[HN Gopher] Demystifying financial leverage
       ___________________________________________________________________
        
       Demystifying financial leverage
        
       Author : arkadiyt
       Score  : 184 points
       Date   : 2022-11-11 17:16 UTC (5 hours ago)
        
 (HTM) web link (bam.kalzumeus.com)
 (TXT) w3m dump (bam.kalzumeus.com)
        
       | ilaksh wrote:
       | Its just pretentious BS used as a smokescreen for _gambling with
       | your money_.
       | 
       | What has happened with FTX is a demonstration of the value of a
       | block chain and the concept of user-controlled wallets versus
       | banks. FTX did what banks do, which is to take a cut of
       | transactions, and especially use customer funds to make bets
       | (that eventually they could not cover, even with all of your
       | funds).
       | 
       | Using centralized exchanges to speculate is a ridiculous
       | perversion of the concepts in cryptocurrency.
       | 
       | The basic advances of cryptocurrency are:
       | 
       | 1) digital signatures used in transactions rather than disclosing
       | secrets such as credit card numbers
       | 
       | and
       | 
       | 2) a public ledger that is cryptographically verified with chains
       | of blocks
       | 
       | Decentralized exchanges are probably usually also often nonsense
       | speculation, but if done right they can at least benefit from 2
       | which means you can see what they are doing and not be surprised
       | at the last second about some secret "over-leveraging".
        
         | [deleted]
        
         | barrkel wrote:
         | > _FTX did what banks do, which is to take a cut of
         | transactions, and especially use customer funds to make bets_
         | 
         | Their terms of service didn't give them the right to do this,
         | as I understand it.
         | 
         | > _None of the Digital Assets in your Account are the property
         | of, or shall or may be loaned to, FTX Trading;_
        
           | wonder_er wrote:
           | Hilariously, this is _precisely_ what "fractional reserve
           | banking is".
           | 
           | https://www.federalreserve.gov/monetarypolicy/reservereq.htm
           | 
           | The banks have a zero-percent reserve ratio allowing them to
           | "loan out" (and have deposited in their own bank as new
           | funds) 100% of the 'digital assets' in their account.
        
           | ilaksh wrote:
           | This is why actually if people can understand what's
           | happening and what cryptocurrency is, this is another
           | incident that is a very good advertisement for
           | cryptocurrency.
           | 
           | Because actually the idea is that instead of relying on some
           | third party to follow some words on paper, you trust math and
           | computer science. You don't need the third party at all for
           | most things, just use you own cryptocurrency wallet.
           | 
           | For more complex things, we can use smart contracts, which
           | are not based on trust but actual math. The program being on-
           | chain literally makes it impossible for them to
           | misappropriate funds (at least without the details being in
           | public and reviewable beforehand).
        
             | btilly wrote:
             | Things that regularly go wrong in cryptocurrency go wrong
             | in cryptocurrency and that is an argument for using
             | cryptocurrency???
             | 
             | I couldn't make this up!
             | 
             | As for the "smart contracts", nobody who is familiar with
             | programming bugs would want there not to be better checks
             | and balances there. The depressing frequency of 8 figure
             | hacks of the terms of said contracts is a concrete
             | demonstration of this principle. Thanks, but no thanks in
             | anything like its current state.
             | 
             | For most users, traditional finance is faster, cheaper, and
             | safer in practice than crypto. Which is exactly why the
             | main use cases for crypto are speculation, money
             | laundering, and various illegal activities like paying
             | ransoms for ransomware attacks.
        
               | ilaksh wrote:
               | I have written and effectively used many smart contracts,
               | although not for speculation.
               | 
               | There is constant abuse of customer funds, as a matter of
               | course, by banks. It generally is less public or visible
               | though than public ledgers (blockchains).
               | 
               | Its the difference between trusting a company that is
               | trying to profit just from holding your funds in ways
               | that you cannot audit, versus trusting a math and
               | computer programs that you can audit.
               | 
               | There have not been more abuses by cryptocurrency
               | exchanges than banks overall. They are just more recent.
               | But what I am saying is that these cryptocurrency
               | exchange companies really don't have anything to do with
               | cryptocurrency -- their business model is antithetical.
        
           | hindsightRegret wrote:
           | ...may not be loaned to, FTX Trading. They could lend it to
           | any other entity though, like Alameda. LOL
        
         | jldugger wrote:
         | > Its just pretentious BS used as a smokescreen for _gambling
         | with your money_.
         | 
         | No, it's pretentious BS used to make more riskier, assymmetric
         | gambles.
        
         | kibwen wrote:
         | _> digital signatures used in transactions rather than
         | disclosing secrets such as credit card numbers_
         | 
         | Credit cards also offer this. I can go to my CC's website and
         | generate virtual cards which can be handed to vendors and
         | individually managed, frozen, or deleted, all without exposing
         | my actual card number.
        
           | wizeman wrote:
           | You're still exposing your virtual card number which gives
           | permission to charge money from your actual credit card.
           | Normal credit cards can also be individually managed, frozen
           | and deleted but that doesn't prevent unauthorized charges.
        
             | kibwen wrote:
             | Deleting a virtual card is tremendously easier than
             | revoking my primary credit card number and updating all the
             | vendors that are using it. It's quite easy to use a virtual
             | card once and then delete it immediately. Furthermore, I'm
             | not worried about a virtual card being exposed to
             | unauthorized charges, because (unlike in cryptocurrency-
             | land) chargebacks exist.
        
