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Blog #9
(September 17th, 2008)
LEVERAGE COMES BACK TO BITE
By Tom McAllister, CFP™
There's an old English saying that comes to my mind given this week's news: “He who borrows what isn’t his'n, must pay it back or go to prison!” While people are no longer thrown in prison for failure to pay their debts (either in England or in the United States), leverage through borrowing money can have unwanted consequences.
Leverage is actually a very useful financial strategy, because it allows individuals and companies to take advantage of opportunities that demand more capital than is available at the time. A consumer uses leverage when moving into a $200,000 home after making a down payment of only $40,000. Should the home appreciate in value by 5% so that its worth becomes $210,000, the buyer's actual cash investment would appreciate by 25%! Companies can expand overseas, build new plants, and grow their business with the help of borrowed capital. It's hard to focus on the positive aspects of leverage in light of all the recent negative news, but the truth is, the amazing and continued growth of our economy would have been impossible without the use of financial leverage.
For decades, it's been common for Wall Street firms and large corporations to borrow money from banks to fund inventories. So long as the collateral for the loans consisted of liquid assets such as stocks and bonds (which could be sold on any business day, even if at a loss) this kind of leverage posed no extraordinary risk. But, when Wall Street went several steps further, "securitizing" mortgages, car loans, and even credit card debt, risk skyrocketed. High leverage was also was used in creating derivatives. These "artificial securities" broadened Wall Street firms' markets and offered diversification, but the entire system depended on continued access to loans. In short, financial corporations began to over-use leverage.
This past week, there have been three major negative news developments, and all of them relate to the consequences of over-use of leverage. First, the 138-year-old financial firm Lehman Brothers decided to file bankruptcy and sell off its profitable divisions. Next, we learned, Merrill Lynch, weakened by leverage in mortgages, is being acquired by Bank of America. The world's largest insurance company, American International Group announced it, too, is short on capital. (Generally insurance companies are sources of investment funds, not consumers of them. But all insurance companies are required to maintain a certain percentage of capital as reserves against their liabilities, particularly to pay claims on the policies they have outstanding, and AIG came up short.)
The common denominator in all three stories is leverage, and more specifically, over-leverage. In Shakespeare's Hamlet, Lord Polonius advises, "Neither a borrower nor a lender be, for loan oft loses both itself and friend." After forty-six years of observing the financial markets and advising clients, I would say Polonius' advice is too limiting. (No one advises getting rid of electricity because of the fact that if it's improperly handled, people might be electrocuted!) Leverage is a tool, and it can be a very necessary and useful tool when properly used. But when leverage is layered upon leverage, that's when we reap the kind of undesirable results we've been reading about in this week's headlines. With apologies to Shakespeare, I'd advise, "Neither an irresponsible lender nor an over-eager borrower be." In both our personal planning and nation-wide - it's not that we need to get rid of leverage; we just need to straighten up and borrow right!
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