Financial Leverage. Article: The Real Cause of the Financial Crisis. Outline. What is financial leverage How financial leverage works Example how financial leverage related to economy crisis. Questions . F inancial leverage.
Article: The Real Cause of the Financial Crisis
In finance, leverage is a general term for any technique to multiply gains and losses.(Brigham 1995)Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. (Mock 1968)
In another words, financial leverage is a tool for investors to increase their profits when they do not have enough money. The most popular ways are purchasing fixed propertiesand using the money they could get from properties.
Generally speaking, it is using your money to make more money. Usually use your fixed properties as mortgage to borrow money from bank and make investment. Use profit you earn to pay for your lending.
*Mortgage: something with value that prove you have ability to pay off your lending otherwise bank can take it to make up its loss.
The property of bank A is 3 billion dollars.
In order to make more money, Bank A uses 20-30 times financial leverage. So Bank A uses its property which is 3 billion dollars as mortgage to borrow 90 billion dollars.
If Bank A applies this amount of money to get 5% profit. Then Bank A earns 150% profit compared to 3 billion dollars.
If Bank A lose in this investment, the result is brank up and debt of 1.5 billion dollars.
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event.
Default- break the deal
Compensate- pay off
In order to minimize the risk of Bank A. Bank A comes up with an idea…
The company C also wants to make money like Company B. So company B and C make a decision which is Company C uses 200 million dollars to buy every single CDS contract. It is also a great deal for company B because company B doesn’t want to wait for so long. Then company C also doesn’t want to wait for 10 years. So it sells those CDS contract on the market. Thus, CDS contract likes goods on the market. As a result, the CDS contract becomes higher and higher in the market and reaches an amount of 62 trillion dollars.
It seems that all the companies earned a great deal of money but whose money?
They borrow money which is with a high rate interest to buy houses and then make houses as mortgages to pay for theirs’ loans. Because some of them have bad credit and get no money to pay for theirs’ loans.
When price of houses is vey high, no one willing to buy a house. Thus, the bankrupt game begins.
If the company who owned CDS contracts go to bankrupt, then the 5% loses will go to the Bank A and Bank A should also pay for the insurance. Government will use taxers’ money to save the company who owned most CSD contract. But the devalue of the America currency as a result.
Much of the current financial market crisis is blamed on two main factors – poor risk management by company executives and the ultra-depressed housing market.( Singh 2008)