               | ilaksh wrote:
               | In cryptocurrency land there is no such thing as an
               | unauthorized charge because you don't ever give a third
               | party access to information that can be used to charge
               | funds, which you have to do constantly with credit cards.
        
               | aaronharnly wrote:
               | Unless you do, right?
               | 
               | > Since token approval requests usually ask for unlimited
               | access to your token balance, if there is a security
               | vulnerability, all of the assets in your wallet could be
               | exposed. Depending on how severe the security
               | vulnerability is, disconnecting your wallet from a dapp
               | may not be enough to fully protect your assets.
               | 
               | https://help.coinbase.com/en/wallet/security/dapp-
               | permission...
        
               | boring_twenties wrote:
               | FWIW, even when they request unlimited access, you can
               | set whatever limit you want. In MetaMask, the defacto
               | standard wallet, you simply just edit the field that
               | appears in the request/confirmation dialog.
        
               | ilaksh wrote:
               | Exactly.. of course we still have very significant
               | problems to solve.
               | 
               | Such as the fact that most of these cryptocurrencies are
               | totally impractical to use for actually buying things,
               | leading to the need to use centralized exchanges for
               | swapping to fiat.
               | 
               | And the fact that there are multitudes of competing
               | cryptocurrencies. And that there is a fundamental lack of
               | integration with government due to government actually
               | needing to radically reform and advance to incorporate
               | cryptocurrency.
               | 
               | But still, they are core advancements that society should
               | take advantage of. Easier said than done.
        
               | wizeman wrote:
               | > Deleting a virtual card is tremendously easier than
               | revoking my primary credit card number and updating all
               | the vendors that are using it. It's quite easy to use a
               | virtual card once and then delete it immediately.
               | 
               | Still harder and not as secure as a digital signature.
               | 
               | > Furthermore, I'm not worried about a virtual card being
               | exposed to unauthorized charges, because (unlike in
               | cryptocurrency-land) chargebacks exist.
               | 
               | You're not guaranteed to perform a chargeback
               | successfully. And both vendors and customers (like you)
               | are paying for that "service".
               | 
               | Chargebacks are also one of the reasons for why there is
               | large-scale credit card fraud. And it is also why vendors
               | are incentivized to collect personal information from you
               | (to detect fraud before chargeback happens, for which
               | they are greatly penalized) and why they are also
               | incentivized to refuse service to legitimate customers in
               | many cases (due to flagging legitimate transactions as
               | suspicious).
               | 
               | Worse, when they refuse service they cannot even tell you
               | why (as that would help fraudsters).
        
               | kibwen wrote:
               | _> You 're not guaranteed to perform a chargeback
               | successfully._
               | 
               | Even in the worst case, because a credit card is an
               | abstraction over my bank account, I have the option to
               | refuse to pay and won't lose my shirt or otherwise become
               | despondent. In the meantime, chargebacks are a feature of
               | the system, not a bug. To wit, cryptocurrency advocates
               | are the last people who should go around lecturing others
               | about fraud. :P
        
               | wizeman wrote:
               | > Even in the worst case, because a credit card is an
               | abstraction over my bank account, I have the option to
               | refuse to pay and won't lose my shirt or otherwise become
               | despondent.
               | 
               | That may also have unintended consequences for victims of
               | credit card insecurity.
               | 
               | > To wit, cryptocurrency advocates are the last people
               | who should go around lecturing others about fraud. :P
               | 
               | Why not? Cryptocurrency advocates know a lot more about
               | it than most people (for good and bad reasons).
        
           | mritchie712 wrote:
           | can be a useful feature (in some scenarios) that crypto is
           | permissionless (unlike the bank that has to approve vendors,
           | limits, nations, etc.)
        
           | ilaksh wrote:
           | Sure but that's a workaround for a fundamentally outdated
           | system.
        
             | kibwen wrote:
             | Where "outdated" and "workaround" here means that it
             | integrates with existing payment processors and therefore
             | works with 99% of the things that you want to buy. There's
             | nothing unique about cryptocurrency solutions in this case
             | that traditional credit cards cannot achieve, and any
             | fancier solution just means that you can't actually use it
             | anywhere.
        
         | paxys wrote:
         | There is nothing inherently wrong with banks lending out your
         | deposits. This system is how a majority of new businesses are
         | funded and how the economy expands. There are a mountain of
         | regulations that banks have to keep up with and the reason why
         | FDIC insurance exists. Investors entering the crypto space
         | willingly rejected these regulations and are now finding out
         | their purpose the hard way.
        
