Clarification:  Our present reality is that the Government has been subsidizing the availability, cost and terms of debt for decades.  If I had my preference institutions like Fannie Mae, Freddie Mac, HUD, FHA, SBA, The Federal Reserve, etc… would not exist.  Given that they do and are likely to persist, I believe that the following perspective is relevant.


Inappropriately high levels of debt relative to equity (“excessive leverage”) are dangerous, debilitating and destabilizing.  This reality is universal, applying to individuals, companies, industries, investment funds, cities, states and countries throughout history. 

A Consensus

There is broad agreement that allowing the use of extreme leverage to finance the purchase of investments or to capitalize companies is a bad idea.

• Allowing investment banks to increase their leverage to 30:1 was irresponsible.  Lehman Brothers, Merrill Lynch and Bear Stearns no longer exist because they subscribed to such extreme levels of debt.

• AIG failed because they were employing extraordinary leverage in underwriting credit default swaps, an unregulated industry, without adequate capital reserves.

• The realization that hedge funds, many of whom have failed as the result of recent volatility, had been operating at extreme leverage ratios of up to 50:1 has prompted inquiries by congress and will likely result in reasonable borrowing constraints being placed on the industry.

The Inevitable Result of Human Nature

To the extent that leverage is made available it will always be employed and abused.  This is the inevitable result of competitive forces, optimism, incompetence and the allure of leveraged-speculative returns. 

The more leverage employable to purchase a given asset, the higher that asset’s price will invariably appreciate.  At some tipping point, the value-inhibiting, prerequisite, access to investment capital is removed or no longer represents a material impediment to purchase.    

When this dynamic occurs, prices decouple from the fundamentals of value and are driven instead by the availability and increasing use of debt. 

Markets dominated by excessive leverage exhibit predictable characteristics.

• Prices rise due to increased demand resulting in:
  • Leveraged-returns
  • The increased use of debt to finance incremental purchases
  • The expectation of future appreciation
• Leverage-driven bubbles develop where unsustainable prices are only constrained by the availability and use of debt
• Price volatility increases
• The more prices decouple from the fundamentals of value, the higher the likelihood of a market collapse
• When the market falters, prices will fall rapidly and in sustained fashion
• Economic damage is magnified by the leveraged erosion of equity and the persistence of excessive debt

The Results of Extreme Leverage can be Economically Devastating

The financial events which triggered The Great Depression were a stock market bubble and the destabilization of the banking system resulting from its crash.  The bubble was driven by 10% margin requirements (9:1 leverage) and low interest rates available to service this debt.  When the bubble popped, equity evaporated but debt remained and the banking industry suffered a debilitating loss of confidence.

The Affordable Mortgage Depression was triggered and is being perpetuated by a housing price bubble produced solely by the availability and use of excessive leverage.  Buyers were able to access 0% down (infinite leverage) or 100%+ LTV mortgages with introductory interest rates as low as 1%.  Without the requirements of capital and cash flow to restrain housing prices, transaction values decoupled from fundamentals and appreciated rapidly driven only by the use of increasing leverage.  When the Housing Bubble popped, prices collapsed but excessive debt remains.  Falling home prices and foreclosures, which will persist until adjustable mortgages have run their course and prices have returned to sustainable levels, continue to apply devastating deflationary pressure on the economy.

Regulating Minimal Capital Requirements and Maximum Leverage Ratios

Government should restrict interference in private enterprise to a minimal role of preventing unacceptable abuses and restraining behavior that the free market can not regulate on its own.  One essential role that regulators play is the establishment of capital ratio requirements consistent with sound, sustainable and healthy economic activity.

Regulators should determine leverage ratios that are suitable and consistent with a vibrant, flexible and growing economy.  These ratios should not be excessive or promote dangerous and unreasonably speculative behavior.  The government has clearly recognized the necessity of such restrictions.

Regulators set minimal capital requirements:

• On the purchase of stock (50% margin requirement, 1:1 leverage)
• For the banking and insurance industries 

The results of regulators reducing or ignoring leverage limits have been disastrous.  Reducing minimal capital requirements:

• On Fannie Mae and Freddie Mac accelerated their collapse
• For Lehman Brothers and Bear Stearns enabled management to destroy the companies

A material, minimal equity investment is fundamental to the stability, solvency and sustainability of any asset class, company or financial system.  

