File:Financial Leverage Profit Engine.png

Text of the Diagram

The text of the diagram is indicated below. Please make edits here and I will update the main diagram periodically.

1. Let’s say an investment bank borrows money from an investor or money market fund and agrees to pay a 5% interest rate. The MBS portfolio is collateral, which the investors can seize in the event of a default on interest payments.
2. The investment bank uses the funds to expand its MBS portfolio, which is paying an 8% interest rate (perhaps due to some higher-risk mortgages comprising the MBS). The 3% difference between the amounts is called the “spread.”
3. For every $100 invested in this manner, the investment bank gets $3 profit margin ($100 X 3%= $3). This provides an incentive to borrow and invest as much as possible, known as “leveraging.” This was considered safe during the housing boom (through early 2007), as MBS portfolios typically received high credit ratings and defaults were minimal. Since investment banks do not have the same capital reserve requirements as depository banks, many borrowed and lent amounts exceeding 30 times their net worth. By contrast, depository banks rarely lend more than 15 times their net worth. Freddie Mac was leveraged nearly 70 times its net worth.
4. With increasing delinquencies and foreclosures during 2007-2008, the value of the MBS portfolios declined. Investors became concerned and in some cases demanded their money back, resulting in margin calls (immediate need to sell/liquidate the MBS portfolios at fire-sale prices) to pay them. At such a high leverage amount, many investment banks and mortgage companies suffered huge losses, bankruptcy, or merged with other institutions.
5. Because MBS securities are now considered “toxic” due to uncertainty in the housing market and cannot be sold readily (i.e., they are “illiquid”), their values have plummeted. The market value is penalized by the inability to sell the MBS; it may be less than the value the actual cash inflow would merit.
6. The ability of financial institutions to obtain funds in this manner via MBS has been dramatically curtailed. Spreads have narrowed, as investors are demanding higher returns to lend money to highly leveraged institutions.

Notes

This diagram is highly simplified, as there are often other parties involved in the creation of the mortgage backed securities. However, it should help illustrate why companies borrowed so much during the boom times, and why they are suffering now. The following source provides excellent, detailed background on the subprime crisis.^[1]The contribution of financial leverage to the crisis is discussed throughout. Freddie Mac's leverage number is calculated from its Q2 financial statements; $879 billion in assets over $13 billion net worth (equity).^[2] Investment banks are not subject to the same capital reserve regulations as depository banks. Some of the larger investment banks were highly leveraged (i.e., a high ratio of debt to capital reserves). As a result, they were not as capable of absorbing MBS losses. In addition, they were also counterparties to complex credit derivative transactions insuring various types of debt instruments. The combination of MBS losses and leverage rendered their ability to perform their counterparty role less certain. This in turn represented a broader risk to the financial system, resulting in their outright or "arranged" takeovers.^[3] European banks also have very high leverage ratios.^[4] A highly leveraged institution can have its equity wiped out due to relatively minor swings in the value of its assets. For example, let's suppose an investment bank has $310 in assets, $300 in debt and $10 in equity capital. This is a leverage ratio of 300/10 or 30-to-1. It is an accounting identity (a rule that must be true by definition) that assets equals the sum of liabilities and equity. Now suppose the value of the assets declines by about 3% to $300. The institution still owes its debt holders $300, so equity must be zero. Many financial institutions are facing this scenario. To get more equity or capital, they typically issue new common stock shares to the public in exchange for funds. However, this dilutes the ownership of current shareholders, placing downward pressure on the stock price. When share prices have been reduced as was the case in 2008, a larger and more dilutive issuance of shares is required. In some cases, new share issuance is done at below the current market value.