           | wizeman wrote:
           | > There is nothing inherently wrong with banks lending out
           | your deposits.
           | 
           | There wouldn't be anything inherently wrong with it 1) if
           | they didn't do it by default 2) if banks informed their
           | customers appropriately, including the risk in doing that
           | (most people don't know what banks do with their funds) and
           | especially 3) if it wouldn't be forced, i.e. if they would
           | let customers choose to keep their funds segregated if they
           | are not willing to take the inherent risk in lending and/or
           | the bank mismanaging their funds (e.g. having the option to
           | have both segregated and normal checking/savings accounts or
           | whatever), so that customers would never be exposed to losing
           | whatever amount they didn't want to (including anything above
           | the FDIC insured amount).
           | 
           | But sure, allow customers to lend their money and expand the
           | economy if they want to. With an appropriate reward for the
           | risk, not a laughable 0% interest rate, which almost nobody
           | would ever take willingly. In fact, the 0% interest rate, or
           | anything below or close to the inflation rate, is a clue
           | which indicates that what they're doing to their customers is
           | wrong and that the customers aren't choosing to take that
           | risk knowingly and voluntarily.
           | 
           | > There are a mountain of regulations that banks have to keep
           | up with and the reason why FDIC insurance exists
           | 
           | You say that like it's a good thing. It's massively
           | inefficient and both "a mountain of regulations" and FDIC
           | insurance are inherently unfair (for several reasons) and
           | have many unintended (negative) consequences.
           | 
           | And it doesn't even actually fix the problem, it just makes
           | it less likely to occur (for starters, because there ends up
           | being much less competition than there would be otherwise --
           | less banks, less bank failures) but when it occurs, it's an
           | even bigger problem. Which means it also gives a false sense
           | of security.
        
           | makestuff wrote:
           | Yeah especially after 2008. I heard a joke from someone who
           | works at a big bank that after 2008 there are 2 compliance
           | people for every one banker. People in finance like to make
           | fun of the "back office" but they seem to be main reason the
           | bank stays solvent.
        
           | ilaksh wrote:
           | It's similar to the situation with credit cards. There is a
           | whole industry related to working around the problem of
           | constantly disclosing the secrets, such as refunding stolen
           | funds.
           | 
           | Likewise we have had to rely on banks to control digital
           | money since we did not have a good alternative. And now there
           | are many regulations and compliance officers etc. dedicated
           | to preventing people from cheating, stealing, or
           | irresponsibly using customer funds.
           | 
           | But at the core level the problem is that these the bank
           | ledgers are secret, difficult to verify or connect together
           | for tracing purposes. Cryptocurrency means using math and
           | computer science to solve these types of problems in a
           | holistic way.
           | 
           | Like everything else, people have abused this technology
           | (such as using it to sell services that are antithetical to
           | the core concept). But that doesn't mean they aren't
           | important advances.
        
       | spyremeown wrote:
       | Off-topic, but can somebody recommend me a book on economics? I
       | need to learn how things generally work in the world and how to
       | manage my money. I'm almost 25 and I have zero clue what I'm
       | doing besides "I need a bigger salary and save more".
        
         | manjose2018 wrote:
         | Economics is supply/demand.
         | 
         | I would focus on investing, particularly defensive investing.
         | 
         | 1. 'The Intelligent Investor' By Benjamin Graham 2. 'David F.
         | Swensen' Unconventional Success: A Fundamental Approach to
         | Personal Investment
         | 
         | If you want the easiest allocation possible put some portion of
         | your paycheck in an S&P500 fund and in 40 years you should have
         | enough for retirement.
         | 
         | Good luck!
        
         | jacobr1 wrote:
         | https://www.bogleheads.org/wiki/Getting_started
        
       | faangiq wrote:
       | Tech bros should just stay away from this area. They don't have
       | the IQ for it.
        
         | dang wrote:
         | Maybe so, but please don't post unsubstantive and/or flamebait
         | comments here.
        
       | pragmatic wrote:
       | Leverage aside, there is no clearer evidence that we live in a
       | SciFi dystopia than this article.
        
         | [deleted]
        
       | [deleted]
        
       | jefftk wrote:
       | _> Interestingly, their customers are also often levered. A
       | homeowner who has just made their 20% down payment is levered
       | 5:1._
       | 
       | Isn't that only if the homeowner has no other equity or
       | liabilities? Which is especially tricky when talking about people
       | who, if we valued them like we value corporations, have equity in
       | the form of the net present value of their future earnings.
        
         | Ilverin wrote:
         | Well the bank can't get your future earnings or other assets if
         | you default, but they can get the house. So if the house is
         | worth zero dollars (never true) then you are 5 to 1 leveraged.
        
           | jefftk wrote:
           | I see: it is true, from the bank's perspective, in the
           | specific case of mortgages, because they're no-recourse
        
             | JumpCrisscross wrote:
             | > _in the specific case of mortgages, because they 're no-
             | recourse_
             | 
             | This varies jurisdiction to jurisdiction. And it isn't
             | really germane to the question of quantifying one's
             | leverage, which is a going-concern analysis.
        
               | jefftk wrote:
               | _> going-concern analysis_
               | 
               | But then don't we need to get into evaluating future
               | earnings?
        
               | JumpCrisscross wrote:
               | > _don 't we need to get into evaluating future
               | earnings?_
               | 
               | Yes, many flow leverage ratios look at this, _e.g._
               | interest to Ebit.
        
               | jefftk wrote:
               | That's just a bit of a funny thing to do with a
               | homeowner, no?
        
               | JumpCrisscross wrote:
               | > _bit of a funny thing to do with a homeowner, no?_
               | 
               | This is why mortgage lenders test your debt burden and
               | interest cost against income.
        
           | JumpCrisscross wrote:
           | > _if the house is worth zero dollars (never true)_
           | 
           | There are numerous real-life scenarios where a house is worth
           | zero dollars.
        
             | paxys wrote:
             | There are numerous scenarios where the house is worth _less
             | than_ zero dollars. For example when there 's a large
             | overdue tax bill attached to the property.
        
