Clarity on the Financial Crisis

This financial crisis is truly a mess. A very complex and expensive mess.

You may have heard of Warren Buffet and if you have, you know he is considered a rational and wise investor who has guided his shareholders through many market swings, delivering consistent returns- over 20% average annual return for the last 40 years- with steady hand and sound strategies. If you don’t know him you should.

In a not so recent (but still very relevant) interview with Charlie Rose, Buffet explains the current financial crisis in terms that the layman can understand. He offers hints as to what happened, what has to happen next and how he and his conglomerate holding company, Berkshire Hathaway, are responding. Buffet has recently gone on a bit of a buying spree of late, gobbling up a stake in General Electric and Goldman Sachs, two respected firms with long histories of solid returns and sound management, which are now very good bargains.

You will find a number of wonderful observations in this piece- particularly about human behavior and whats “rational” and not. But one key term you will hear and undoubtedly have heard in the press is “Leverage”. So let me provide a high level explanation of leverage as it’s a key element in many important business and personal decisions.

Simply put leverage is debt. Knowing what it means isn’t enough to be very helpful. Knowing how it’s used is what’s important. Corporations use leverage in some of the ways you might. When you take out a mortgage to buy a house, you are leveraging borrowed money. A down payment of $50,000 can buy you a $400,000 asset. You are borrowing $350,000, but you in a sense, own the asset. Now, yes, it’s true that until you pay off that mortgage, the bank owns the house- but only the amount owed to them. As that house appreciates you, not the bank, reap the appreciation on that asset. That appreciation is the benefit of leverage and its very attractive.

If you have $50,000 and you can either buy a house or invest it in the stock market (the long term stock market rather than the one of the last few weeks) how do you assess which is the best investment. Leaving out diversification of your investments and the utility or need you have for a house as factors in your decision, you would look at the rate of return on that $50,000 investment.

The stock market traditionally (not recently though) returns around 9% per year. The real estate market typically returns around 3 or 4% (again- not recently). You might think that stock market is the best way to go. But you should consider one very important thing. In the stock market you are getting 9% of $50,000 or $4500/yr- and if you mortgage a house you are getting 4% of $400,000 or $16,000/ yr. It’s the same $50,000 you put up, but in the real estate investment- by taking on debt- you are leveraging your money. This “levering up” to own a more valuable asset allows you to collect a return on an asset worth much more than the money alone. The higher the levering, the more debt you are assuming. Of course you need to pay off that debt- that’s the rub in the crisis today.

That is leverage in a nutshell. It’s a powerful tool. Potent when it works for you and devastating when it doesn't.