The twist was that the football player had to push right next to the hinges, while the skinny kid got to push on the edge farthest from the hinge. The scrawny boy won easily! The reason was leverage; being farther from the hinge provided an enormous advantage.

Housing has been the road to riches for two reasons. First, U.S. housing prices have been rising relentlessly since World War II. Second, because people are able to buy houses with relatively small down payments they can have tremendous leverage.

Recall Fatima Melos home purchase that we discussed earlier. The young couple bought a house for $95,000, which they sold for $358,000. So they bought a house that increased in value by 277%. So how much did they earn on their investment? They invested $5,000 and borrowed $90,000. After selling the house and paying off the mortgage this $5,000 had swelled to $268,000! Now thats leverage! Figure 9.7 shows the return on this investment in reality (with leverage) and how it would have performed without leverage.

Financial leverage is great in bull markets. To make the most money the rule is simple: The lower the down payment, the greater the return on

6000% 5000% 4000% 3000% 2000% 1000% 0%

5260%

277%

277%

% home price % return without Actual % return increase leverage (with leverage)

FIGURE 9.7 Leverage Boosts Returns in a Rising Market

investment. Alternatively, for any fixed down payment, the bigger the house, the more profits. The road to riches in the U.S. housing market has been to buy as much property as possible and borrow as much as possible to leverage profits. It has truly been an astounding way to make money.

There are two risks to leverage. One is individual, and the second is the spillover effect on others.

Groucho Marx learned the individual consequences of leverage in the 1929 stock market crash.11 Groucho was opposed to gambling but had nevertheless invested his life savings into stocks. And he bought stocks on margin. In the 1920s the customary margin requirement was 10%. This allowed a speculator (or investor) to buy $1,000 worth of stock with $100 of cash. A 10% margin requirement allows for 10 to 1 leverage.

What are the effects of buying stocks on margin? With maximum leverage, any movement in the stock is magnified 10-fold. So a 1% rise in stock would produce a 10% return on investment. Throughout the bubbly 1920s people focused on the ability of leverage to increase returns.

Groucho found out that leverage works to dramatically decrease returns in a down market. A 1% decline in a fully margined account leads to a 10% loss on investment. More important, a mere 10% decline leads to total wipeout-a 100% loss.

As Grouchos stocks declined in 1929 he did what he could to avoid selling into a dropping market. He put up additional cash, and he borrowed money to provide margin for his stocks. In the end, he lost every penny.

Leverage was financial disaster for Groucho Marx (fortunately for him, he was able to recover through making successful movies after he went bankrupt). Grouchos decision to margin stocks also hurt other investors. At the market top, Marx owned a lot of stock. Once he was bankrupted he owned none-he was forced to liquidate his holdings as the market declined.

In a leveraged market, price declines put owners in financial distress as they are forced to liquidate. The liquidation puts further selling pres-

sure on prices, and the further declines then cause more financial distress and more forced selling.

Margin calls were widely attributed as a major cause of the 1929 crash. The Securities Exchange Act of 1934 was enacted to curb the excesses of the 1920s. Section 7 of the Act addresses margin lending, beginning:

For the purpose of preventing the excessive use of credit for the purchase or carrying of securities, the Board of Governors of the Federal Reserve System shall...prescribe rules and regulations with respect to the amount of credit that may be initially extended and subsequently maintained on any security.12

Under this law, the Federal Reserve sets stock margin rates. They have maintained the required level at 50% for several decades.

A dollar today can buy two dollars worth of stock. The same dollar can buy many, many dollars of real estate. It is relatively easy to borrow $20 for every $1 of down payment. Furthermore there are a large number of ways to avoid putting any money down to buy real estate (and these go far beyond no money down techniques so common on infomercials). Small down payments create massive leverage. The greater the leverage, the greater the possible gains-and possible losses.

Mortgage debt is now at all-time highs, and home equity as a percentage of home values is at an all-time low.13 Investors are increasing their leverage.14 Presumably, they hope to hit a home run like Fatimas. The negative potential, however, is that leverage in the real estate market will lead not to riches but to an outcome more like Grouchos.

Risk #3: Adjustable Rate Mortgages

My nephew Brent attended the University of Montana and immediately after graduation began work as a real estate agent in his hometown of Ann Arbor. Early in his career he had a great chance to buy some bargain real estate.