Demystifying Financial Leverage

Patrick McKenzie (patio11) • November 11, 2022

Leverage is one of the most difficult concepts to grasp for non-financial specialists. It's a bit obscure, requires some ease with math, seems vaguely scary, and is regularly found near smoking craters asking "Did I do that?"

Leverage is much easier to understand than many people think.

Basic mathematics of the balance sheet

Every business has a balance sheet that contrasts its assets (the valuable things it owns) and its liabilities (the valuable things it owes to other people). The difference between assets and liabilities is equity.

Financial companies frequently hold non-financial assets and liabilities. Ignore them for simplicity. Forget the beautiful building, the computers, the Friday payroll for work already completed. Focus only on financial assets and liabilities, such as "mortgages held by our bank" (assets) and "customer deposits" (liabilities).

Leverage is the ratio of your liabilities to your equity. Simplified division. Fourth grade math. If you have $110 million in assets and $100 million in liabilities, you have, by subtracting, $10 million in equity from your $100 million in liabilities. They say you are in debt 10:1.

Why leverage as a concept is useful

Finance deals with teleporting value in time and space. This is an extremely useful activity, but it requires taking various risks. Leverage makes it possible to quickly quantify the level of risk taken by a financial company.

This is easier to understand in the banking example. Imagine the simplest possible toy version of a bank, which only offers two products: checking accounts and mortgages. The primary source of value for banking as a business is maturity transformation: it teleports value over time to allow someone whose current account currently has significantly less than cost of a house to buy a house anyway and gain the benefits of living there. To do this, he puts part of the bank's capital at risk and mobilizes this capital using deposits in current accounts.

This bank is exposed to various risks. The first is that, because people can demand money from their current accounts at any time, the impecunious operation of the bank could cause the value of mortgages to drop just a tiny bit at a time when people have need most of the money in their life. verify accounts. This killed many, many banks.

(Mortgage values ​​sometimes go down for both easy-to-understand reasons, like the homeowner suddenly not wanting to repay, and for reasons that strike many non-specialists, like rising mortgage rates. interest. That's a long story, which we won't tell today. Back to leverage.)

How many asset write-downs can the bank take before its equity runs out? If you know the leverage ratio, you can mentally calculate an approximation in a trivial way. Add one to the leverage ratio. Take the reciprocal. Bam, that's how much a decline in asset values ​​wipes out equity.

A 10:1 leveraged business is wiped out if the assets lose 1/11th (~9.09%) of their value.

Manage the leverage effect of its clients

Many financial firms naturally go into debt; it is necessary to do the work. Interestingly, their customers are also often exploited. A homeowner who has just made his 20% down payment is in debt 5:1.

Financial firms often have to manage their clients' leverage, because just as a financial firm becomes more risky as the leverage ratio increases, so do their client accounts. After a certain point, the finance company will take painful steps to get you out of debt.

Let's take the example of margin accounts at brokerage houses. Google costs around $100 per share these days, so you can buy around 10 shares for $1,000 from your brokerage of choice.

Your brokerage firm, however, is willing to offer you leverage on your assets. In exchange for a commission (and to win your deal, as this is considered a very important feature for brokerage clients), they will lend you money against your assets, allowing you to buy more from Google than you had. They can allow you to have 2:1 leverage when you buy shares: your $1,000 buys 20 shares now.

Why would you want that? Because you love Google and want more exposure to it than you can afford. In future worlds where Google successfully sells ads and cancels chat apps, you'll make even more money that way.

So: The brokerage loaned you money (...