I watched theinterview with Jon Stewart and Jim Cramer. Early on Jon mentions 30 to 1 levered loans. What is he referring to? Later he claims the big companies were playing short term games for profit with people’s long term investments. Could somebody explain this or link to an explanation?
“Leverage” is what financial wizards call it when you borrow money on the value of another financial instrument. To use your 30-to-1 ratio, if you had a stock, bond, or mortgage worth $10, 000, you’d borrow $3,000,000 on it (did I get that right?) That ratio is very foolish for the borrower, and insane for the lender.
A loan is not leveraged, an investment is. Leverage is taking out a loan to buy an investment, like stock. 30:1 leverage means that for every $30 that was invested, $1 of it was contributed by the investor and the other $29 was borrowed money. Leverage greatly increases the potential gain to the investor, but also the potential risk. The additional risk is obvious: if the investment decreases in value, the investor has to pay back the loan out of his own pocket. Had he simply invested his $1, $1 is his maximum loss. With 30:1 leverage, his maximum loss is $30.
The increase in the potential gain is due to the fact that the investor owns 30x more of the investment than he would have had he only invested his own money. Suppose he pays 5% on the loan, and the investment goes up 10%. If he only invested his $1, he’d make 10 cents. At 30:1 leverage, his investment goes from $30 to $33. After paying off his $29 loan and $1.45 of interest, he has $2.55. His earnings went from 10% without leverage to 255% with leverage!
$30 plus interest, of course.
This is the best explanation I have seen. enjoy!
:smack:
155%. If $1 -> $1.10 is 10%, then $1 -> $2.55 is 155%. The point stands, though.
Bear with me, I’m slow on this. Why is it called leveraged? Why isn’t it just borrowing money to invest?
I get that part. If I feel an investment is a great thing I might borrow money hoping to increase my profit and still pay back the money I borrowed.
So, the lender isn’t participating in the risk of the investment right? Unless of course the investment falls through and the borrower can’t pay off the loan.
Because leverage is only one word. 
I believe that the word comes from an analogy with the concept of leverage from physics. The longer a lever one uses, the less strength it takes to move an object. Leverage effectively increases one’s strength. In the financial world, the use of leverage increases the power of a dollar, allowing it to get much higher gains.
Exactly right. It’s important to remember that if borrowing money to make an investment was guaranteed to make you money, the person offering the loan wouldn’t bother loaning it to you; he’d be investing in the investment himself.
A lever takes force on one side and gives you substantially more force on the other. A leveraged investment is the same way. The principal you have is the input force and the debt is the lever. Out the other side comes a gigantic profit – or a gigantic loss.
That was helpful thanks.
So basically it was just long term greed as investors and bankers and brokers involved wanted to get richer?
Another thought.
I was always pissed about the practice of CC companies sitting on campuses offering CCs to unemployed college students. It seemed to me that the CC companies were really counting on the parents to cover the debt which is why they were willing to issue credit to someone they normally wouldn’t.
Why did they lend to higher risk people? Was it because they thought rising property values would cover potential loss?
Yes.
The available investor money and the ability to pass on the risk pressures the lender to make riskier loans.
The easy credit pressures prices up. The parties taking the real risk, investors, think prices will go up forever.
This concept is very different for “recourse” versus “noncrecourse” loans.
If the loan is “nonrecourse,” then the lender can look only to the collateral (i.e., the property that secures the loan) for repayment of the loan. If the loan is “recourse,” the borrower is personally liable for the loan.
So, on a nonrecourse loan, the lender “participates in the risk of the investment” in a certain sense in that if the borrower doesn’t repay the loan, the lender gets only the collateral, so if the collarateral is worth less than the remaining loan amount when the borrower defaults, the lender loses. So, when a person makes a nonrecourse loan on real estate, they do much of the same due diligence that a person looking to buy the real estate would do.
If you think of a loan this way, then being the lender and being the borrower are just different ways to participate in the underlying investment. The owner gets all of the upside after he makes enough to pay off the loan. The lender has limited his upside (he gets only interest on the loan) but gets paid first (because the loan must be paid off before the equity owner gets any proceeds of the sale of the property).
