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Demystifying financial leverage

309 points by arkadiyt 4y ago

ogogmad 4y ago
Why is leveraged long even legal? I'm naive about finance.
- jefftk 4y ago
  Things are legal by default. What's the argument for banning it?
- everfree 4y ago
  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?
fhrow4484 4y ago
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 :)
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JumpCrisscross 4y ago
> 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/leverage-ratios/ https://corporatefinanceinstitute.com/resources/accounting/l...
- Nemi 4y ago
  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 4y ago
    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 4y ago
  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 4y ago
    > Where does the ratio of 10 to 1 come in Debt to equity. $10 of debt for every dollar of equity.
kqr 4y ago
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.
- triceratops 4y ago
  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 4y ago
  > 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 https://en.wikipedia.org/wiki/Operating_leverage
  - kqr 4y ago
    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!
ilaksh 4y ago
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".
- kibwen 4y ago
  > 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.
  - mritchie712 4y ago
    can be a useful feature (in some scenarios) that crypto is permissionless (unlike the bank that has to approve vendors, limits, nations, etc.)
  - ilaksh 4y ago
    Sure but that's a workaround for a fundamentally outdated system.
    - kibwen 4y ago
      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.
jefftk 4y ago
> 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 4y ago
  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.
  - JumpCrisscross 4y ago
    > if the house is worth zero dollars (never true) There are numerous real-life scenarios where a house is worth zero dollars.
    - selectodude 4y ago
      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.
      - JumpCrisscross 4y ago
        > 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.
      - kgwgk 4y ago
        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.
photochemsyn 4y ago
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-ceos-for-failure-to-increase-interest-rates-on-savings/ 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.
KerryJones 4y ago
As a Googler, I really enjoy all the Chat-app mockery.
em500 4y ago
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.
- askafriend 4y ago
  > This seems a bit too wordy to demystify the concept. Pretty normal for a patio11 post.
  - theonething 4y ago
    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.
    - sqs 4y ago
      Personally, I love the writing style. It's enjoyable to read, and it conveys a lot more of his sentiment than dry writing would.
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thrwy_918 4y ago
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 4y ago
  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.
chatterhead 4y ago
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.
faangiq 4y ago
Tech bros should just stay away from this area. They don’t have the IQ for it.
- dang 4y ago
  Maybe so, but please don't post unsubstantive and/or flamebait comments here.
skizm 4y ago
I forget the exact phrasing, but something along the lines of: "Leverage almost always works out. But when it doesn't, you die."
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friend_and_foe 4y ago
Liabilities / (Assets - Liabilities). That's really all there is to it, the article explained it in the second paragraph.
wonder_er 4y ago
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 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 4y ago
  > "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.
spyremeown 4y ago
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 4y ago
  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 4y ago
  https://www.bogleheads.org/wiki/Getting_started https://www.bogleheads.org/wiki/Getting_started
  - dwightgunning 4y ago
    +1. So glad I found this group. But it’s just a data point… gotta do your research.
pragmatic 4y ago
Leverage aside, there is no clearer evidence that we live in a SciFi dystopia than this article.
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dia80 4y ago
Patrick McKenzie makes the usual smart person mistake of trusting their intuition on finance because it has served them well in other domains. In this case the pertinent question to ask oneself a priori is: "if, as I believe, tether breaks down what are the chances that people will be defaulting on Defi platforms thus turning my clever trade in a catastrophe where I lose my principal?" This is what traders call "wrong way risk" - your trade becomes self-defeating. An example.od this from real life is JPY cross currency basis swaps. A cross currency basis swap consists of 2 back to back loans in different currencies. Japanese investors have excess JPY and seek to convert it to USD via this mechanism so they can buy higher yielding assets in USD. Cross currency basis swaps attract a premium, in this case as the flows are predominantly lending JPY, the lenders get a lower interest rate than the prevailing market rate. The problem arises if you are a US or European bank and wish to do this trade with a Japanese bank. If there is a JPY crisis the premium will become even more negative as Japanese entities scramble to get USD in to meet liabilities by lending JPY. As the foreign bank you will have a mark-to-market profit on the JPY you lent but your Japanese counterparty may well be unable to pay due to the unfolding crisis in Japan.
- patio11 4y ago
  > In this case the pertinent question to ask oneself a priori is: "if, as I believe, tether breaks down what are the chances that people will be defaulting on Defi platforms thus turning my clever trade in a catastrophe where I lose my principal?" I am extremely aware counterparty risk in DeFi protocols, which is why I have a toy-sized position and only put that on once someone explained to me, persuasively, that in futures where DeFi explodes I will gain more utility from the story than I will lose from a toy-sized position. I have sometime sardonically referred to this as 'mining comedy gold.' This is also why, when people ask me how to short Tether, I try my darndest to avoid blessing any particular mechanism, because you can be right and still lose everything, as you're aware. I have been saying that on HN since before DeFi existed as a concept.
SevenNation 4y ago
> Your stock brokerage, though, is willing to offer you leverage on your assets. In return for a fee (and to gain your business, because this is considered a high-saliency feature for the customers of brokerages), they will lend you money against your assets, allowing you to buy more Google than you had cash for. They might allow you 2:1 leverage when you buy stock: your $1,000 buys 20 shares now. Not widely known, but it's the US Federal Reserve that tells stock brokers how much leverage their clients are allowed to assume. This is one of the most potent tools in the Fed's toolbox, and it has not used it since 1974: https://www.frbsf.org/economic-research/publications/economic-letter/2000/march/margin-requirements-as-a-policy-tool/ https://www.frbsf.org/economic-research/publications/economi... Forget the sissy Fed funds rates, forget the lamo QE/QT ceremony, if the Fed really wanted to take compulsive gamblers to the woodshed, all it needs to do is raise the margin requirement, thus de-leveraging brokerage customers by force. Whenever the topic of hash-related gambling catastrophes comes up, there's always an outcry for MOAR REGULATION. If history had demonstrated that regulators not only knew when to use their tools but that they could wield them in a wise and timely manner, that would be one thing. But time and again regulators do the wrong thing at the wrong time.
liamYC 4y ago
I liked the article! Thanks
keeganpoppen 4y ago
i must be missing something, but how does this even remotely check out?: > 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. how are you levered 10:1 when assets > liabilities? really feel like i am missing something.
- Armisael16 4y ago
  You started with $10 million. You took out an interest-free loan for another $100 million, so you have $110 million in assets (the money) and $100 million in liabilities (the debt). You’re levered 10:1 because you have $100 in borrowed assets you have to pay back and only $10 million in assets you fully own.
schizoid 4y ago
This sounds like the ramblings of a schizophrenic to me.
dharmatech 4y ago
Here's a fractional reserve banking simulator that can help to illustrate the concept of leverage and insolvency. https://twitter.com/dharmatrade/status/1553059401975533568?t=pNqcvN2Dy0o_eBTd2l59aQ&s=19 https://twitter.com/dharmatrade/status/1553059401975533568?t... Video demo: https://youtu.be/Kygc8OrTK_A https://youtu.be/Kygc8OrTK_A
random314 4y ago
> It does this by putting a bit of the bank’s own capital at risk and levering that capital using the deposits in the checking accounts. This is not at all how modern banking works!
parentheses 4y ago
> A homeowner who has just made their 20% down payment is levered 5:1 Shouldn’t this be 4:1 @patio11 ?

