Leverage

While Sudeshna Sen complains about “how every kerbside operator thinks they know better than Hank Paulson what’s going on,” I am going to write a few paragraphs on yet another word that is going to join the list of hitherto unknown words that can now be heard almost everywhere – leverage.

A word that has its origins in physics – applying a small amount of force on one end to lift a heavy object on the other end through the process of magnification of force – leveraging in finance refers to the practice of using debt instead of equity in business so that profits and the return on equity (ROE) can be maximized.

In any business, ROE and its maximization plays a very important role. Consider an example where a business has two shareholders – X and Y – both investing $100 in the venture – it has not borrowed money, yet. And assume that the business of the firm is such that it can easily earn 20% return on its assets (ROA). In our example, the assets = liabilities = $200; so the firm earns $40. Assuming that there are no expenses involved, the entire earnings are profit; the ROE is 20%. Now, the business requires more money to grow, and the management has a few alternatives available –

  1. increase equity by accepting more money from existing shareholders – X and Y.
  2. increase equity by accepting money from new shareholder Z.
  3. borrow money from PQR bank.

If the firm goes for options 1 or 2, and brings in an additional $200 of equity, neither the ROA nor the ROE change. $400 of assets will result in earnings of $80 and the ROE remains unchanged at 20%. If the firm borrows $200 from PQR bank however (option 3), at (say) 10% interest, the situation changes. Now, the assets are $400, and the ROA being 20%, earnings are $80 – same as cases 1 and 2. But since interest needs to be paid on the loan (10% of $200), profits are $80 – $20 = $60. But even after paying interest, the shareholders are better off because the ROE is now 30%. On an equity base of $200, while they were earning $40 before taking out a loan, they are now earning $60. As long as banks are willing to lend the firm money at interest rates lower than the firm’s ROA, borrowing money instead of raising equity makes eminent sense. If PQR lends an additional $1600 to the firm, then-

  • the total assets = $2000,
  • liabilities on account of loans = $1800, and
  • equity = $200.

And in this scenario,

  • earnings = $400,
  • profits = $400 – $180 (10% of $1800) = $220
  • ROE = $220 / $200 = 110%

Who doesn’t like a 110% return on his investment? Of course, the case I am using is simplistic, the spread/ margin is huge, the case of the shareholder borrowing money and pumping it in as equity etc is not considered (the Modigliani-Miller theorem) but this is how it works. And the debt-equity ratio (one of the leverage or gearing ratios) in our case is 9 : 1 or 9 or 900% (Deutsche Bank’s ratio is 50 : 1, and 60 : 1 for Barclays. Comforting?)

The problem starts when the return on assets falls below the rate of interest paid on debt, whatever the reason. If the business scenario changes and the ROA drops to 5%, or the bank increases its interest rate to 25%, or the firm loses part of its assets in a bad investment, or the bank calls in some part of its loan forcing the firm to indulge in a fire sale of some of its assets (deleveraging), then the whole scheme will collapse and the firm will begin hemorrhaging money. This is what leveraging essentially is.

People, particularly the idiots who pretend to be experts and write columns in newspapers that barely serves the role of toilet paper, should know that the worldwide credit crisis has not been caused by excess leveraging nor has deleveraging exacerbated it. The crisis would not have happened if the leveraging was done on the basis of loans issued from sound money – real savings – and not magic money. Government intervention, central banking, magic money and monetary policy are the real culprits. Read the Austrian School view on deleveraging here

Is it true that if every bank were to attempt to “fix” its balance sheet, the collective outcome would be disastrous for the real economy? On the contrary, by adjusting their balance sheet to true conditions, banks would lay the foundation for a sustained economic recovery. After all, by trimming their lending, banks by implication also curtail the expansion of credit “out of thin air.” As we have seen, it is this type of credit that weakens wealth generators and hence leads to economic impoverishment. Contrary to the proponents of the “paradox of deleveraging” we can only conclude that if every bank were to aim at fixing its balance sheet, in the process curtailing the expansion of credit “out of thin air,” this would lay the foundation for a healthy economic recovery.

Risk is something that also needs mention. If someone invests his own funds, his maximum loss is limited to that investment. If he borrows money and invests, however, he is liable to pay off the loan even if his investment ends up as a dud. If you can take risks and understand what it is all about, or get a high from doing it, leverage, or follow Warren Buffett’s advice and don’t borrow money for investment purposes. There is are no “safe” ways of leveraging, only rules of thumb. Leveraging, simply put, is one among many tools of financial management and capital structuring, and has its risks. Real businessmen understand risks, and survive. Others pretend to, and fail.

PS: A blog run by economists sympathetic to the Austrian School that I discovered while writing this post (thanks, Wikipedia) – Organizations and Markets; it has some posts on the financial crisis (how can any self-respecting economist not write about it?). I have read precisely one post, but it looks interesting.

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