A Public Policy Reality Meets “The American Dream”

Strangely, the lessons of excessive leverage are largely ignored when it comes to housing.

The down payment is integral to sustainable homeownership, the regulation of prices at fundamentally justifiable valuations, avoiding foreclosures and ensuring the health of the nation’s housing market.

At present the Government and HUD finance mortgages with 3% down payments. 

There is no sustainable benefit from the provision of mortgages with down payments approaching or the functional equivalent of zero.  Houses do not magically become more affordable with 3% down payments.  Prices inevitably rise driven by competitive forces as the percentage of nation’s income directed towards housing expense continues to be allocated for this purpose but in a more leveraged manner.  The Housing Bubble was created in such a way.   

The reality is that a person who can only manage a 3% down payment can not afford to buy the house in question and should not have access to such a mortgage. 

What the availability of low or no-down payment mortgages does accomplish is to decouple prices from the determinants of value, promote bubbles, increase volatility, create instability and establish the environment in which a debilitating, deflationary economic collapse may occur.

The argument will be advanced that houses would be unaffordable with a high down payment requirement.  But houses are only expensive because insane levels of leverage have inappropriately been made available to buyers with the support, approval and explicit guarantee of the U.S. Government.

Two Relevant Case Studies - Texas and the SBA

The state of Texas has laws that restrict many of the features which desensitized buyers to the price during the Housing Bubble.  As a result, the state neither experienced price distortions nor will it suffer the same debilitating rate of bank failures and foreclosures.




For those not aware, the Small Business Administration (SBA) provides loans to Americans for the purchase of businesses ("The Other American Dream") but requires a 20% (4:1) down payment to qualify.

The surest way to create an unsustainable, price bubble amongst small businesses would be to reduce the SBA down payment requirement to 3% (32:1).  Leverage would rapidly be employed, prices would decouple from the determinants of values, expectations of further gains would arise and capital would flow into the asset class.  At some point the leverage bubble would pop and the results would be economically damaging. 

Defenders of HUD-sponsored, 3% deposit mortgages may decry the SBA 20% requirement as an injustice.  But the reality is that even the Government recognizes the considerable risk involved in owning, operating and financing a small business. 

Yet this same Government, through HUD, FHA, Fannie Mae and Freddie Mac, issues highly leveraged mortgages under the asserted justification that housing is safe, local and rarely declines in value.  In recent years these assertions of low risk have been demonstrated to be preposterous.  Nonetheless, the Government continues to issue mortgages with insane leverage ratios.

The U.S. Government is the World’s Largest Predatory Lender

Not only has the Government failed miserably in its duty to responsibly regulate the use of leverage in home purchases, it has proactively made such inappropriate mortgages available on a massive scale and is presently acting as the World’s largest predatory lender.

HUD and the other GSEs continue to push mortgages on people who are not qualified to receive these extraordinarily risky loans.  By issuing 3% down payment mortgages the Feds are promoting transactions with leverage in excess of 32:1.  No investor, speculator, bank or hedge fund would be allowed to overtly finance the purchase of an asset with 32x leverage, yet illiquid, financially unsophisticated Americans are being given these destructive loans in an environment where real estate prices are collapsing.

The Government is willfully risking the financial health of its citizens and threatening the stability of the economy. 

Housing prices are dropping and will continue to fall as they return to values supportable by economic fundamentals.  Many of those people receiving predatory Government loans will rapidly find themselves in financial distress or at minimum trapped indefinitely in an underwater mortgage.

The Public Policy Debate

I do not advocate a specific, minimal, mortgage down payment percentage.  Twenty percent seems reasonable but a number higher or lower would also be effective.

I do know that this figure can not be subject to manipulation by self-serving politicians who lack an understanding of the reality of economics, and instead pursue goals defined only by social agendas. 

A suitable down payment should be high enough to act as a cushion against falling housing prices or during times of personal economic distress.  The required investment should be enough to avoid the self-perpetuating, cycle of foreclosures we are presently experiencing.  A mortgage down payment also must be of sufficient size to ensure that purchasers are sensitive to price and have material capital at risk.

If the Government does not learn to appreciate the central importance of down payments to sustainable home prices, the housing market will be both volatile and risky into perpetuity.  In an environment where 3% down payment mortgages are sponsored by the Government, it is inevitable that bubbles will emerge and result in economically devastating crises.