Understanding Debt, Risk and Leverage

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I don’t understand all the dominoes in the financial crisis. In situations like this, it’s helpful to step away and look at general principles: never mind the pieces, what’s the “gravity” that makes them fall? And fall so hard?

Leverage. Leverage is debt used for investment purposes, and is extremely important. Why?

  • Debt, when invested, multiplies return (profits and losses)

Leverage is a multiplier, a super-power. Super-strength is great when times are good, and horrific when you accidentally “bite your tongue” (it’s super-strength, not invulnerability). Concepts like leverage are casually mentioned, but let’s see why the dominoes fall.

Get Rich Quick

I’ve got a great investment plan for you. Ready?

  • Step 1: Withdraw all your money
  • Step 2: Go to Las Vegas
  • Step 3: Bet it all on red in roulette (Get it right and double your money — get it wrong and lose it all)

It’s perfect! We’ll double our money in one step.

Sure, there’s a “chance” that things go wrong. But even then it’s no so bad — we’ll be at zero, like the day we were born. Presumably naked and crying as well.

Double My Money? But I Want More!

The plan sounds interesting, but there’s a problem — what if I only have $100? Doubling to $200 is nice, but not life-changing.

A few wild thoughts later, and we’re onto a better idea: let’s borrow money! The plan becomes exciting:

  • Take our $100 and borrow $1,000,000 from friends, families, banks, and unsavory characters. (How? Well, show different people our $100 and ask to borrow another $100, with our original cash as collateral).
  • Go to Vegas
  • Bet the $1M dollars on black! I mean, red!

What happens now?

If we win: we get $2M, pay back our $1M loan, and are sitting pretty with our profit of $1M.

And if we lose? Uh oh. Now we’re worse than naked: we’ve lost our shirts and everyone else’s too! Because we took debt, our worst case scenario is no longer going broke — it’s going negative.

Notice how the loan changed the outcomes — neither wild riches nor debtor’s prison were possible without the loan.

The Risk Multiplier

What just happened? Debt multiplies our risk and reward. The good times get great, and the bad times become awful. In our example, we went from winning or losing $100 to winning or losing $1M — a 10,000x difference in profit and loss!

This effect from investing debt is called “leverage”. Why?

I suppose it’s because a lever lets you move one end a tiny bit (one inch) and have the other side move a large amount (1 foot). It’s also called a leverage or gearing ratio — move the big gear one cycle and move the small gear many cycles.

My inner geek cringes, since the sides of a lever move in opposite directions (one side up, one side down) and same with the gears (one side clockwise, the other counter-clockwise). Remember that with financial leverage, both sides move the same way.

I imagine leverage as a game of follow-the-leader: I push my money in one direction (making a bet), and the huge pile of money I borrowed does the same.

Use whatever analogy works for you — the key is if your money wiggles up or down, the borrowed money does the same.

The Risk and Benefit of Leverage

Why does leverage work? At its heart, you are borrowing someone’s assets and reaping the benefits. It’s like borrowing a cow and selling the milk! What a great idea!

It’s great until the cow runs off. Now you’re stuck — you owe a cow and don’t have one to return. The risk of leverage is investing that debt and losing what you borrowed, which can wipe out any profits.

Let’s try a more realistic example then roulette: investing in a house. Suppose you have 10k and borrow 90k, to purchase a $100k house. You have a leverage ratio of 10:1 — for every 10 dollars of the asset, you’ve put in 1 dollar of equity (your own money).

If house prices rise by 10%, how much did you make? At first blush we’d say 10%, which is true — but you made 10% on the entire 100k! The house is now worth 110k, and after paying your 90k debt you’re left with 20k. That 10% growth became 100% profit on your initial investment!

  • leverage ratio = asset / equity
  • return = leverage ratio * percent change

Again, with 10x leverage, 10% growth becomes 100% return on our initial equity. From our analogy, we were in “control” of 10 dollars for every 1 we put in. So, we gained 10x the profit.

Now what about the reverse — when the house falls 10% to 90k?

Well, we can sell the house for 90k, pay off our loan (90k) and are left with… zero! Similarly, a 10% dip in prices becomes a 100% loss of equity — we’re wiped out! We get 10x the loss when prices go south.

