.S. banks supposedly may have a total derivatives exposure, on and off balance sheet investments (publicly admitted or not), close to $250 trillion dollars, yet these same Top 25 U.S. banks’ combined total assets are only $8.3 trillion. If these numbers are fairly accurate, then these Top 25 U.S. banks are allegedly leveraged at thirty (30) times (x) their assets.
Sadly, U.S. banks may now have a derivatives exposure risk much higher than back near the start of the Credit Crisis in the summer of 2007, or back when the world’s financial system almost collapsed in late September 2008, as publicly admitted by Federal Reserve Chairman Ben Bernanke in the Spring of 2009 in front of a Congressional subcommittee hearing. The rapidly declining interest rate plunge between 2007 and 2013 is partly to blame for the increased derivatives risk exposure as T-Bill rates dropped from 5.12% to almost ZERO (or 0.03%) since these near zero yields motivated many banks to try to find higher yields in the derivatives markets.
Bailouts & Derivatives: Create Money “Out of Thin Air” for the Casino
Since the near financial implosion of the U.S. and world’s financial markets back in late September 2008, how many trillions of dollars of anonymous and not so anonymous bailouts have the Top 25 Banks, investment banks, insurance companies, and other businesses deemed “Too big to fail” have U.S taxpayers helped to subsidize and save from their own financial implosion?
If the fictional ABC Bank did perhaps receive $5 trillion in “bailout” money, then shouldn’t a fair amount of that same $5 trillion in funds be set aside to both boost the company’s stock values as well as to make more affordable loans to their banking customers? However, many financial analysts allege that the bulk of the “bailout” funds are being used to invest even more money in the riskier derivatives markets. In fact, some banking analysts suggest that the vast majority of the largest U.S. banks currently earn the bulk of their income from derivatives investments as opposed to fees and rates earned from making loans to their banking customers (i.e., mortgage, business, and credit card loans).
Leverage & The Bond Market
Over the past year, the 10 Year Treasury yields have reached as low as 1.55%. In recent times, the 10 Year Treasuries have fluctuated within the 2.8 to 2.9% ranges. Since 30 year fixed rate mortgages are tied to the direction of the 10 Year Treasuries, then increasing Treasury Yields and fixed rates are making it more challenging for borrowers to qualify for larger loan amounts with increased leverage.
With recent increased Treasuries Yields partly due to the Federal Reserve’s “tapering” comments by Fed Chairman Ben Bernanke, in which he alleged that the Fed may eventually taper or cut back on the amount of Quantitative Easing (QE) investments in the future. If the Fed may cut back on their QE investments in stocks, bonds, and mortgages, then the overall demand for these investments may lead to worsening prices. As bond prices fall due to less investors, then Treasury Yields increase since they are inverse to one another somewhat like a “see saw.”
Increasing mortgage rates then leads to decreasing mortgage loan amounts which borrowers may qualify for when trying to acquire real estate. As a result, home buyers or investors may need to invest larger down payments in their future real estate investments, since they will have less leverage options at their disposal, or reduced mortgage loan percentage options.
Leverage & Government Backed Mortgages
Over the past five (5) plus years, government backed or insured mortgages have rapidly increased in percentages nationwide, partly due to the weakening mortgage securities market. Once Fannie Mae and Freddie Mac were bailed out by the U.S. government and the FDIC almost imploded themselves back in the Fall of 2008 after the Washington Mutual collapse (* the largest bank collapse in U.S. history), then fewer private, non-governmental backed or insured lenders were as willing to make real estate loans (residential or commercial). This was true partly since they did not have very many secondary market investment sources which may buy these same funded mortgage loans from them at a later date.
FHA, VA, USDA, Fannie Mae, and Freddie Mac represented the bulk groups of government backed or insured entities which were directly or indirectly behind the funding of 97% of all U.S. residential mortgage loans in recent years. Additionally, SBA (Small Business Administration) and USDA (United States Department of Agriculture) have stepped up even more in recent years to help fund small to very large commercial properties (i.e., Retail shopping centers, hotels and motels, gas stations, industrial, office buildings, etc.).
We Need Better Capital Access
As I have said for many years now, the number # 1 factor behind the various “Boom” and “Bust” real estate cycles over the past several decades is related to the supply of capital. How readily available is the money today as compared with back in 2005? Even though 2005’s interest rates were higher than 2013’s interest rates, most people would answer that it was much easier to qualify for a mortgage loan back in 2005 than today, in spite of the higher interest rates back then.
I keep hearing rumors of more private money investors or investment groups interested in creating their own secondary markets for new and existing mortgage loans. If more secondary market investors begin purchasing funded residential and commercial mortgage loans, then private investors, small banks, and even larger banks will have more options to sell off their mortgage loans in bulk. Historically, private non-governmental loans typically have fewer fees associated with them such as FHA insurance premium fees, which recently increased even more partly allegedly related to the increasing mortgage default rates for the highly leveraged FHA loans in past years.
Back in the 1980s, I remember “Hard Money” loans, which were called “The Perfect Vision Loan” because the interest rates were 20%, and the cost to fund these loans was 20 points (or “The 20/20 (“Perfect Vision”) Loan”). Today’s private money loan options are incredibly cheap as compared with the old “Perfect Vision Loans.” In many cases, private money loans may be funded in a week or two as opposed to a month or two with various types of government backed or insured loans.
For the real estate markets and U.S. economy to continue improving in the near and long term, we need better access to capital for small investors and “Mom and Pop” business owners who truly represent the bulk of the U.S. consumer market. Even if interest rates continue to slowly increase as they have in recent months, due to the fears associated with potential reduced Quantitative Easing (QE) policies (or “create money out of thin air to bail out the Big Banks and Wall Street firms in order to continue increasing their bets in the world’s largest casino”), then the easing of underwriting guidelines and more private money or non-governmental funding options will help to better stimulate both the real estate sector as well as the rest of the U.S. economy.
Author: Rick Tobin
Rick Tobin has a diversified background in both the Real Estate and Securities fields for the past 25+ years. He has held seven (7) different Real Estate and Securities brokerage licenses to date.
Rick has an extensive background in the financing of residential and commercial properties around the U.S with debt, equity, and mezzanine money. His funding sources have included banks, life insurance companies, REITs (Real Estate Investment Trusts), Equity Funds, and foreign money sources.
You can visit Rick Tobin at RealLoans.com.