               | NovemberWhiskey wrote:
               | Or it's in extremely bad repair and will need to be torn
               | down before you can rebuild on the land. If you look at
               | listings for land, a surprising number of them are
               | actually listings for "houses not fit for human
               | habitation".
        
             | selectodude wrote:
             | The land itself is worth about 35-50 percent of the house
             | depending on location. So there are never situations where
             | the value of the house is worth zero.
        
               | kgwgk wrote:
               | The cost of getting rid of the house - or other
               | liabilities - is sometimes higher than the value of the
               | land itself. There are situations of zero and even
               | negative value.
        
               | Ekaros wrote:
               | It is entirely possible for land that house stand on
               | being nearly valueless. Think of really rural or low
               | demand area. And on other hand house it self being
               | expensive to take down. Maybe containing mold or
               | asbestos.
        
               | JumpCrisscross wrote:
               | > _land itself is worth about 35-50 percent of the house
               | depending on location_
               | 
               | This is not always true. (Trivially: your land is
               | declared a superfund site. Less trivially: fire sale.)
               | 
               | > _there are never situations where the value of the
               | house is worth zero_
               | 
               | I guess a decade and a half is all it takes to forget.
        
       | KerryJones wrote:
       | As a Googler, I really enjoy all the Chat-app mockery.
        
       | em500 wrote:
       | This seems a bit too wordy to demystify the concept. Here's a
       | simpler example.
       | 
       | 1. Bank A offers you 5% interest for a 1 year deposit. You
       | deposit $100 of your own money. You are unlevered. Things go well
       | and after a year you receive $105, a neat 5% return on your
       | investment. Or things don't go well, bank A turns out to be a
       | scam and you receive $0, a -100% return.
       | 
       | 2. Bank B offers you a loan for a year for 4% interest. You
       | borrow $900, together with your own $100 you deposit $1000 at
       | bank A. You are levered 1:9. Things go well and after a year you
       | receive $1050 ($1000+5% interest) from bank A, you repay bank B
       | $936 ($900 + 4% interest), so you're left with $114, a very neat
       | 14% return (almost triple the unlevered return). Or things don't
       | go well, bank A turns out to be a scam and you receive $0. But
       | now you still owe bank B $936, so together with your own $100
       | loss you made a -1036% return. Oops.
       | 
       | p.s. It's called leverage because (like a physical lever that
       | allows you to lift something much heavier than without)
       | supplementing your own funds with lots of borrowed money allows
       | you to tackle something much bigger than using only your own
       | money, like buying a house or starting a business or getting 5%
       | on $1000 instead of on $100.
        
         | divbzero wrote:
         | P.S. It is also called leverage because the same rule of
         | proportionality applies: With a 10x physical lever, _e.g._ the
         | lever is 10 cm on one side of the fulcrum and 100 cm on the
         | other, moving one end of the lever by 1 cm will move the other
         | end by 10 cm. With 10x financial leverage, _e.g._ you use $10
         | of equity (your own money) and $90 of debt (borrowed money) to
         | invest $100 in assets, an extra +1% return on assets
         | corresponds to an extra +10% return on equity.
        
         | hn_throwaway_99 wrote:
         | I'm not a fan of your examples because taking on leverage for
         | fixed income assets is not the most common use of leverage,
         | precisely because the rewards aren't that much better but the
         | risks are so high. Also, "being a complete scam" is not the
         | most common downside risk in leverage.
         | 
         | I think an easy example nearly anyone can understand is their
         | mortgage. You put down $50k for a $500k house. The house goes
         | up just 10% to $550k, if you sell you've doubled your money
         | after repaying the $450k you've borrowed. Of course, if the
         | price goes down 10%, you're completely wiped out.
        
           | em500 wrote:
           | Sure, mortgages are the most common example of leverage for
           | non financial pros. But that's also a reason _not_ to use it
           | as an example. Because even if they 're levered 9:1 nobody
           | thinks they're wiped out if their house price goes down 10%,
           | they'd think they just need to hold on to it till it
           | recovers.
        
             | hn_throwaway_99 wrote:
             | > Because even if they're levered 9:1 nobody thinks they're
             | wiped out if their house price goes down 10%, they'd think
             | they just need to hold on to it till it recovers.
             | 
             | Amazing how time flies. I'm pretty sure anyone who was old
             | enough to own a home in 2007/2008 in a "hot" market knows
             | exactly how mortgage leverage can work on the downside.
        
         | rabidonrails wrote:
         | You could simplify this further by making it a bit more
         | abstract:
         | 
         | You have $100 worth of stock in Google. You think Google stock
         | is going to appreciate so you borrow $50 of my money to buy
         | more stock. I see that you have $100 worth of Google stock
         | which provides me with some security that you have a valuable
         | asset and are a worthwhile borrower.
         | 
         | But, instead of Google's stock value increasing it starts to
         | fall. You took my money and I'm getting nervous so I force you
         | to sell your Google stock. At one point you had $150 worth of
         | Google stock but now I've forced you to sell your stock for a
         | total of $75 which allows me to recoup my lent money ($50) plus
         | my fees and I really don't care how much money you are left
         | with, if any.
         | 
         | This is important for the economy because credit (which this
         | is) helps create growth and drives economies - when credit is
         | tight then economies grow slowly if at all.
        