And if the house price falls 20% (impossible! improbable! unlikely!), we suffer a 200% loss — we’ve lost our initial 10k and owe 10k beyond that (sell the house for 80k, but the loan is still 90k).

Hopefully the magnifying effect of borrowed money is becoming clear. You lose your equity when the investment drops 1/leverage ratio — in this case, 1/10 or 10%. With a 25x leverage ratio, the investment only needs to drop 4% in order to be wiped out. One way to think about it: you’re paying for losses out of your own pocket, not the borrowed money (you always have to pay it back). Your pocket is only 1 dollar of the 10, so once you lose it (1 dollar out of 10, or 10%) you are wiped out. Any more, and you’re in debt.

Real-world Examples

Leverage appears all over finance, but sometimes in disguise. Let’s take a look:

Getting a mortgage: As we saw, borrowing money to buy a house is a form of leverage. With 5% down (a 20x gearing ratio), your house only needs to drop by 5% to lose money. With 0% down, your house has to drop… wait for it… any amount for you to lose! And after your house is worth less than your mortgage, there’s little incentive to pay it off (better to go bankrupt, depending on the debt).

Lending money for a mortgage: Even banks are levered. When they offer money, where do you think they get it? From deposits! They borrow your deposits to loan it out to other people. If they have 10k of deposits they might loan out 100k (there’s some magic that happens here, how banks loan more money than they have; that’s for another time). If they loaned money for a house, and the house drops 10% in value and the debtor doesn’t pay, the bank has lost all if its deposits.

Offering mortgage insurance: Insurance companies might have 10k worth of cash, and offer 100k worth of insurance coverage to banks (C’mon, did you really think the insurance company had enough to pay off everyone’s claims?). Of course they don’t expect everyone to file a claim, but if even 10% of people do, they are wiped out. There isn’t an explicit loan, but the insurance company has created an obligation to pay (called the insurance leverage ratio).

See the set up? When prices are rising:

  • Owners are making a lot of money (they leveraged the house)
  • Banks are making a lot of money (they leveraged their loans, and earn a lot of interest on the borrowed money)
  • Insurance companies are making a lot of money (they’re offer more coverage, which means more premiums)

If the music stops and house prices fall, problems arise:

  • Borrowers lose equity — a 5% drop when 20x levered means the borrower is wiped out. Any more and the loan is worth more than the house.
  • Banks lose loans — if 5% of loans go bad, the banks have to pay for the lost value themselves.
  • Insurance companies lose money — if 5% of claims are called in, when the insurance company is 20x levered, it means the company has lost all of its assets!

For 20x leverage, a 5% drop would wipe you out to zero equity. Any more and you’re going negative — you’re at zero equity and still owe money!

The Lessons

I don’t understand the crisis, but I’m getting a grasp on leverage: it’s the gravity that pulls down the dominoes. In fact, it can multiply the dominoes as they fall! Here are the key points:

  • Leverage multiplies profits and losses: You can make a “regular” investment swing as wildly as you like by borrowing money.
  • Return = leverage ratio * percent change: A meager 10x gearing ratio can double your money with a 10% gain, or wipe you out with a 10% loss. By the end of a crisis, some banks increased their leverage ratio to 30:1 — if prices fell even 3% they would be wiped out!
  • Leverage appears everywhere: Companies have debt/equity ratios (how levered they are) and stock portfolios have beta (riskiness beyond the market average, which is increased by debt). Whenever you see debt or investment, look to see if it’s leveraged in some way.

Leverage make the boom times better and the busts harsher. The financial crisis has many other effects in play (such as the liquidity crisis, which makes it difficult to sell the assets you have to pay off your debts), but let’s take one idea at a time. A good friend found somepodcasts on the crisis — if you’ve found a resource that helps you get the crisis, feel free to share it below.

Other Posts In This Series

  1. The Rule of 72
  2. Understanding Accounting Basics (ALOE and Balance Sheets)
  3. Understanding Debt, Risk and Leverage
  4. What You Should Know About The Stock Market
  5. Understanding the Pareto Principle (The 80/20 Rule)
  6. Combining Simplicity and Complexity
Kalid Azad loves sharing Aha! moments. BetterExplained is dedicated to learning with intuition, not memorization, and is honored to serve 250k readers monthly.

