# Explain financial leverage to me

On the Daily Show yesterday they were talking about bank leveraging and how nothing has changed since last year. John Stewart and his guest threw out numbers like “30 to 1” and “10 to 1”. What does all of that mean? Please use small word, 'cause I don’t get this stuff.

Thanks!

Let’s say you want to buy some widgets because you think the price of widgets will go from \$10 to \$11. You use all your money to buy 10 widgets for \$100 and then the next day the price moves as you expected, so you sell them for \$110. Wahoo! Profit!

Now imagine that instead of using your \$100 to buy widgets, you used \$100 plus the widgets you’re buying as collateral for a \$1000 loan. Then you use the \$1000 to buy 100 widgets instead of ten. This is 10:1 leverage (actual numbers extremely simplified.) Now when you sell them at \$11 each for \$1100, you’ve made ten times as much money as you could have without borrowing.

The downside is that if the price swings the other way, you’re still on the hook for the loan.

Borrowing money to invest is called “leverage” because like an actual lever, it will multiply the gains or losses that come out the other side.

friedo’s got it. Leverage is investing with borrowed money.

There is nothing inherently wrong with it, just as there is nothing inherently wrong with financial derivatives. A bank can use financial derivatives to limit the downside of using leverage. So without knowing the portfolio and understanding how they may be mitigating risk, it would be difficult to say whether a bank’s leverage is a good or a bad thing.

I like that Jon Stewart tends to call things out, and he seems to be quite intelligent, but he might be out of his league here. I’m not saying he is wrong, because I don’t know the portfolios. But he isn’t necessarily right, either.

Now waitaminute. If \$100 will buy \$100 worth of widgets, then according to my simplistic math, my \$100 plus the widgets I could buy with that has a combined value of \$200.

Are you actually saying that there are banks out there – indeed, from the way this has come up it sounds like it’s standard practice – that will loan out \$1000 based on a collateral worth of \$200? What idiots started that practice?

I knew that a big part of the financial crisis was caused by stupid banks lending money to people to buy houses that they couldn’t afford, but I thought that at the very least, the banks could rationalize the practice because (at the time, anyway) the value of the house was at least the value of the loan.

But you’re saying that there’s an accepted practice of loaning money at five or ten or more times the value of any collateral? I think we have a new definition of “insane” here.

Seriously, if this is the case, why do they even bother with the sham of any collateral at all? “Hey bank, I’d like to borrow a thousand dollars.” “Ok, here you go.”

No, that was bad wording on my part.

Let’s say you’ve got \$100 cash and somebody willing to give you 10:1 leverage. They lend you \$1000 which you use to buy \$1000 worth of widgets. If you can’t repay, they take the widgets and your original \$100.

(Or in some cases,. whatever portion of the \$100 is necessary to make up the difference in price.)

In real life, it’s more complicated than that, but that’s the basic idea.

when banks make these types of loans, they don’t really care about the collateral. they care about the credit risk, period.

that has two components: the creditworthiness of the borrower, and the riskiness of the investment their money is going towards

banks/lenders analyze the market for wigets, and decide if it’s worth their while to give you the loan for an asset that you hope will appreciate. that’s what happened in real estate, collective assumptions all around that housing prices would continue to go up (or at least not decline) results in them being a lot more willing to hand over money.

you won’t be able to lever yourself if you’re investing in an activity where there is a clear risk of a drop in value (unless the bank can go after the borrower directly - i.e. assessing the borrower’s creditworthiness). for example, if the widget in this example is buying up old-school tube televisions with the expectation of selling them at 10% profit, you won’t get your loan. it’s all dependent on the underlying analysis of the transaction being contemplated.

they are fully collateralized anyways. their loan is going to buy new widgets.

Ever bought a house?

The bank doesn’t loan you money based on twice your down payment (ie, the money you have, and the widgets/amount of house you could buy with it), they loan you money based on the value of the widgets/house. They also have a leverage ratio they’re willing to support, which is why you usually need a certain percentage of the value of the widgets/house as down payment, but you can certainly get loans for far more than twice the assets you have as long as you have a plan to use the loan money to buy other assets that the bank can assign a value to, and potentially repossess if you default.

