7 ms·

Leverage is often framed as being sophisticated and savvy when in reality it's just reckless gambling. The house normally wins. Unsophisticated people realize t

by _wldu 5y ago

Leverage is often framed as being sophisticated and savvy when in reality it's just reckless gambling. The house normally wins. Unsophisticated people realize this.

fennecfoxen 5y ago
Leverage still makes lots of sense if you can put your liabilities in a separate limited-liability container. If you win, you win big; if you lose, you lose a finite amount in the form of the down payment, get a percentage of the value back as something you can deduct from your taxes, while whoever lent you money is stuck with your asset. (This does become problematic at scale when you borrow from the government or taxpayer-backed entities, like when Fannie Mae originates your commercial real-estate venture's mortgage.)
- fallingfrog 5y ago
  How is that possible/legal? Is that some kind of structure that wealthy people have access to but regular people don’t? It sounds like you’re describing a way to externalize your losses to the bank or to the public, which is indeed the best way to make money fast, but is parasitic on society as a whole.
  - fighterpilot 5y ago
    It is both possible and legal for anyone in an agency relationship, be it an executive at a company or a hedge fund manager. Executive - take a massive unjustified risk (in terms of company direction), if it works out, get a huge bonus, if it doesn't work, get fired (by the board) Hedge fund manager - take a massive unjustified risk (in terms of a trade), if it works out, get a huge bonus, if it doesn't work, get fired (by your clients) These are both long call options with the premium equal to the opportunity cost of missed salary and the reputational impact. Individuals can't do it because they're not an agent for another group or another individual.
  - friesfreeze 5y ago
    Limited liability entities (e.g. corporations, LLCs, etc) are one of the legal cornerstones our economy. Anyone can form one, but it takes expert (thus expensive) advice from a lawyer to make sure you are in compliance and thus really protected - either as a shareholder or an agent of the company. This makes sense when a lot of money is at stake. To be clear: the entity is liable for the debts it incurs but not necessarily its shareholders or agents. If it cannot pay its debts it goes into bankruptcy and is either reorganized with its creditors as its new owners or liquidated and sold.
  - fennecfoxen 5y ago
    This is something anyone has access to. The price of registering and maintaining some sort of corporation (LLC, etc) is in the $100-$400/yr range depending on state. Most people obviously don't find it's worth the hassle, obviously, and it comes with additional troubles like paperwork and taxes, but the barrier is not all that steep. The limited-liability corporation structure moreover has some majorly useful properties for society. For instance, you probably own some shares of a major pharmaceutical company in your portfolio (through a retirement fund). If the company loses a lawsuit related to, say, the opioid epidemic, and owes billions, and goes totally bankrupt, then you can 100% lose your stake in the company as it is turned over to creditors — but those creditors cannot go after you personally as an owner of the corporation for every dollar that you own; your liability is limited. This has democratized investing a lot, and individual investors benefit quite a bit, as they have lesser risk tolerance than the billionaires. However, the limitation of liability is a reason prudent lenders ought consider the risks inherent in lending to you. For instance, if you bring an adequate down payment, and you are using the proceeds to purchase an asset that has some reasonable value — the worst case is they're stuck with a building still worth something, plus the down payment. The problem, again, is when taxpayers end up becoming imprudent lenders because of policy or bailouts.
    - twic 5y ago
      Creating a limited company purely to Dockerise your own wild trades might not work, though - that might be a piercable veil: https://en.wikipedia.org/wiki/Piercing_the_corporate_veil#United_States https://en.wikipedia.org/wiki/Piercing_the_corporate_veil#Un...
      - fennecfoxen 5y ago
        Yeah, the "holding corp with a business plan to buy a building with a down payment and a mortgage — renovating it, collecting rent and deprecation, and later selling, hopefully for a profit" is a pretty normal thing, and describing a huge portion of commercial real estate (n.b. this means real estate owned for profit, not in the SimCity zoning sense). A failure leaves the lender owning the building. This is expected. A single owner running insanely levered stock trades, though, could easily be found grossly undercapitalized, and that's another matter entirely.
- nradov 5y ago
  It's not that simple. Banks have tighter lending standards for LLCs. It's not like any random person can form an LLC, borrow money from a bank or brokerage, YOLO it in the stock market, and walk away if the bet goes bad. In reality the lender will usually demand significant collateral and/or require the LLC owner to accept personal liability. LLCs have their uses but they aren't financial magic.
  - kwere 5y ago
    a prime brokerage lends to institutions, llc or not
    - nradov 5y ago
      Prime brokerages only lend to institutions which pass credit checks and have sufficient collateral.
WanderPanda 5y ago
Smoothbrain apes realise this
- swarnie_ 5y ago
  The four million new users spamming WSB with comments like this have fundamentality ruined the sub this year. Congrats on killing it....
hogFeast 5y ago
Leverage constraints are one of the primary sources of market inefficiency. I don't know who you think the house is...is it the investment banks? They are holding the bag for $5bn+.
whoknowswhat11 5y ago
The house wins in lots of cases because of capital differences. You often end up in a forced sell LOW situation with leverage. Ie, market swings up and down 10%, then up and down 20%, at some point on a down swing if you are levered up a lot house calls you up for an extra $5B which you don't have, so they sell everything out from under you. So you can end up selling low not high in these models.
fairity 5y ago
Whether it's reckless gambling depends entirely on the bet being made. There exist bets that carry little to no risk, and whose returns exceed the cost of leverage. In Hwang's case, he seemed to be uninterested in risk management, in which case your generalization probably holds true.