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27 Comments

  1. Thank you Kalid!!! I thought I understood the leverage model but after reading this article I found out that I really didn’t get the how sever the ‘leverage’ is in the negative direction. It all stems from leveraging homes mtgs. to people who had no chance to pay them back (balloon payments, ARMS etc.). Factor into your leverage model the loss of jobs such as high tech in Ma. , manufacturing country wide and you can see how a small ripple becomes a financial tsunami. Capital injections won’t solve this problem alone. It is confidence. It goes back to money over a period of time which means jobs. A national program such as FDR did to end the great depression comes to mind. Repairing the infrastructure in the U.S would help in the short term but the final solution is high paying jobs here over time.
    Take care
    T

  2. Very Good article. You also haven’t taken into consideration the interest while borrowing from banks. Assuming we borrow 90k with an interest-rate of 8%, wouldn’t just 2% fall in housing rates wipe out our whole investment. Yes, there are certain economies which have close to 0% interest rate, which i think you have used as an example.

  3. @Mr. Rose: Thanks for dropping by! Yeah, I was pretty surprised by how much a negative swing can get multiplied into a huge loss — and the inability to pay back loans definitely kicked off a tidal wave. You’re right, there is a crisis in confidence right now, as banks are afraid to lend, making the problem even worse.

    @Azhar: Thanks for the comment. Yes, I thought about mentioning interest (I may go back and add it briefly), but the key point of leverage is the multiplying effect (interest acts like a fixed cost in a way — the interest you owe isn’t tied to your gains or losses). But definitely appreciate the comment.

    @Aditya: Glad you enjoyed it — yep, it’s nice to be blogging again :)

    @Ranga: Thanks!

  4. I did need some leverage to understand the concept and you provided just the right amount of push to increase my knowledge gain!.. Thanks again for a wonderful post!

    Its inspiring to read your posts! Keep posting!

  5. Not only is the negative leverage a tsunami but the greed as well. It worked so well for so long that the risk factor started to be ignored. Instead of taking profit and paying off debt, they took the borrowed money, borrowed more and leveraged the whole package. What would that be, factorial??

  6. Thanks for the article, and the links to the podcasts. A lot of this appears to be uncharted territory, so brushing up on some basic economic principles is a big help.I’m afraid this is going to get a lot worse before it gets better, and unfortunately, it will be the people struggling to make ends meet that suffer the most. I don’t have any sympathy for Wall Street, if anything there should be some criminal investigations. It’s strange how we will spend millions of dollars investigating a blowjob, but reward gross financial incompetence with more money. Its amazing to watch all these corporations start lining up at Wasingtons door now, trying to get their share of the loot before it dries up. Maybe I am old school, but I’ve always felt corporations and financial institutions should take responsibility for their own stupidity, and/or greed, and suffer the consequences accordingly. Instead, astonishingly, some of these companies are still paying out huge bonuses and other perks. No-one will ever be able to convince me why or how some ceo of a company that is failing deserves a $5 million dollar bonus in addition to all the other pay, perks and benefits. At what point does absolute greed bother these people, and if it doesn’t ,they must not have a conscience, and should be dealt with accordingly.

  7. This was a very good read. Even after taking multiple finance courses in college leverage was a murky subject (but I got very good at filling in formulas). Thanks!

  8. Hi anh. Another great article! =) It shed light upon some things we talked about briefly during the economic crisis & the election. It becomes more concrete when you put key words into context, such as leverage, return, and equity into the equation, and even bringing in examples of everyday mistakes people make into tangible realities. Makes me want to explore into the unknown territories of… *drumroll please*…FINANCE… the dreaded word that is becoming more of a friend lately. Thanks for the inspiration dear.

  9. @Mr. Rose: Yeah, that was definitely a problem. People used leveraged investments to buy more leveraged investments… on and on. You’ll get insane gains and destructive losses… pretty much exponential I’d say (depending on the leverage factors in between — I’d have to multiply it out).

    @Peter: Yes, one giant problem with leverage is if you can get bailed out if things go sour, you have incentive to make things as risky as possible. Imagine going to the casino and your rich Uncle Sam saying he’ll cover your debts if things go south. Why not bet $1M on red?