I personally think houses are the best way to explain financial leverage to someone without an intimate understanding of finance. I think the idea of borrowing \$80 for every \$20 you have sounds incredibly risky and imprudent until you stop and think that it’s what most Americans do when buying a house.

Obviously the risk of the asset and the cost of borrowing matters a lot, but I think home ownership is a good illustration of how financial leverage can be entirely prudent.

Yes, the mortgage analogy is good. You are getting a \$500,000 house with \$25,000 down payment; that’s leverage. Same idea as buying widgets or shares or whatever.

the bank is betting that worst case, either the house will cover whatever you haven’t paid yet; or if the value does go below \$475,000 you the good customer will continue to pay what you owe instead of declaring bankruptcy to get out of the debt.

When everything tanks big-time, that does not always work.

the banks are in the business of loaning money. So they can take your deposit or 401K, loan it out to someone who wants to buy a car. They can take the loan document, go to another bank or the central bank, and ask for a loan against it, and get even more money to then lend to someone else to buy a house, etc.

Eventually, if you tally it up, some banks would have actual cash on hand of about 1/30th of the outstanding loans, bonds, etc. As long as everything’s fine and everyone trusts everyone, this works. the moment any banks start wondering if the other bank will default instead of payiung those bank-to-bank loans, everything grinds to a halt. that’s what happened last fall.

Remember when Donald “hairweave” Trump was foaming at the mouth a few years ago because Rosie O’Donnell said he went bankrupt? He didn’t personally. He did his projects in separate companies, and each relied on his schmooze to raise money from other people and banks. So he leveraged his tiny contributions into a huge hundred-billions projects. Several of his ventures have been disasterous, but even though some Trump casino or whatever went belly up, his money is intact. And up until they went belly-up, he still got his management fees and name-rights royalties out of them. So, he’s not as dumb as he looks.

Ok, clearly I got confused by friedo’s example. So now it sounds like leveraging is nothing more than loaning money where the collateral is the thing(s) the money will be used to purchase, right? The details (like how much down payment is required, etc.) obviously vary, but isn’t that how most “large” loans are done? I mean, credit cards are basically a way of getting a loan with no collateral, but for other bank loans, doesn’t the bank require something that, at least at the time the loan is given, is perceived by the bank as having at least the value being loaned? So then is there really a difference between the borrower having the collateral in hand, vs. telling the bank that he’s going to buy it with the money borrowed? In other words, getting a loan to buy a house is “leverage”. But if I walk into a bank with, say, a bunch of stock certificates that the bank agrees are worth \$100,000, and use that as collateral to get an \$80,000 loan, is that something different than leverage?

At its core, “leverage” is a “loan.” So why not just stop there? Why can’t Wall Street be like everyone else and just use the simpler word “loan” or “debt”?

The extra idea in “leverage” is that the “loan” is used in a very particular context: it used specifically to multiply the returns (profits) of investments.

If a company gets a “loan” just to buy an office building, a tractor, or another company, that’s not leverage. If you get a loan (mortgage) to buy one house that you will move into, that’s not quite “leverage” in the Wall Street sense. “Leverage” has 2 components to its meaning – the “loan” and the “multiplying purpose.” Now, if you were to convince the bank to let you take on 10 mortgages so you could buy & flip 10 houses, THAT’s leverage. You multiplied the potential profit of rising real estate values on more than the house you happen to live in.

If you take a crowbar, you use it as a “lever” it multiply the force applied by your muscles to pry open a door. There’s no way you could open that door with just your fingers and arm muscles. With “leverage”, you can.

Collateral and leverage are two completely different things. They are related here only in the sense that you have been given example of using borrowed money as a means to get leverage, and an example of using collateral to borrow money.

Leverage simply means you are using some mechanism (often money) to multiply your profit potential (leveraging usually also multiplies your loss potential). See the examples above.

Collateral is security for a loan, and may vary from none to more than the value of the loan. I may have a paid-up house with a market value of \$100,000 and take out a home equity line of credit for \$25,000 against it, for example.

