The perils of leverage

One of the biggest lessons of the current financial crisis is: don’t take on too much debt.

This may sound like common sense advice, but it’s amazing how often people forget it.

If you buy a house with cash and its value increases 20%, you’ve gotten a 20% return. If, however, you borrow 80%, put 20% down, and its value increases by 20%, you’ve just doubled your money. There’s a big upside to using leverage.

But, debt is a double-edged sword. It doesn’t just give you bigger returns if things go well, it also gives you bigger losses if they don’t go well.

Using the same example above, someone who pays cash for a house that decreases 20% in value losses 20%. Someone who only puts down 20%, though, has lost everything.

Archimedes said he could move the world with a large enough lever. The lever multiplies the impact of your input. But, such leverage works both positively and negatively.

When banks were as free as they’ve been, in the late 19th century (1800’s), they carried 40% equity and borrowed 60% (levered 2.5 to 1). Banks operated that way could generally survive the inevitable economic storms that come along with economic cycles.

But, banks nowadays are regulated to be levered 10 to 1: they borrow 10 dollars and only contribute 1 of their own (or shareholders’). Such leverage is a double-edged sword, too. If a bank levered 10 to 1 makes loans and 9.1% of them go bad, the bank is basically insolvent. That’s what’s been happening recently.

Investment banks were levered 30 to 1. The top 5 investment banks are all gone or have been forced to become levered 10 to 1. Mortgage insurers and bond insurers were levered as highly as 140 to 1, they are now almost all insolvent. Many other insurers were levered up too much, such as AIG, and they didn’t understand the leverage they had taken on. That lack of understanding didn’t save them (or taxpayers).

Our current crisis is a perfect illustration of the perils of leverage. Companies like GM and GE are in trouble because they financed their companies with too much debt. It is difficult for almost any but the least levered companies to borrow money, now. As a result, almost any company with too much leverage has had their stock price massacred.

Everyone seems to understand that too much leverage is bad. But many businesses and individuals took on too much leverage and they blew up. Those are the folks getting bailed out now, and they are being bailed out by those who didn’t take on too much leverage. That just doesn’t seem right.

It seems like taking on too much leverage is a lesson that must be learned periodically. Those who survived the Great Depression were terrified of borrowing money.

Unfortunately, our country is currently trying to fix our leverage problems by levering up our government. It’s hard to understand how you can solve the problem of leverage with more leverage.

When a government gets too levered, the resulting problem is almost always inflation. Inflation solves the government’s problem with leverage, but not its citizens’.

Beware leverage. Beware inflation.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.