by _wldu 5y ago

Leverage is often framed as being sophisticated and savvy when in reality it's just reckless gambling. The house normally wins. Unsophisticated people realize this.

fennecfoxen 5y ago

Leverage still makes lots of sense if you can put your liabilities in a separate limited-liability container. If you win, you win big; if you lose, you lose a finite amount in the form of the down payment, get a percentage of the value back as something you can deduct from your taxes, while whoever lent you money is stuck with your asset. (This does become problematic at scale when you borrow from the government or taxpayer-backed entities, like when Fannie Mae originates your commercial real-estate venture's mortgage.)

fallingfrog 5y ago
How is that possible/legal? Is that some kind of structure that wealthy people have access to but regular people don’t? It sounds like you’re describing a way to externalize your losses to the bank or to the public, which is indeed the best way to make money fast, but is parasitic on society as a whole.
- fighterpilot 5y ago
  It is both possible and legal for anyone in an agency relationship, be it an executive at a company or a hedge fund manager. Executive - take a massive unjustified risk (in terms of company direction), if it works out, get a huge bonus, if it doesn't work, get fired (by the board) Hedge fund manager - take a massive unjustified risk (in terms of a trade), if it works out, get a huge bonus, if it doesn't work, get fired (by your clients) These are both long call options with the premium equal to the opportunity cost of missed salary and the reputational impact. Individuals can't do it because they're not an agent for another group or another individual.
- friesfreeze 5y ago
  Limited liability entities (e.g. corporations, LLCs, etc) are one of the legal cornerstones our economy. Anyone can form one, but it takes expert (thus expensive) advice from a lawyer to make sure you are in compliance and thus really protected - either as a shareholder or an agent of the company. This makes sense when a lot of money is at stake. To be clear: the entity is liable for the debts it incurs but not necessarily its shareholders or agents. If it cannot pay its debts it goes into bankruptcy and is either reorganized with its creditors as its new owners or liquidated and sold.
- fennecfoxen 5y ago
  This is something anyone has access to. The price of registering and maintaining some sort of corporation (LLC, etc) is in the $100-$400/yr range depending on state. Most people obviously don't find it's worth the hassle, obviously, and it comes with additional troubles like paperwork and taxes, but the barrier is not all that steep. The limited-liability corporation structure moreover has some majorly useful properties for society. For instance, you probably own some shares of a major pharmaceutical company in your portfolio (through a retirement fund). If the company loses a lawsuit related to, say, the opioid epidemic, and owes billions, and goes totally bankrupt, then you can 100% lose your stake in the company as it is turned over to creditors — but those creditors cannot go after you personally as an owner of the corporation for every dollar that you own; your liability is limited. This has democratized investing a lot, and individual investors benefit quite a bit, as they have lesser risk tolerance than the billionaires. However, the limitation of liability is a reason prudent lenders ought consider the risks inherent in lending to you. For instance, if you bring an adequate down payment, and you are using the proceeds to purchase an asset that has some reasonable value — the worst case is they're stuck with a building still worth something, plus the down payment. The problem, again, is when taxpayers end up becoming imprudent lenders because of policy or bailouts.
  - twic 5y ago
    Creating a limited company purely to Dockerise your own wild trades might not work, though - that might be a piercable veil: https://en.wikipedia.org/wiki/Piercing_the_corporate_veil#United_States https://en.wikipedia.org/wiki/Piercing_the_corporate_veil#Un...
    - fennecfoxen 5y ago
      Yeah, the "holding corp with a business plan to buy a building with a down payment and a mortgage — renovating it, collecting rent and deprecation, and later selling, hopefully for a profit" is a pretty normal thing, and describing a huge portion of commercial real estate (n.b. this means real estate owned for profit, not in the SimCity zoning sense). A failure leaves the lender owning the building. This is expected. A single owner running insanely levered stock trades, though, could easily be found grossly undercapitalized, and that's another matter entirely.
nradov 5y ago
It's not that simple. Banks have tighter lending standards for LLCs. It's not like any random person can form an LLC, borrow money from a bank or brokerage, YOLO it in the stock market, and walk away if the bet goes bad. In reality the lender will usually demand significant collateral and/or require the LLC owner to accept personal liability. LLCs have their uses but they aren't financial magic.
- kwere 5y ago
  a prime brokerage lends to institutions, llc or not
  - nradov 5y ago
    Prime brokerages only lend to institutions which pass credit checks and have sufficient collateral.

WanderPanda 5y ago

Smoothbrain apes realise this

swarnie_ 5y ago
The four million new users spamming WSB with comments like this have fundamentality ruined the sub this year. Congrats on killing it....

hogFeast 5y ago

Leverage constraints are one of the primary sources of market inefficiency. I don't know who you think the house is...is it the investment banks? They are holding the bag for $5bn+.

whoknowswhat11 5y ago

The house wins in lots of cases because of capital differences. You often end up in a forced sell LOW situation with leverage. Ie, market swings up and down 10%, then up and down 20%, at some point on a down swing if you are levered up a lot house calls you up for an extra $5B which you don't have, so they sell everything out from under you. So you can end up selling low not high in these models.

fairity 5y ago

Whether it's reckless gambling depends entirely on the bet being made. There exist bets that carry little to no risk, and whose returns exceed the cost of leverage. In Hwang's case, he seemed to be uninterested in risk management, in which case your generalization probably holds true.