Banks are in the business of lending (among other things). When they lend they need to establish risk, and when minimizing risk they take collateral into account. That is not the only factor, although it’s the most obvious one for ordinary mortgages. The home is the collateral. A bank might lend me money just because they like my business plan, though. There’s no collateral per se; just an evaluation of how risky that loan is. (Obviously simplified, and harder to do in today’s environment, but just to give you an idea.)

It is not the case I have to use borrowed money to leverage an investment. Some types of stock options leverage profit potential, and it’s perfectly common to use my own money to buy them.

When I was taking an economics in HS (this was in 1953), the reserve rate was 20%. This meant that for each dollar the bank lent they had to actually have 20c in their vaults (actually in treasury notes). That was 5-1 leverage and was considered quite conservative. The banks could also require a 30 day notice of withdrawal, although they never did. I had a school account and the bankbook was very clear about that requirement and my father had to explain that they never enforced it. All this went back to the depression when banks could not cover instant demands for withdrawal.

This all worked very well and very few banks went under while businesses could easily borrow working capital. There was a second way that banks could leverage their deposits. Let’s say that they owned a note for \$1 payable in a year. They could take that to the discount window of their local Federal Reserve bank and get, say, an immediate 95c in cash. I am not sure if the Fed assumed liability in case of non-payment. The discount rate and reserve requirement were two of the main ways the Fed tried to keep the economy on an even keel. The third was the margin rate that, in the 50s varied between 50% and 100%. This determined what percentage of a stock could be used as collateral for a loan. A margin rate of 100% meant that stocks could not be used as collateral at all. The reason for this was that margin calls were a major cause of the stock market crash in the 20s. If, say, you used 90% of your stock for collateral and the stock went down by 10%, your lender wanted you to pay part of it back and so you had to sell for whatever price you could get. If everyone (or a large percentage of everyone) was in the same boat, you had panic selling.

Gradually, as time went on and memories of the depression receded (I certainly don’t remember it, but it is was in the conciousness of everyone in my parents’ generation) these various controls were lifted or modified to the point (IMHO) that they no longer protected against anything. Of course, the more highly leveraged you were the more money you could make–or lose.

Financial leverage really is just a synonym for debt used to finance an investment. So while you’re probably making a valid point that will help people understand better, you’re not technically correct in saying a house bought with 20% down isn’t leveraged in the finance sense. Upward or downward movement in the home’s value will be amplified compared to what it would be if you hadn’t financed the purchase. It’s exactly the same as it would be if you invested \$10,000,000 in credit default swaps on margin. And both are what’s meant by financial leverage.

I guess what I’m saying is, you’re right that few people would describe a home purchase as a financially leveraged deal, but it’s only because financial professionals use industry specific terminology that ‘normal’ people dont, just like any profession. It’s not actually an inaccurate way to describe it. That’s all there is to it - debt and financial leverage aren’t any different.

Incidentally, to go along with your reference to the crow bar - the reason you hear about financial leverage instead of “debt” is because the idea being conveyed is using debt to multiply the potential risk/reward, just like a crowbar multiplies force. Just talking about debt misses the ‘intention’. We also have ‘operating leverage’ which looks at how increased revenue impacts increased income. You could just talk about fixed costs vs. variable costs and be completely accurate but we keep using the ‘leverage’ word. Why? It gets to the heart of what we’re trying to discuss better.

Back to the OP – a financial definition of “leveraged”…

(Yes, in this example I’m leaving out details like sales commissions, margin interest, time value of money, etc. Once **Daddypants **understands then we can get into that stuff.)

An Example of **Not **Being Leveraged:
You have \$1000, cash, in your pocket, right now. It is yours. You own it.

You identify a stock that you think will go up in price. The share price of the stock, right now, is \$10/share.

The share price goes up to \$11/share. In other words, the share price has increased by +10%.

You sell your 100 shares, at \$11/share = \$1100

You now have \$1100, cash, in your pocket.

The share price of the stock increased +10%.

You invested \$1000 of your own money and earned \$100 on your investment. \$100 is 10% of \$1000. Your return was also +10% on your own money.

