As a professional programmer I expect to make money doing what I do. At first I just threw the leftovers in the corner of my 401(k)/IRA and went on programming. In time it became big enough that that felt irresponsible. So I got serious about putting it to work making more money. In the Western world almost all ways of using money to make money involve leverage (see the first comment for a different way). Leverage has been in the news more than bit lately and I am trying to educate myself what it is and what it means for my savings. This and subsequent posts are thinking out loud about leverage in order to understand it. You are welcome to listen in.
The basics are simple
- raise some seed money
- borrow additional money at a low rate
- invest or loan it at a higher rate
- pocket the difference
Leverage is the ratio of the seed money to the borrowed money. The total return on the seed money is the investment’s rate plus the leverage ratio times the difference between the two interest rates. More leverage equals higher return.
The financial leverage idea is common to a lot of different institutions: retail banks, investment banks, stock brokerages, mutual funds, etc. However, the names of things can differ. To be consistent, I’ll call the seed money capital, the borrowed money the liabilities, and the investment or loan the asset. They must all balance out: assets minus liabilities equals capital.
As they say, show me the money. A group of ten friends pool their money, $10K each = $100K. The local bank pays 3.5% on $10K 12 month Certificate of Deposit (CD) but 4.0% on $100K 12 month CDs. The balance sheet for this unleveraged investment is:
| Assets: |
$100K |
12 month CD |
| Liabilities: |
-$0K |
|
| Capital: |
$100K |
seed money |
At year’s end the Profit and Loss (P&L sheet) is:
| Income: |
$4K |
$100K for 1 year at 4% |
| Expenses: |
-$0K |
|
| Profit: |
$4K |
|
The profit can be distributed (i.e., dividends), kept for another round of investing (retained earnings), or both capital and profits handed out to everyone and the deal is done (liquidation). By pooling their capital they have made more (4%) than they could separately (3.5%). This is basic capitalism, using money (capital) to make money instead of using work (labor) to make money. If you have a saving account, CD, an IRA or 401(k), own stock, bonds, or a mutual fund, you are at least part capitalist.
Now let’s look at what the bank does with the money from the CD. The World’s Smallest Bank (WSB) was founded by ten investors who each put in $10K. (Beware: this example is decidedly not realistic.) With this equity in hand, they sold 9 $100K 12 month CDs that paid 4%. They took this $1,000,000 and made an interest only home loan to J. Big Bucks for a McMansion on the lake at 6%. The balance sheet is (dollar amounts in balance sheets are typically in thousands):
| Assets: |
$1,000 |
the McMansion |
| Liabilities: |
$900 |
the nine $100K 12 month CDs |
| Capital: |
$100 |
seed money |
At the end of the first year, J. Big makes an interest payment of $60K. The P&L sheet is:
| Income: |
$60 |
6% of $1M |
| Expenses: |
$36 |
9 $100K CDs at 4% |
| Profit: |
$24 |
|
The year-end balance sheet is:
| Assets: |
$1,000 |
the McMansion |
|
$24 |
profit, i.e., cash |
| Liabilities: |
$900 |
nine $100K 12 month CDs |
| Capital: |
$124 |
seed money + profit |
The investor’s initial $100K has grown in one year to $124, a return of 24%. With a leverage ration of 9 to 1 the investors boosted the 2% difference between the CDs and the home loan by 12 times. Nice money if you can get it. A more realistic example would include employee salaries, office rent, office supplies, utilities, and other expenses.
More leverage will boost the return even more, but leverage at most financial institutions is capped by law in the 10–15 to 1 range. The upsides and downsides of leverage will be covered in posts about the good, the bad, and the ugly. To get an idea of what the ugly looks like, in 2004 five of the largest investment companies (Lehman, Goldman Sachs, Morgan Stanley, Merrill Lynch, and Bear Stearns) convinced the Securities and Exchange Commission (SEC) that they big enough and sophisticated enough to handle more leverage. In exchange for more oversight (which didn’t happen!) the leverage caps were removed. In the last year, Bear Sterns and Merrill Lynch were taken over by JP Morgan and Bank of America, respectively, to keep them from crashing in public. Lehman is in bankruptcy. Goldman Sachs and Morgan Stanley may yet survive, though Goldman’s stock is down by half from a year ago and Morgan Stanley is down by better than two-thirds. Leverage multiplies the returns on the way up and the losses on the way down. Stay tuned for details.