         | em500 wrote:
         | Btw, a great, well known quote from John Kenneth Galbraith
         | (from _A Short History of Financial Euphoria_ ) is:
         | 
         |  _" The world of finance hails the invention of the wheel over
         | and over again, often in a slightly more unstable version. All
         | financial innovation involves in one form or another, the
         | creation of debt secured in greater or lesser adequacy by real
         | assets."_
         | 
         | In the 2008 financial crisis, some have paraphrased this as
         | "All financial innovation is leverage dressed up as something
         | different."
        
           | shafoshaf wrote:
           | "I'm not so much interested in the return ON my money as I am
           | in the return OF my money." -- Will Rogers
        
             | NovemberWhiskey wrote:
             | That's actually a fascinating error that people make with
             | fixed-income investing; too much focus on safety of
             | principal vs. actual compounded yield and recovery rate in
             | the case of default.
        
             | [deleted]
        
           | asah wrote:
           | This is just as reductionist as saying that all computers or
           | programming languages are the same.
           | 
           | Sure it's true at some level but not a useful distinction if
           | you're a customer or vendor.
        
             | didericis wrote:
             | It's a useful thing to keep in the back of your head to
             | inoculate yourself against marketing shenanigans.
             | 
             | The basic underlying principle of a product/service should
             | be communicable and relatively universal. The details are
             | of how it's tailored to your specific situation should come
             | with cons and unknowns in other situations.
             | 
             | If it's not communicable and/or sounds like there are no
             | cons they're not being honest about what it is
             | (intentionally or unintentionally).
        
           | lisper wrote:
           | There are some useful distinctions to be made. Insurance, for
           | example, could be seen as "negative leverage", but it really
           | is a different kind of animal.
        
         | askafriend wrote:
         | > This seems a bit too wordy to demystify the concept.
         | 
         | Pretty normal for a patio11 post.
        
           | theonething wrote:
           | Was going to say something very similar. His content is
           | usually great, but the writing style doesn't appeal to me
           | because of the verbosity. It generally doesn't keep me from
           | reading them if the topic is interesting to me though.
           | 
           | Anyways, this is all very subjective and based on personal
           | preference so it's probably not useful so I'll shut up now.
        
             | pooper wrote:
             | > Was going to say something very similar. His content is
             | usually great, but the writing style doesn't appeal to me
             | because of the verbosity. It generally doesn't keep me from
             | reading them if the topic is interesting to me though.
             | 
             | I appreciate that patio11 states things that might seem
             | obvious to someone knowledgeable in a field. It reminds me
             | of [WP:Obvious] from back when I started using Wikipedia.
             | It states:
             | 
             | > State facts that may be obvious to you, but are not
             | necessarily obvious to the reader. Usually, such a
             | statement will be in the first sentence or two of the
             | article.
             | 
             | https://en.wikipedia.org/wiki/Wikipedia:Writing_better_arti
             | c...
             | 
             | This is such a difficult thing to do "correctly" because
             | there is a danger as you see on the wikipedia link that you
             | might start stating that the sky is blue. (Meta: Did I just
             | do that?) This is what patio11 does so well.
             | 
             | I mean this is pretty early on in the article:
             | 
             | > Every business has a balance sheet, which contrasts its
             | assets (valuable things it owns) against liabilities
             | (valuable things it owes to other people). The difference
             | between assets and liabilities is equity.
             | 
             | > Financial businesses will frequently have non-financial
             | assets and liabilities. Ignore those for the sake of
             | simplicity. Ignore the nice building, the computers, the
             | payroll due on Friday for work which has already been
             | completed. Focus just on the financial assets and
             | liabilities, things like "mortgages our bank owns" (asset)
             | and "deposits from customers" (liability).
             | 
             | > Leverage is the ratio of your liabilities to your equity.
             | Simple division. Fourth grade math. If you have $110
             | million in assets and $100 million in liabilities you, by
             | subtraction, have $10 million in equity against your $100
             | million in liabilities. You are said to be levered 10:1.
             | 
             | Now if I were to edit this, I'd probably go off a tangent
             | at this point. I would say something silly like You have
             | deposits from customers worth USD 100M. You loaned out USD
             | 110M.
             | 
             | What happens if, of the people you loaned your money to,
             | half of them disappear with your money? Now, your assets
             | are only USD 65M. However, your liabilities are still USD
             | 100M. Your equity is USD 65M - USD 100M = a negative USD
             | 35M! You are properly screwed.
             | 
             | In fact, you'd be screwed if your loans soured by anything
             | greater than your equity of USD 10M, let say USD 11M. Lets
             | say your borrowers are unable to repay you any more than
             | USD 99M of the USD 110 they owe you. Your equity is USD 99M
             | - USD 100M = - USD 1M.
             | 
             | What just happened? I took you, the unsuspecting reader, on
             | my boat and threw you out in the middle of the ocean. I've
             | done you a disservice. Did you expect to read that tangent
             | after the quote I had from patio11? Probably not. Did you
             | expect to see a concept like negative equity and negative
             | leverage if you're just learning about leverage? Unlikely.
             | 
             | In any case, the fact that I feel dissatisfied just writing
             | this comment is a testament to just how difficult it is to
             | explain something. Even when the concept I am trying to
             | explain is nothing more than "it is difficult to explain
             | something in brief".
        
