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Six Degrees of Leverage: Part II



December 10, 2007 – Comments (4)

In  Part I I looked  how a 10-year bond can be leveraged and the increased leverage of the money supply because of banks and I suggest that this increased leverage comes with substantial increased risk. 

A 10-year bond with a utility company is very different than the bonds being sold for mortgages. 

First, how different are families from utilities?  There is an implied trust that payment streams will continue from families until the debt is repaid.  What’s the relative difference in risk?

I did a blog, “Bad Feeling Good Times,” which was inspired by how the employment world, and standard of living has been changing.  Workers born between 1957 and 1964 have held an average of 10.5 jobs and I think that is probably getting worse, not better.  Add in that mortgages are based on family incomes and families fail.  A utility company isn’t going to get a divorce, cancer or have an unexpected pregnancy.

And homes have been priced to family income based on low interest rates.  This is another form of leverage.  Traditionally mortgages were granted so that only 30% of your gross income could be used for the mortgage payments and property taxes.  It seems to me that when I worked in banking mortgages were over 25 years, not 30, butI will use 30 years because this is what is being sold.  Heaven forbid, a blog I read somewhere this week was talking about mortgages that had been granted allowing 50% of income for debt servicing.  Seriously, this is economic slavery.  There is no hope ever of digging out of that level of debt. 

So, in how many ways is this leverage playing out in the economy that it can collapse?  Take a household income of $100k lets have a look at how much mortgage they qualify for at different interest rates and difference percentages of income.  To simplify this calculation I assume only mortgage payment, and no property taxes for this 30-year table.

Rate / % income

30% 35% 40% 45% 50% 2% 676,000 789,000 902,000 1,015,000 1,127,000 3% 592,000 691,000 790,000 889,000 988,000 4% 524,000 611,000 698,000 785,000 873,000 5% 465,000 543,000 621,000 699,000 776,000 6% 416,000 486,000 556,000 625,000 695,000 7% 375,000 438,000 501,000 564,000 626,000 8% 340,000 397,000 454,000 511,000 568,000 9% 310,000 362,000 414,000 466,000 518,000 10% 285,000 332,000 380,000 427,000 475,000 11% 262,000 306,000 350,000 394,000 438,000 12% 243,000 284,000 324,000 365,000 405,000

First, the fact that this is a 30-year table means that it already has debt amortized over an excessive amount of time.  It means that it is already not conservative in any way, shape or form.  Because it has become a social norm does not mean it has prudence built into it.  Set the qualifying standards to 30% of income at 12% as the maximum for a prime loan over 30 years and now you have prudence built into it.  It is insane and grossly ignorant to have allowed mortgage amounts to have increased to an identical percentage of income as rates declined.

And then a larger degree of insanity was added when the allowable percent of income was increased.  And this has been referred to as progress and even a good thing by calling it “modernization” of loans?  It isn’t a good thing, a wise thing, or modern innovation; it is an innovation of mass economic destruction that lines the pockets of a few for a relatively short period at the economic peril of the masses for a long term and has enormous spill over costs that are already being felt around the world, for example, Yukon has $36 million of this mortgage debt frozen, a bunch of Norway small towns have lost half this year's budget, including the school budgets, etc.

The degree of leverage, or money creation as that table goes from prudent at 12% and 30% of income to Master of Snake Oil finances at 2% and 50% of income is 464%.  To see the same income qualify from a low of $243k to a high of $1.1 million is an absurd range with an absurd level of increased risk.

In part III I will look at the declining leverage of families to get ahead due to the structural difference of low interest loans compared to high interest loans and the gross negative leverage implications for families.

4 Comments – Post Your Own

#1) On December 10, 2007 at 3:13 AM, XMFSinchiruna (26.57) wrote:

Wow... that's really interesting stuff dwot!  Thanks for the education on leverage!  Add to that effect the 'bull market' in housing which was manufactured by the lending industry and perpetuated by the media in the latter stages with the frenzy of shows like "Flip that House"... and you had mean home prices skyrocketing at the same time that the underlying leverage and lending dynamics you laid out so nicely.  So, we were able to borrow more with greater risk on increasingly leveraged debt, while mean home prices as a product of mean annual household income was also on a steady upward trajectory.

I wish I knew how to post charts within these blog posts, cause I think this is the perfect spot to discuss a cool chart tracking the long-term relationship between the price of gold and the cost of the average US House as priced in gold.  Given your obvious insight into the housing market, I would think this might aid my argument that this whole debacle is inflationary rather than deflationary.  :)  If you tell me how, I'll throw that chart up on my blog.  :)

But anyway, my hat's off to you for your grasp of economic theory!  What's your background dwot?

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#2) On December 10, 2007 at 6:07 AM, saunafool (< 20) wrote:

Great chart. How do you post tables on your CAPS blog?

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#3) On December 10, 2007 at 9:39 AM, dwot (29.28) wrote:

I use html code to post a chart, although I do "short cut" it and use two other sites to help me out.  A little table is easy to just code, but when they get bigger you spend forever checking your work.

I use the blog feature on to make the initial table.  It doesn't give you the code, nor can you just copy it.  I then copy it to the blog feature in blogger, with the "compose" tab.  Then I click the html tab and it has filled in my code for me.

I tried it with word but word puts in so much garbage code...  And stockhouse lets you easily add colour. 

I suppose I have a fairly broad background.  I started working in a tiny credit union right out of high school and with only a staff of 3 I had the opportunity to work in a much broad range of activities.  I was 18 and I was taking the odd loan application and I had a mentor that discussed more than just numbers in terms of who and what you wanted to loan money for.  One example I specifically remember was this guy wanted to borrow for xmas and he wanted to pay it back over 18 months.  My mentor's position was that if he couldn't pay for his xmas in 3 months he couldn't afford it and he did not get the loan he wanted.  I suppose the changes in banking no longer protect people from themselves, but I suspect that will change when it turns out the rest of us end up paying for the spill over cost of those people who've been allowed to run amok.  People are allowed to be stupid when it is their problem, but they aren't when it becomes our problem.

I've done lots of things... Report this comment
#4) On December 10, 2007 at 11:59 PM, dwot (29.28) wrote:

What did I just say about it become our problem...

This article on JP Morgan is basically they figured the mortgages they were writing were high risk so they sold them.  High risk investments aren't supposed to have a AAA rating.  Good for JP Morgan, grant mortgages they know are a problem, line their pocket and dump it on some unsuspecting investor.

They certainly have made this everyone's problem. 

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