Business Ethics / Economics / Finance

Leverage: What is it, Why do we use it, and How have we used it?

leverageMoney plays a large role in society. I understand that starting any article with such an obvious statement is extremely generic. However, I feel like that statement isn’t said enough, especially considering that nowadays it is a very popular idea to use other people’s money. This is the layman’s term for leverage. Leverage in a more formal definition is the use of financing from outside sources to amplify returns. This idea is so popular in finance, that it has singlehandedly brought down entire financial systems on multiple occasions. Shall we return to 1994 when a seemingly-divine team of financial and economic professionals formed a hedge fund called Long Term Capital Management. They assembled the biggest names in economics and finance to make a super team of investment professionals. Because of their respect on Wall Street, they were able to borrow against each dollar of assets they had. This led to them having over 100 billion dollars in holdings. Fast forward 4 years and they somehow managed to expose themselves and their investors to about 1 trillion dollars of market risk. The firm only had about 4 billion dollars in total assets under management (AUM). This happened due to its extreme amount of leverage.

I’m not here to question these professionals’ character, motives, or train of thought. Quite frankly, give me an Ivy League education, a great network, and 4 billion dollars, and I might have the capacity to cause a good amount of trouble in the markets. However, I feel like the idea of leverage needs to be further examined by the general public. The average citizen wouldn’t like to admit it, but we like leverage too. In fact, we love leverage, for just about everything. We get financing for our homes, cars, educations, and general purchases. The credit card in and of itself is just a short-term loan. Yet, we separate ourselves from top executives when they display irrational behavior. Can you rationalize taking out hundreds of thousands of dollars to spend on a degree that will get you a career that won’t pay off the loan you took out in the first place? I can’t, but many of us end up doing just that. Now it can be argued that an education does provide the opportunity to generate adequate income and ascend up the economic ladder. However, that doesn’t do much for the current trillion-dollar student debt bubble. College tuition will continue to rise and the average high school graduate will need to borrow more and more to continue their education. However, there is a more alarming example of consumer leverage.

“Maturity (x-axis) means time and yield (y-axis) is essentially interest. The curve moves up over time because of volatility.”

It’s called a house mortgage. Do people really consider their financial situation when they are purchasing a home? During the financial crisis, it can be argued that someone’s credit worthiness didn’t even matter. Sure, low interest rates and predatory lending definitely played a part in the mortgage default crisis. However, no one forced those people to take those loans. Adjustable rates on mortgages can leave a potential homeowner vulnerable to many different risks as time goes on. Even in a normal market, the economy is ever changing and always moving. In economics, a very basic concept is the idea of a yield curve. Maturity (x-axis) means time and yield (y-axis) is essentially interest. The curve moves up over time because of volatility. And this is in a normal market. Sure, adjustable rate mortgages may provide a cushion during times of low rates, but what about when they are raised? Your rates will go up but your income won’t, and you can’t ask for a raise because the economy is following its own universal laws.

Yes, owning a home is a very personal and emotional decision, but foreclosure is also a very personal and emotional event. As people who are pursuing the ultimate goal of one day being financially secure and free, we should examine the lengths we are willing to go to reach that goal.

I believe that taking huge amounts of borrowed money, no matter who you are, can be rewarding but dangerous without the proper precautions. It can sometimes go against all rationality. Leverage isn’t necessarily bad when used in moderation. This is why there are margin requirements (or cash requirements) to invest using borrowed money. Amplifying returns isn’t morally wrong. It isn’t a crime to seek out profits from the financial markets. The issue is when pride overshadows principal (literally). Some of the greatest minds in the world have had their successes simply reduced to nothing because of excessive leverage. Whenever this happens, we usually point blame and then throw away the greater conversation. Is there any person or entity that is above leverage abuse? To boost its economy, the Chinese government has made it easier for private equity firms to get financing to buy Chinese companies. This sounds like a good idea, however, what is the limit? Did we reach our limit? By “we”, I mean the United States government, and by limit I mean the $19 trillion debt that is looming on its balance sheet. Oh, and we are considered the most credit worthy nation ever. All I want to know is, does anyone actually know how to use borrowed money?

Sources:

http://www.businessinsider.com/the-fall-of-long-term-capital-management-2014-7?op=1/#e-idea-for-ltcm-began-with-john-meriwether-who-ran-bond-arbitrage-at-salomon-brothers-he-resigned-from-that-bank-after-an-employee-was-discovered-deliberately-deceiving-the-us-treasury-1

http://www.reuters.com/article/us-carlyle-group-china-idUSKCN11X17Q

http://www.treasurydirect.gov/NP/debt/current

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