C&B Notes

Leverage Cuts Both Ways

The creation of esoteric financial products and investors’ inability to recognize (or unwillingness to acknowledge) the risks associated with them has been labeled a primary culprit of the 2008 financial collapse.  However, the most significant driving force in spectacular, financial system-wide failures is the use of leverage to boost expected returns.  In reality, leverage is a double-edged sword, multiplying both gains and losses.  The long-run expected return on a levered portfolio is -100%.

Since then it has been a common theme in the media that mathematics, especially obscure advanced mathematics, is largely responsible for the catastrophe that doomed the world to the last five years of recession and slow growth.  This theme plays on the fallacy that danger always comes from complexity.  It’s a fabrication that obscures the real causes, that makes it easier to say, “Hey, it wasn’t my fault, I was blinded by science.”

The reality is much simpler and less sexy.  Wall Street killed itself in a time-honored fashion: Cheap money, excessive borrowing, and greed.  And yes, there is an equation one can point to and blame. This equation, however, requires nothing more than middle school algebra to understand and is taught to every new Wall Street employee.  It is leveraged return.

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The equation, though simple, reveals one dangerous truth that investors love to exploit.  If you can find an asset that returns more than the cost to borrow money then any return is possible with enough leverage.

How to exploit it though?  Two conditions need to be met: A low borrowing cost and somebody willing to lend lots of money.  Both came together perfectly in the six years preceding the meltdown of 2008.