Leverage is using borrowed money to increase your potential return on investment. It is relying on debt in order to speculate. The use of leverage can make you take risks that you would not ordinarily take. The borrower is trying to earn a higher rate of return from investing than the rate in which he borrowed. Leverage can either maximize returns or maximize losses.
American banks, companies and consumers were overleveraged. Banks were leveraged at rates as high as 40 to 1. This means for every $1 of earnings; they borrowed $40. Investment banks and companies used leverage to produce extraordinary profits when the housing marking was booming. These same institutions found themselves overextended when the subprime crisis hit and their losses were magnified by the use of leverage. Banks tried to postpone their losses as long as possible but as is always the case eventually they had to pay.
I like to think of leverage like this. When I was in college and a professor would assign a term paper that was due in 4 weeks. For weeks I would do any and everything but work on the paper. I would know that the paper was due but I would keep putting it off. I kept telling myself I had more time. I figured I could go to the library, research the topic and write the paper in no time. Then the night before the paper was due; I would find myself trying to read the book, write the paper, spell check, print the paper and make it to class by 7:50 am. All I had done was overextended myself and delayed the inevitable.
That is exactly what using leverage is like. You eventually realize that you have to pay the bill. We kept borrowing money all the while knowing that the due date was rapidly approaching. Federal and state governments alike borrowed too heavily. Companies kept borrowing money so that they could fuel growth. Consumers kept borrowing so that they could buy more material goods. And what has finally happened is the bill has come due. Now we are all going through the long and painful deleveraging process of unwinding debt.
Finance
deleverage, leverage, ROI
Why do executives get paid millions of dollars a year to run a company into the ground? Why do these same executives earn hundreds of millions of dollars in bonuses, stock options and golden parachutes after driving these companies into bankruptcy? I was watching CNBC the other day and saw an alarming statistic. The average CEO’s salary is more than 435 times the average worker’s salary. That is unbelievable. I am an advocate of the whole pay for performance philosophy. But not when CEO’s like Richard Fuld of Lehman Brothers, James Cayne of Bear Stearns, Kerry Killinger of Washington Mutual, Martin Sullivan of AIG, Daniel Mudd of Fannie Mae and Richard Syron of Freddie Mac were paid hundreds of millions of dollars in salary and bonus packages to drive their companies into Chapter 11 bankruptcy. Why is it that when a company falls into financial trouble the employees are always the ones who have to suffer the losses?
The latest example of poor management can be found in the US auto industry. Richard Wagoner of GM, Robert Nardelli of Chrysler and Alan Mulally of Ford have been paid millions of dollars to fix the three largest domestic auto manufacturers. They have failed miserably. Their companies are on the verge of going out of business. So you would think they would be willing to take a cut in compensation? Of course not. A CEO would rather lay off 30,000 employees then eliminate his own bonus.
The management of GM, Ford and Chrysler have mismanaged the auto companies and are now seeking 25 billion dollars to stay afloat. I think that if Congress does give the auto manufacturers federal assistance that they will keep doing business as usual. This means laying off a significant number of employees in 2009 while management takes no reduction in compensation. Don’t get me wrong. I think the Federal government should help the auto makers but with some stipulations: (1) management needs to be replaced (2) salaries need to be much more realistic (3) management needs to develop a workable business plan. So what happens to the typical corporate CEO after he is let go from a failing company that he has mismanaged? He is given a signing bonus along with a hefty compensation package at another firm and begins the process all over again.
Finance
bankruptcy, Bear Stearns, CEO, CNBC, Ford, GM, Lehman, leverage
What caused the economic crisis?
A number of contributing factors have led to the current economic crisis that we face. I will list three of the major factors.
1) U.S. Housing Bubble - From 1999 - 2006, home prices in the US rose at a rate that was not sustainable and property valuations appreciated much greater than income levels. During this time period of “easy money”, lenders were giving loans to unqualified borrowers. These borrowers had below average credit scores and low income levels. Also, predatory lenders were taking advantage of these sub-prime borrowers by giving them high fee adjustable rate mortgages that would reset to double digit interest rates. These bad loans were then packaged together and sold to banks, businesses and investors as mortgage backed securities.
2) Credit Crunch - American consumers relied heavily on debt as a way of financing their purchases. Too many people treated their homes like an ATM and would refinance it whenever they needed money. As home prices declined, borrowers were unable to take money out of their homes. This led to a rise in the number of homes that went into foreclosure.
3) Liquidity Crisis- Wall Street investment banks and U.S. banks relied too much on leverage. For every dollar of cash that an institution had, they would borrow 40 times that. As more and more homes were foreclosed, the value of the existing mortgage backed securities owned by financial institutions declined. This caused a liquidity crunch for these institutions where they needed cash but had no means of obtaining it. The availability of credit shrank and the cost of obtaining credit skyrocketed. Banks were scared to lend to banks. Businesses that rely heavily on loans to fund operating activities were unable to obtain financing.
Other factors such as credit default swaps, derivatives, easy money policy from the Fed and high commodity prices also placed a part. All of these issues led to business bankruptcies, rising unemployment, major stock market decline and the delevering of financial institutions.
Finance
credit crisis, economy, housing bubble, leverage, liquidity
