Many of us are taking advantage of leveraging without even knowing because the most common form of it is our mortgage. Simply put, using leverage involves borrowing to increase capital for our investment(s). While many people don’t perceive it that way, our house is one of the many investments that we will make in our lifetime. The down payment is our capital and with it, we increased our leverage with a mortgage to buy a house that we otherwise wouldn’t be able to purchase.
Simple Stock Example
A more common way of thinking about leverage are with stock investments. Leverage, also known in the investment world as margin, can help provide us with spectacular returns. Let’s say the brokerage account allows you to borrow $5,000 on top of the $5,000 that you have to invest with. If you start investing in stock with the $10,000 and sold it when it goes up 20%, you will return the $5,000 to your broker (ignoring fees, interests etc) and pocket $7,000, a 40% gain!
As you can see from the simple example, leverage can be very powerful in helping us achieve great returns. However, using leverage is not without its risks. Consider the same example and using the same $10,000 to buy a stock that subsequently lost 20% of its value ($8,000). If you sold then, you will still have to pay back $5,000, leaving you with $3,000.
In the real world, the effects are even more severe. In order to protect the brokerage firms, investors must maintain adequate capital (known as the minimum margin requirement) to prove that the margin can be repaid. In an event that an investment is going against you and is losing value, the brokerage firm can give you a margin call and force you to either deposit more money to maintain capital or sell your investments to maintain a good balance to margin ratio.
If you don’t sell your investments and simply ignore the call, the firm has the power to liquidate your investments for you. At this point, you will have no control over which investments are sold so be careful with margin!
In order to encourage borrowing, investment bankers created what is known as Derivatives. It allows leverage without investors explicitly borrowing.
The most common form are options where an investor can purchase a right to buy a security at a given price point in the future. Another form of investing, which the investing world loves, are structured products. To satisfy the need for higher returns, many different types of investments can be packaged together on leverage and sold to others.
Leverage Can Be Risky Even for the Professionals
In the financial crisis of 2008, companies like Bear Sterns and Lehman Brothers leveraged their investments to upwards of 40 to 1 (borrowed $40 for every $1 they own) to buy mortgage derivatives. With this kind of leverage, investments that lose less than 3% would wipe out the equity they had in it. That’s why those two companies had so much trouble when the housing bubble crashed and couldn’t find enough capital to sustain operation. As a result, Bear Sterns was bought out with the help of the federal reserves and Lehman Brothers was let to go bankrupt.
Leverage is powerful, but if professionals at once powerful companies can misuse it to bring down multi-billion dollar firms, perhaps you should take extreme care as well.