An Example of Being Leveraged:
You have \$1000, cash, in your pocket, right now. It is yours. You own it.

You borrow \$200. It isn’t yours. You don’t own it. It doesn’t matter where you borrow it from (a bank, a friend, a parent) you have to pay it back. You now have \$1200 to invest, or 20% (\$200) more than what you started with (\$1000). You are “20% leveraged” in this transaction.

You take that \$1200 and invest it in the same stock from the previous example, at \$10/share.

Because you are investing \$1200 at \$10/share, you are able to buy 120 shares. (In the previous example you were only able to buy 100 shares. In this example you are “20% leveraged”, and notice you are able to buy 20% more shares too. 120 instead of 100.)

The share price goes up to \$11/share. In other words, the share price has increased by 10% (same as before).

You sell your 120 shares, at \$11 share = \$1320

You pay back the \$200 you borrowed \$1320 – \$200 = \$1120

You now have \$1120, cash, in your pocket.

The share price of the stock increased +10%

But you invested \$1000 of your own money and earned \$120. \$120 is 12% of \$1000. Your return was +12%.

Notice that 12% is 20% more than 10%. The stock price rose +10%. *Your *return, on *your *money, was +12%. You were “20% leveraged”, so your return, on your money, was magnified (“leveraged”) by 20% compared to the change in price of the stock.

It Works The Other Way, Too:
You have \$1000, cash, in your pocket, right now. It is yours. You own it.

You borrow \$200. It isn’t yours. You don’t own it. You have to pay it back. You now have \$1200 to invest, or 20% (\$200) more than what you started with (\$1000). You are “20% leveraged” in this transaction.

You take that \$1200 and invest it in the same stock from the previous example, at \$10/share.

Because you are investing \$1200 at 10/share, you are able to buy 120 shares.

The share price goes down to \$9/share. In other words, the share price has decreased by –10%.

You sell your 120 shares, at \$9 share = \$1080

You pay back the \$200 you borrowed \$1080 – \$200 = \$880

You now have \$880, cash, in your pocket.

The share price of the stock decreased –10%

You invested \$1000 of your own money and lost \$120 on your investment. \$120 is 12% of \$1000. Your return was –12%.

Notice that –12% is 20% more than –10%. The stock price changed by –10%. Your return, on your money, was –12%. You were “20% leveraged”, so your negative return was magnified by 20%.

Leveraged 60%
You have \$1000. You borrow \$600. You invest \$1600 at \$10/share. You are “60% leveraged”. You now own 160 shares. The share price rises to \$11/share and you sell. 160shares X \$11 = \$1760. You pay back the \$600, \$1760 – \$600 = \$1160. The price of the stock rose +10%. Your return on your money was +16% (you earned \$160 on an investment of \$1000), or 60% more than the +10% the stock rose.
Leveraged 40%
You have \$1000. You borrow \$400. You invest \$1400 at \$10/share. You are “40% leveraged”. You now own 140 shares. The share price falls to \$8/share and you sell. 140shares X \$8 = \$1120. You pay back the \$400, \$1120 – \$400 = \$720. The price of the stock fell –20%. Your return on your money was –28%, or 40% more than the –20% the stock fell.

If you borrow \$600 and use \$1000 of your own money that’d be 0.6:1 leverage (60% leverage). If you borrow \$1000 and use \$1000 of your own money that’d be 1:1 leverage (100% leverage). If you borrow \$2000 and use \$1000 of your own money that’d be 2:1 leverage (200% leverage). If you borrow \$5000 and use \$1000 of your own money that’d be 5:1 leverage (500% leverage). If you borrow \$30,000 and use \$1000 of your own money that’d be 30:1 leverage (3000% leverage).

Remember that leverage magnifies *your *return on *your *money. It magnifies the gain, it also magnifies the losses(!). If you’re leveraged 30:1 on an investment and it has a positive return, your return will be 3000% better!!! You’re a genius!!! If it has a negative return… whoever it was that loaned you all that money is going to come after you with a vengance.

Thanks for a good, understandable explanation, with no jargon.

(and why can’t the techies who write computer manuals learn to write like you?)