[HN Gopher] Demystifying financial leverage
___________________________________________________________________
Demystifying financial leverage
Author : arkadiyt
Score : 184 points
Date : 2022-11-11 17:16 UTC (5 hours ago)
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| 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.
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