As we have seen, consumers, firms, and governments all borrow. Borrowing can be a useful tool but it’s also possible to borrow too much. In the years leading up to the financial crisis, Americans borrowed more than ever before, especially in the closely related sectors of home mortgages and banking. It used to be common, for example, for home mortgages to require “20% down,” which means that a lender would lend at most 80% of the price of a house. On a $400,000 house, for example, a lender would agree to lend at most $320,000, requiring the buyer to put up at least $80,000 (20% of $400,000) as a down payment.

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The difference between the value of a house and the unpaid amount on the mortgage is called the buyer’s equity or owner’s equity. Lenders want buyers to have some home equity because this protects them if the buyer defaults. If a buyer has $80,000 of home equity, for example, then even if the price of the house falls from $400,000 to $350,000 the bank could still recover all of its loan in a foreclosure. The buyer’s equity gives the bank a cushion.

In the 1990s and 2000s, however, lenders became convinced that house prices were unlikely to fall and they became willing to lend with much lower down payments, just 5% down or even less. Indeed, at the height of the housing boom in 2006, 17% of mortgages were made with 0% down! Many people thought that house prices would continue to rise so buying with zero down was a way to speculate. If house prices rose, they could borrow more or sell at a profit. If house prices fell, they could default and not lose any of their own money. Yet if house prices were to fall and buyers were to begin to default on their loans, the banks no longer would have a cushion.

In finance, the ratio of debt to equity is called the leverage ratio. For example, if a buyer of a $400,000 house borrows $320,000 and spends $80,000 of her own savings, then her leverage ratio is . If the buyer is able to borrow $360,000 to buy a $400,000 house, then the leverage ratio is much greater: . Put differently, when the leverage ratio is 9, a buyer with $80,000 in cash ‘ can borrow $720,000 and buy a house worth $800,000. More leverage means that the same force (your cash) can be used to move (i.e., buy) bigger and bigger assets. As the financial crisis approached, house buyers were using more and more leverage.

Home buyers weren’t the only ones leveraging more; so were banks. Lehman Brothers, for example, had assets worth hundreds of billions of dollars but it had borrowed hundreds of billions of dollars to buy those assets. Moreover, just like homeowners, in the 2000s banks had been borrowing more and more with lower and lower “down payments.” In 2004, for example, Lehman’s leverage ratio was around 20—which meant that for every $105 in assets that the bank owned, it had borrowed $100, leaving it with equity of just $5. A leverage ratio of 20 is already pretty high.

Notice that if the value of Lehman’s assets were to fall by just 10%, it would have $94.50 dollars worth of assets and $100 dollars of debt, which means that a 10% fall in asset prices would make Lehman insolvent. An insolvent firm is simply one whose debts or liabilities exceed its assets (liabilities are legal debts plus other amounts owed, e.g. wage payments). Insolvency is usually followed by bankruptcy. Instead of reducing leverage in 2004, however, Lehman increased leverage so that by 2007 Lehman had an astounding leverage ratio of 44!9 At a leverage ratio of 44 even a small decrease in asset prices would bankrupt Lehman and in 2007 housing prices started to fall dramatically.

You might wonder why banks would ever want such a high leverage ratio. As we said, a leverage ratio of 44 means that even a small drop in asset prices would bankrupt Lehman but for exactly the same reasons a small rise in prices meant tremendous profits. When times are good leverage makes everything better. Moreover, when Lehman did well, Lehman’s managers received hundreds of millions, even billions, of dollars in bonuses and stock compensation. But when Lehman went bankrupt did Lehman’s managers go bankrupt? No. Most of them lost some money but they still ended up being very rich. Lehman’s managers wanted a lot of leverage because when things were going well the sky was the limit but when things went poorly most of them had limited downside risk.

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