What is leverage?
After today’s highly publicized collapse of Lehman Brothers and the ongoing worries about different firms’ capitalization and leverage levels, there are probably many people out there wondering what exactly it all means.
Leverage is actually a rather simple concept. It’s the ability to use a relatively small amount of capital to control a large amount of assets. Basically, it’s borrowing money, the same way that an individual might try to purchase a house with a mortgage.
Imagine having $10,000 to your name and no means to making new money to live outside of return on your investments. As a great investor, you might be able to employ that $10,000 and get 20% annual returns on a regular basis. Even with 20% returns, you will only be making yourself $2,000 a year. But, if you had the ability to leverage that initial $10,000 and take out an extra $100,000 in loans from someone, your same 20% investments could make you $22,000 a year.
Obviously, there’s no way to get free money to use on your investments. Ultimately, you will have to pay it back… with interest. So, let’s imagine you can borrow money at 12% and you can make investments that return you 20%. At the end of the year, you’ll make $22,000 in capital appreciation and pay back $12,000 (12% of the $100,000 loan). Your end result: $10,000. Still a 500% the $2,000 you could make without leverage.
The leverage in the situation above was 10 to 1. You borrowed to control ten times the assets that you could have with your initial capital. Imagine what you could do with 30 or 40 times worth of leverage! That’s exactly what investment banks have been doing and in a market of super low interest rates and some pretty incredible returns in the capital markets. Unfortunately, all is well and good until your investments stop generating the returns that you so desperately count on.
Let’s go back to the situation above. Imagine you took the $10,000 you started with along with the $100,000 and bought stocks that you thought would appreciate 20%. Instead, the stocks lost 10% of their value. At the end of the year, you have just $99,000 and you still have to pay 12% interest on the money you borrowed. So, you’re left with $77,000. If you’re lucky, the bank would come asking for you to return the money you borrowed and maybe you can put the $77,000 back to work in hopes of making some money next year. But, if it turns out that the bank decides to get a little stingy and calls in your debts, you still owe $100,000 and you only have $77,000. Unless you can secure another lender quickly, you’ve got precious few options and, clearly, you’ve lost all of the $10,000 you initially invested. And, that, is how you end up like “the Brothers”.
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