             | sqs wrote:
             | Personally, I love the writing style. It's enjoyable to
             | read, and it conveys a lot more of his sentiment than dry
             | writing would.
        
         | [deleted]
        
       | chatterhead wrote:
       | Leverage is and has always been stealing from Peter to pay Paul.
       | People can justify it however they want and do, but the fact
       | remains profit is supposed to be the signal that an operation is
       | a viable going concern. Leverage masks this and trades the long-
       | term for the short-term.
       | 
       | Most companies use leverage so their c-suite can make more while
       | producing less. That's the truth. It's bullshit and should be
       | outlawed. Corporations need to compete based on inputs and
       | outputs.
       | 
       | Labor creates value. Leverage creates a mirage. Feel free to
       | disagree. Enjoy your business cycles.
        
       | thrwy_918 wrote:
       | I find this uncharacteristically hard to understand.
       | 
       | In the stock brokerage example, we're told:
       | 
       | >They might allow you 2:1 leverage when you buy stock: your
       | $1,000 buys 20 shares now.
       | 
       | But then a couple of paragraphs later:
       | 
       | >But you now owe $1,000 to your brokerage, and are 1:1 levered
       | 
       | My brokerage offers 2:1 leverage, which results in me being 1:1
       | levered? I think I understand what patrick is saying here but I
       | also find it hard to follow
       | 
       | On the other hand:
       | 
       | >One is that, because people can ask for money from their
       | checking accounts at any time, impecunious operation of the bank
       | could cause the value of the mortgages to be impaired just a tiny
       | little bit at a time when people need most of the money in their
       | checking accounts.
       | 
       | I've read this four or five times and I don't understand the
       | chain of cause-and-effect here at all. Why does "people can ask
       | for money from their checking accounts at any time" mean that
       | "impecunious operation of the bank could cause the value of the
       | mortgages to be impaired just a tiny little bit at a time when
       | people need most of the money in their checking accounts"?
        
         | btilly wrote:
         | The first one seems like confusing word choices to me. They
         | allow you to buy 2x as much stock as you are putting money down
         | (2:1 leverage when you buy stock). After you do so, you have 10
         | shares that you own to 10 shares that you control by don't own
         | (and therefore are 1:1 levered).
         | 
         | The second one is only confusing because you're trying to find
         | a cause and effect between 2 events that simply happened to
         | happen at the same time. Though in practice the events may have
         | an underlying common cause and so do show up more often than
         | you'd expect.
         | 
         | A concrete scenario is a community bank in a place where a
         | major employer just did a layoff. The value of the mortgages is
         | now impaired because some people won't be able to pay them
         | back. The laid off people also need most of the money in their
         | checking accounts because they have no job. The bank now has a
         | challenge - its cash reserves don't meet anticipated needs, and
         | it can't sell the mortgages to get more cash.
         | 
         | The troubled bank has a good chance of surviving unless the
         | third leg of the trifecta shows up - word gets out about the
         | bank's trouble. Now everyone scared of losing their checking
         | accounts all show up to withdraw money at the same time. The
         | bank doesn't have the cash for this "run on the bank", and goes
         | bankrupt.
         | 
         | This scenario was historically common. People accepted it until
         | there was an event during the Great Depression where enough
         | banks went under at the same time that people got scared about
         | what were otherwise healthy banks. Even though their assets
         | were good, they couldn't pay out all accounts at once, and
         | began going under en masse. FDR took fairly drastic actions to
         | fix this (bank holiday, confiscating gold, etc) and then put in
         | the FDIC to stop it from ever happening again.
         | 
         | There is a well-known portrayal of this run on the banks in the
         | movie, _It 's A Wonderful Life_.
        
           | thrwy_918 wrote:
           | >The second one is only confusing because you're trying to
           | find a cause and effect between 2 events that simply happened
           | to happen at the same time
           | 
           | The author uses "because", which in context clearly indicates
           | to me a cause and effect relationship.
           | 
           | Even overlooking that, "impecunious operation of the bank
           | could cause the value of the mortgages to be impaired" is not
           | addressed by your explanation. You explain how external
           | factors could reduce the value of the mortgages.
        
             | btilly wrote:
             | You have a point, and I think there is a bit missing.
             | Currently it says:
             | 
             |  _... impecunious operation of the bank could cause the
             | value of the mortgages to be impaired just a tiny little
             | bit at a time when people need most of the money in their
             | checking accounts._
             | 
             | And probably should say something like:
             | 
             |  _... impecunious operation of the bank could cause trouble
             | if the value of the mortgages is impaired just a tiny
             | little bit at a time when people need most of the money in
             | their checking accounts._
        
       | fhrow4484 wrote:
       | Very interesting read, especially the ELI5 part before the DeFi
       | story.
       | 
       | Are the 3 ways explained to cover a margin call how it works in
       | practice? can one choose either of these 3 options?
       | 
       | > Fourth grade math. If you have $110 million in assets and $100
       | million in liabilities you are said to be levered 10:1.
       | 
       | Actually got some trouble on the 4th grade math ... morning
       | coffee not working properly?
       | 
       | $110m assets - $100m liabilities = $10m of "surplus".
       | 
       | liabilities:surplus ratio is 100:10 --> 10:1.
       | 
       | > You've got $1,600 in assets against $1,000 in debt, so $600 in
       | equity, so ~1.67:1 levered.
       | 
       | here liability = 1000, a better name for the surplus is "equity"
       | at 600,
       | 
       | 1000:600 ratio --> ~1.67:1
       | 
       | 4th grade math checks out :)
        
