Suppose I buy a house by paying $5K upfront as equity and get the rest $95K as loan from the bank. This is where I am using leverage to own a property by paying a minimal down payment myself and getting the rest as a debt. If I can sell the house at $105K after a year, than I will make a profit of $5K. After returning the loan of $95K to the bank, I will make a profit of $5K on my $5K investment, that is a 100% margin! However if the price drops to $95K in a year, than I loose my entire equity after paying the debt of $95K. If the market drops to less than $95K, than I can not pay back my debt and can potentially become bankrupt. This is how real estate and many other businesses use leverage; sometimes it can be highly profitable, but it comes with its own set of risks.
Most investment banks and hedge funds have generated more than normal profits in last several years by using leverage as high as 1:30 or even more. They were banking heavily on real estate market which was growing continuously for years. Hence even when an owner defaults because of some personal challenges, the bank would occupy the house and sell it back at a higher price. However in last 1 year, the price has crashed by more than 20% (average) and hence banks were unable to salvage anything out of these non-performing assets. Since house owners often started with very little equity in the house (some times less than 1% now), banks had to bear all the losses. And this is when the real estate market brought the financial sectors down.
For a more technical discussion on leverage, please click here!
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