Most of us use leverage, although many probably don’t think about it that way.
When you buy a home, you simply apply for loans and then go with the one that has the best terms… typically it’s a 30-year repayment schedule with 20% down.
That’s simple enough, but when you look at it another way, this transaction involves you getting someone else (the bank) to put up $4 for every $1 you kick in. That levers you, the borrower, 4:1.
Immediately after you close, you’re on the hook to the bank for the repayment of the total amount, no matter what happens.
If your home drops in value by 10%, well, that’s okay, because you still have some equity. Sure, you’ve lost half of your down payment, but if worse comes to worst you can sell the home, pay off the loan, and still walk away with some cash.
If the home drops in value by 20%, then you’ve lost all of your own money.
At any number over 20%, we apply the dreaded term, “underwater.”
At this point, you would have to give the bank all of the proceeds from the sale of your house, plus extra money to make up the shortfall.
The logic here is that when borrowing money to invest or buy an asset, the greater the amount of your own money you put into the deal, the less likely you are to go broke if the value of the asset (in this example, your home) falls in value. Your money provides a cushion against downturns in the economy.
However, this logic seems to be lost on European banks. Even after everything that has happened since 2007, they want to hold less of a cushion, not more!
Compare the idea of having a smaller cushion in European banks to what is happening in America.
Under new regulations, U.S. banks are required to use less leverage (meaning have more of their own skin in the game) by 2018. Leverage will be capped at 5%, or $1 in capital for every $20 of deposits that they take in (some bank subsidiaries will need a bit more in capital, but not much).
Consumers should like this since it means banks will take bigger hits before closing their doors.
Taxpayers should be thrilled since banks will eat more losses before coming to the U.S. Treasury and Fed with their cap in hand.
It’s true that a 5% leverage ratio still seems risky (remember that homeowners usually have a leverage ratio of 20%), but it’s better than where we were.
What’s most interesting is that these levels, which seem paltry requirements, are twice the international levels. So while U.S. banks will be required to hold more capital, banks in other countries, like those of the euro zone, won’t.
Let’s consider this for a minute.
In the U.S. — where banks haven’t cleaned out all of their ugly loans from the financial crisis, but have at least sold off some of their foreclosed properties — leverage ratios are shrinking.
Meanwhile, in Europe, where banks have not written off much of anything, leverage ratios will remain exceptionally high, with such banks contributing only 2% to 3% of their own capital. So any shock to the system that wipes 4% to 5% of value off the books of banks would be a tremendous blow to U.S. banks, but would effectively wipe out European banks.
This brings up a very interesting point.
European banks tend to hold a lot of government-backed bonds, and not only from their own governments. German banks will hold Spanish bonds, Italian bonds, even Greek bonds.
It seems possible that, some time in the near future, some of these issuers could see their bonds go down in value… maybe by a little… maybe by a lot. At that point, those European banks with large holdings of such bonds could be effectively bankrupt.
No wonder the European Central Bank (ECB) keeps pressing the point that it will never let any of the euro zone countries fail. If the weak players stopped paying on their debt, it would cripple large private banks in the richer countries.
As big a problem as that is, there’s one bigger. That is, no matter how hard the ECB has tried and no matter what it has pledged, the countries of Southern Europe are not “fixed.”
Unemployment in Greece and Spain remains above 25%, while unemployment in Italy just moved up to 12.9%.
The figures don’t reflect recoveries. So while the ECB leaders can talk about great things ahead, they can’t point to any.
When Europe falls back into recession — and it will — be very careful of the region in general, and take special care to avoid the banks. They burned investors once. There’s no need to let them burn investors again.
Let them destroy their own (limited) capital.
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