         | [deleted]
        
       | photochemsyn wrote:
       | Nice writeup. A good popular discussion of leverage is in the
       | movie Margin Call, regading the 2008 meltdown:
       | 
       | > "Well, as you probably know, over the last 36 to 40 months, the
       | firm has begun packaging new mortgage-backed security products
       | that combine several different tranches of rating classification
       | in one tradeable security. This has been enormously profitable...
       | Well, the firm is currently doing a considerable amount of this
       | business every day. Now the problem, which is I guess why we are
       | here tonight, is that it takes us, the firm, about a month to
       | layer these products correctly, thereby posing a challenge from a
       | risk management standpoint... Well, we have to hold these assets
       | on our books longer than we might ideally like to. But the key
       | factor here is, these are essentially just mortgages, so that has
       | allowed us to push the _leverage_ considerably beyond what you
       | might be willing or allowed to do, in any other circumstance,
       | thereby pushing the risk profile without raising any red flags. "
       | 
       | Running the money printing press was the government response to
       | that situation, i.e. 'deleveraging the bank holding companies
       | (BHCs) via quantitative easing' - which does illustrate how a
       | government controlled by financial oligarchs operates in
       | practice. The actual homeowners could have been the recipients of
       | the bailouts - i.e. the government would have taken over their
       | loans, provided a zero-interest period, converted the loans from
       | adjustable to fixed-rate, sold them back to the banks (or just
       | set up a separate institution), and then the homeowners could
       | have stayed in their homes and continued to pay off their
       | mortgages at an acceptable monthly rate - or some combination of
       | the above. The BHCs would have suffered much more significant
       | losses under that scenario, and perhaps more would have gone the
       | way of Bear Stearns and Countrywide.
       | 
       | Notably, this illustrates that regardless of whether monetary
       | policy is tight or loose, the government's fiscal policy can be
       | engineered to support the financial oligarchs. For example,
       | today's high interest rates are going to be used to justify
       | government fiscal policies that benefit the oligarch class (i.e.
       | pushing for mass unemployment to bring down wages to 'fight
       | inflation', etc.). Similarly, large banks are not being forced to
       | raise personal savings interest rates as the Fed rate rises (as
       | that would benefit ordinary people, even if inflation is
       | outpacing interest rates).
       | 
       | https://thehill.com/policy/3656474-lawmakers-slam-big-bank-c...
       | 
       | As far as cryptocurrencies, it seems fairly unlikely that crypto
       | funds will be the beneficiaries of quantitive easing or other
       | government largesse, as crypto hasn't yet bought enough corrupt
       | politicians.
        
       | [deleted]
        
       | [deleted]
        
       | kqr wrote:
       | There's a form of leverage not mentioned here:
       | 
       | You promise you'll fix Johnny's roof for $200. He hooks you up
       | with a computer for $300. You pay him the difference of $100. You
       | have transacted for $500 but only circulated money of $100.
       | That's 5:1 leverage.
       | 
       | Futures markets work on this principle, among many other things.
        
         | jefftk wrote:
         | And the tax agency still wants their share of the uncirculated
         | $200 from each of you.
         | 
         | (Even though your didn't use cash, barter transactions are
         | still taxed at their fair market value)
        
         | triceratops wrote:
         | I thought leverage implied borrowing money. This is just
         | bartering.
         | 
         | EDIT: Never mind, I missed where you said that the roof fixing
         | will happen later in the future.
        
         | JumpCrisscross wrote:
         | > _a form of leverage not mentioned here_
         | 
         | You're alluding to operating leverage [1]. The carrying cost of
         | the computer and cost of services for the labor being working
         | capital constituents.
         | 
         | This is distinct from the financial leverage, which deals with
         | explicit borrowing. (Futures markets do not work on operating
         | leverage. They work on offsetting financially-levered claims.)
         | 
         | [1] https://en.wikipedia.org/wiki/Operating_leverage
        
           | kqr wrote:
           | No, what I'm describing has nothing to do with fixed or
           | variable costs.
           | 
           | What I'm saying is that when you separate the action (fixing
           | roof, hooking up with computer) from the payment, you're in
           | debt, you're creating an implicit loan.
           | 
           | If you then clear this debt not by opposing transactions but
           | with just the minimal set of transactions (similar to ring
           | clearing after a poker game) then you have allowed
           | transactions with far more money than any party actually
           | produced cash for.
           | 
           | That is financial leverage.
           | 
           | That is exactly what happens in future markets, too. You
           | don't need cash corresponding to the full value of a 5000 bu
           | wheat contract to buy one. All you need is enough to cover
           | the mark-to-market payments and then a little safety buffer.
           | It's all an implicit loan until the contract expires. If you
           | offset it, you continue to transact in way more money than
           | you put in. Financial leverage!
        