    @Anonymous: You’re welcome, I was in the same boat as well. I’m always surprised by how revisiting the so-called “basics” can shed light into more complex matters.

    @Valerie: Thanks Em — yeah, I find many articles in the media will just mention “leverage” but without concrete examples it can be tough to see why it’s so dangerous. You’re welcome for the article :).

    @Arun: Glad you enjoyed it!

    @Anonymous: Thanks!

  10. The lever analogy works better if you imagine a second-class lever instead of a first-class one. There, a small force produces a greater force in the SAME direction.

  11. @Luciano: Ah, interesting point! I think the relation between force and distance may be too subtle compared to rotations of a gear, but I like the thinking.

  12. First, the bank investment isn’t wiped out by owning a house that is 95% of its original value in your example. The bank breaks even because it has the 5% down + the house.

    Your misunderstanding of banks is very common. If you were right, then that 10x deposits would be invested in houses. The sellers of the houses put their 10x money in their banks as deposits. You say these banks lend 10x deposits, so now we have 100x the original deposit, and this expansion continues, creating infinity bucks. So you must be wrong.

    The right explanation is that 90.9% of deposits are lent and 9.09% of deposits are stored. This gives a reserve ratio of 10:1. Also, as those lendings go to other banks, the same 90.9% is reinvested, and multiplying to infinity gives a maximum amount of 10x the original deposits. AFAIK, if the bank runs low on reserves, it must borrow from the federal reserve, and cannot count this lent money as a deposit. I mean it can’t re-lend the fed’s loan.

  13. @Martino: Thanks for the comment! Let me see if I can clarify what I mean.

    Suppose a bank has 110k in deposits and gives out a 100k loan. Right now, the bank has zero net assets — all its deposits are owned by other people. The bank is hoping it can earn interest on the deposited money (5% let’s say) and keep that 5k as a profit for itself.

    Now let’s say the housing market crashes — the 100k loan is only worth 95k. The borrower stops paying the mortgage, the bank forecloses, and somehow manages to sell the house for the full price of 95k. What happens to the bank’s profits?

    Well, the depositors still think they have 110k in deposits. The bank only has 95k (recovered loan) + 10k (reserve) = 105k. The bank lost 5%, but it was 5% on a huge amount of money it didn’t have. The bank is now down 5k (on an “initial investment” of 0, as it didn’t put in any of its own money).

    As far as I can tell, the banks borrow deposits (for zero interest), invest them, and suffer the same consequences if the investments drop in value. (There are separate money-creation steps when the investments are subsequently deposited, but that’s a separate article).

    Thanks for the comment — I should clarify the example because banks aren’t “leveraged” in the traditional sense. They’re responsible for the entire loss, so a 5% drop means they lose 5% of the total amount they loaned out.

  14. @ Kalid
    I made a mistake. I checked wikipedia and found the reserve ratio is 9:1 or 10%. ( not 10:1)

    I also found out that savings accounts and CDs have no reserve ratio, which seems odd, and lots of countries have very low or zero reserve ratios. There must be a portion of each loan that isn’t deposited in another bank, and that must limit the money supply. When those unknown circumstances change, it could cause uncontrollable changes in the money supply.

  15. Thanks for the post.

    I would appreciate if you post something about money printing. And also what exactly happens when money is sent from one country [Dollar for example] to a different country [Euro for example].

  16. What about the system itself – in the loss situation has the money (1m) disappeared or just transferred to the casino?
    1. friends family : -1m
    2. Me : -1m
    3. Casino: +1m

    Is the system down 1m or is it even

  17. 1. Returning $1 million is not at all true :
    a) you have to pay the tax in case if you win.
    b) you are surely going to pay interest on borrowed amount either you lose or win.
    c) On a bet your probability of winning is a significant figure but in a highly dynamic market the chances are surely not at all quantitative( but thanks to great analyst and statisticians they give us a best figure)

    bu yes the best part of taking debt is you wont lose what you are expected to be if you have invested all what you have.

    what i suggest to all investors is to do your homework before investing:
    1. Business Model.
    2. Performance so far.
    3. Initiatives and proposals.
    4. organization’s own financial team and its brand value.
    5. use your own senses and be up to date

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  19. Hi Hassan, I set up an email list (you can join on the sidebar) to help stay up to date. Hope that helps.

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