On a recourse loan, on the other hand, the lender doesn’t really care what the borrower does with the money, they just care that the borrower is a creditworthy person and doesn’t borrow more than the lender thinks the borrower can repay.
Another way of looking at it, a way I find easier to get my head around, is what percentage of your investment is your money (capital) as opposed to borrowed money?
If you make a $100,000 investment with $20,000 of your own money and borrow $80,000, that’s 20% or 5-to-1. If you only put in $10,000 and borrow the rest, that’s 10% or 10-to-1. At a ratio of 30-to-1 you’re putting less than 3% of your capital into that investment and borrowing the rest, which is a huge amount. The more money you leverage against your capital, the more profit you can make but the risk is higher for you and your lenders if it goes wrong.
It is called leverage because that is what it does. An investment with 20% down has a 5 to 1 leverage.
I buy a house for 100,000 with 20,000 down. if the house goes up 5% it is now worth $105,000. I still owe $80,000 so the $25,000 equity is mine. I have a gain of $5,000. that is a 25% increase on my investment. That is 5% times the leverage of 5. Of course less my expences. But if it is a house that I am renting and the rent covers my expenses now I am at 25%.
I didn’t watch the video but if that’s the message you got from it, then it had a very incomplete explanation.
There is also greed on the part of consumers. People want the latest iPhone, a new car every 3 years, a big house, and all of it on debt piled on top of debt. And they want their 401K to deliver better than 7% returns. This keeping-up-with-the-Jones mentality plays right into the hands of all those greedy investors. Too much “fake” wealth (debt/leverage) chasing after equities.
The greed from the “bottom-up” (the consumers) was a bigger factor than the investors and bankers! This aspect is not played up in mainstream media but I believe future historical analysis will place more and more blame on the consumers. For now, the current generation can’t blame itself: why bother looking in the mirror when it’s easier to blame the greedy bankers?
Because it’s their frickin job. If I write SW I’m resposible for making sure that daylight savings time, leap year and other details are handled correctly. If I’m a structural engineer I am responsible for making sure the bridge stays up. If I’m a banker I’m responsible for making sure that care is taken with the assets I control on your behalf.
Now a cutomer may go to the designer of a bridge and say that they want the span to “look lighter”, but they have an obligation to say no if that compromisies safety. Same with a banker: especially if they are pulling in millions a year in bonuses for supposedly being so good at their job.
Maybe we’re getting into GD territory but I disagree. It is not a banker’s job to protect your money. To me, it doesn’t make sense for bankers to second-guess their borrowers’ financial ineptitude or the macroeconomic implications of their risky strategies. History has shown that nobody is smart enough to foresee all the negatives. Even Warren Buffet Berkshire Hathaway lost half its value last year.
Yes, it’s possible to outsource sex duties with your spouse, but would you want to? Like you said, people should outsource the building of bridges and surgery and can’t be expected to know what the engineers and doctors know. However, money is a very special category of knowledge and should be grouped with sex as something you must understand yourself. One of the repeated lessons I’ve gotten is that you cannot outsource the handling of your money & taxes. Society and its corruptible humans (e.g. B Madoff) have repeatedly shown that the financially ignorant will be taken advantage of.
If one outsources tax form preparation because it’s an administrative hassle, that’s fine. On the other hand, if he outsources it because he doesn’t understand taxes, that’s a big problem.
True, but then what happens when all your bridge customers migrate to the other guy that is designing “lighter” bridges? Sure his designs might not be as “safe” as yours, but some of them have been holding up for 5 years, and they were all cheaper to build than your designs. You can either:
A) go out of business.
B) get in on the “lighter” bridge market yourself and keep your job.
C) try to convince your former customers that your safety margins are worth the higher price. But no one cares, which leads you back to A).
I agree that people need to live within their means and too often want material things they could easily do without but the consumer didn’t leverage investments did they?