             | JumpCrisscross wrote:
             | > _what I 'm describing has nothing to do with fixed or
             | variable costs_
             | 
             | I linked to an admittedly terrible Wikipedia article. What
             | you're describing involves leveraging working capital, a
             | form of operational leverage. Every business does this.
             | Restaurants are operationally levered--they serve you food
             | before you pay. In your example, services were rendered in
             | anticipation of payment. None of this is financial
             | leverage.
             | 
             | > _offset it, you continue to transact in way more money
             | than you put in_
             | 
             | This is netting. The loan is explicit in a way distinct
             | from operating leverage. These differences are meaningful
             | in both how we measure the phenomena as well as the law.
        
       | friend_and_foe wrote:
       | Liabilities / (Assets - Liabilities). That's really all there is
       | to it, the article explained it in the second paragraph.
        
       | JumpCrisscross wrote:
       | > _If you have $110 million in assets and $100 million in
       | liabilities you are said to be levered 10:1_
       | 
       | There is no single leverage ratio [1]. On an asset basis, this is
       | an 11:1 leverage ratio, _i.e._ $11 of assets for each dollar of
       | equity. A lot of miscommunication around leverage seems to stem
       | from this ambiguity.
       | 
       | [1]
       | https://corporatefinanceinstitute.com/resources/accounting/l...
        
         | Nemi wrote:
         | Yes, it seems he even mixed definitions as well. He said that
         | the $110M in assets and $100M in liabilities was a 10:1
         | leverage.
         | 
         | However, later he says that a home owner with a down payment of
         | 20% is levered 5:1. Yet, if we do the same math as he did
         | above, then 20% of $100,000 loan is $20k in equity with an $80k
         | loan, giving a leverage ratio of 4:1.
        
           | gota wrote:
           | I came to the comments to check if that was correct - I was
           | following that definition and calculated 4:1 in my head, too.
           | 
           | Later he uses the example of purchasing $2000 worth of ($10)
           | stock by paying just $1000 and having the other thousand lent
           | by the brokerage.
           | 
           | As per his definition, $2000 in stocks (assets) minus the
           | $1000 loan (liability) equals $1000 in equity. Then if
           | leverage = equity/liability, in this case it turns out to be
           | 1:1
        
         | pdntspa wrote:
         | Where does the ratio of 10 to 1 come in here? I see 110:100, or
         | 1.1:1, or 10%.
         | 
         | His explanation doesn't make sense to me. Are those assets
         | borrowed or something? And having $10 million extra in assets
         | means that if suddenly all your liabilities come due, you have
         | $10m left over? How could that possibly wipe you out?
         | 
         | Very confused.
        
           | JumpCrisscross wrote:
           | > _Where does the ratio of 10 to 1 come in_
           | 
           | Debt to equity. $10 of debt for every dollar of equity.
        
             | pdntspa wrote:
             | I get that, but the example as given seems to be $1.10 of
             | equity (assets) to every $1 of debt (liabilities).
        
               | JumpCrisscross wrote:
               | > _the example as given seems to be $1.10 of equity
               | (assets)_
               | 
               | Equity (in accounting) is assets minus liabilities.
               | $110mm assets, $100mm liabilities and thus $10mm equity.
               | 
               | You may be thinking of equities (from trading), which is
               | another word for stock. (The link being equities
               | represent ownership of equity, _i.e._ the value of a
               | company's assets net of liabilities.)
        
       | skizm wrote:
       | I forget the exact phrasing, but something along the lines of:
       | "Leverage almost always works out. But when it doesn't, you die."
        
       | ogogmad wrote:
       | Why is leveraged long even legal? I'm naive about finance.
        
         | everfree wrote:
         | Every time you borrow cash with an asset as collateral - a
         | house loan, a car loan, an iPhone loan, a 401k loan, a margin
         | loan - it could all be said to be a leveraged long in some
         | sense.
         | 
         | Or would you say that you're against the idea of borrowing
         | against stocks specifically?
        
         | jefftk wrote:
         | Things are legal by default. What's the argument for banning
         | it?
        
       | wonder_er wrote:
       | I'd say "leverage" is the slightly affirmative, slightly
       | pejorative term for a phenomena that could also be labeled
       | 'fractional reserve banking'.
       | 
       | Read the Federal Reserve's on words on what they 'guide' banks to
       | do with deposited funds:
       | 
       | > The Federal Reserve is carefully monitoring credit markets and
       | is prepared to use its full range of tools to support the flow of
       | credit to households and businesses and thereby promote its
       | maximum employment and price stability goals
       | 
       | https://www.federalreserve.gov/monetarypolicy/reservereq.htm
       | 
       | Following the "quacks like a duck" rule, a fractional reserve
       | 'policy' and 'using leverage' look very similar. Both root in
       | criminal misuse of deposited funds.
       | 
       | There is nothing new under the sun:
       | 
       | Leverage, fractional reserve banking, and most of the shenanigans
       | in crypto are all violations of the legal principles governing
       | the monetary irregular-deposit contract.
       | 
       | I _love_ reading anything new by patio11, so absolutely just took
       | a long break from my day to read this and leave the comment.
       | Thanks much! Looking forward to the next BAM!
        
         | JumpCrisscross wrote:
         | > _" leverage" is the slightly affirmative, slightly pejorative
         | term for a phenomena that could also be labeled 'fractional
         | reserve banking'_
         | 
         | Leverage is deeper and more pervasive than fractional-reserve
         | banking. Leveraged merchants going bust was commonplace in the
         | days of hard money.
        
       ___________________________________________________________________
       (page generated 2022-11-11 23:00 UTC)