Monday, October 13, 2008

Debt Disaster (2)

On Friday I attended a presentation on the state of the economy offered by our financial advisor. (We met with her a few years ago to plan for college savings ... then Robin went back to school!) The presenter said something that helped me understand the impact of debt on the failures of major investment banks. Not a quote, but the gist: If you buy a house with 20% down (1/5 of the value), you are "leveraged" 5:1. If the market value of the home drops by 10%, all that loss comes out of your equity, and you lose 50% of your equity. (That's the multiplying effect of debt or leverage.)

Investment banks packaged mortgages with the basic idea that this would limit risk. And, almost 95% of mortgages are being paid on time. So, why the big trouble? It can't be all because of late payments and foreclosures. To make the kind of money they were making, the investment banks were highly leveraged. Bear Sterns was at 33:1. Even a minor drop in housing values can have a catastrophic effect.

Just one more reminder on the dangers of excessive debt. . . .

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