309 points by arkadiyt 4y ago

ogogmad 4y ago

Why is leveraged long even legal? I'm naive about finance.

jefftk 4y ago
Things are legal by default. What's the argument for banning it?
everfree 4y ago
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?

fhrow4484 4y ago

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 :)

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JumpCrisscross 4y ago

> 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/leverage-ratios/ https://corporatefinanceinstitute.com/resources/accounting/l...

Nemi 4y ago
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 4y ago
  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 4y ago
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 4y ago
  > Where does the ratio of 10 to 1 come in Debt to equity. $10 of debt for every dollar of equity.

kqr 4y ago

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.

triceratops 4y ago
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 4y ago
> 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 https://en.wikipedia.org/wiki/Operating_leverage
- kqr 4y ago
  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!

ilaksh 4y ago

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".

kibwen 4y ago
> 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.
- mritchie712 4y ago
  can be a useful feature (in some scenarios) that crypto is permissionless (unlike the bank that has to approve vendors, limits, nations, etc.)
- ilaksh 4y ago
  Sure but that's a workaround for a fundamentally outdated system.
  - kibwen 4y ago
    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.

jefftk 4y ago

> 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 4y ago
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.
- JumpCrisscross 4y ago
  > if the house is worth zero dollars (never true) There are numerous real-life scenarios where a house is worth zero dollars.
  - selectodude 4y ago
    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.
    - JumpCrisscross 4y ago
      > 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.
    - kgwgk 4y ago
      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.

photochemsyn 4y ago

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-ceos-for-failure-to-increase-interest-rates-on-savings/ 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.

KerryJones 4y ago

As a Googler, I really enjoy all the Chat-app mockery.

em500 4y ago

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.

askafriend 4y ago
> This seems a bit too wordy to demystify the concept. Pretty normal for a patio11 post.
- theonething 4y ago
  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.
  - sqs 4y ago
    Personally, I love the writing style. It's enjoyable to read, and it conveys a lot more of his sentiment than dry writing would.
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thrwy_918 4y ago

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 4y ago
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.

chatterhead 4y ago

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.

faangiq 4y ago

Tech bros should just stay away from this area. They don’t have the IQ for it.

dang 4y ago
Maybe so, but please don't post unsubstantive and/or flamebait comments here.

skizm 4y ago

I forget the exact phrasing, but something along the lines of: "Leverage almost always works out. But when it doesn't, you die."

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friend_and_foe 4y ago

Liabilities / (Assets - Liabilities). That's really all there is to it, the article explained it in the second paragraph.

wonder_er 4y ago

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 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 4y ago
> "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.

spyremeown 4y ago

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 4y ago
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 4y ago
https://www.bogleheads.org/wiki/Getting_started https://www.bogleheads.org/wiki/Getting_started
- dwightgunning 4y ago
  +1. So glad I found this group. But it’s just a data point… gotta do your research.

pragmatic 4y ago

Leverage aside, there is no clearer evidence that we live in a SciFi dystopia than this article.

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dia80 4y ago

Patrick McKenzie makes the usual smart person mistake of trusting their intuition on finance because it has served them well in other domains. In this case the pertinent question to ask oneself a priori is: "if, as I believe, tether breaks down what are the chances that people will be defaulting on Defi platforms thus turning my clever trade in a catastrophe where I lose my principal?" This is what traders call "wrong way risk" - your trade becomes self-defeating. An example.od this from real life is JPY cross currency basis swaps. A cross currency basis swap consists of 2 back to back loans in different currencies. Japanese investors have excess JPY and seek to convert it to USD via this mechanism so they can buy higher yielding assets in USD. Cross currency basis swaps attract a premium, in this case as the flows are predominantly lending JPY, the lenders get a lower interest rate than the prevailing market rate. The problem arises if you are a US or European bank and wish to do this trade with a Japanese bank. If there is a JPY crisis the premium will become even more negative as Japanese entities scramble to get USD in to meet liabilities by lending JPY. As the foreign bank you will have a mark-to-market profit on the JPY you lent but your Japanese counterparty may well be unable to pay due to the unfolding crisis in Japan.

patio11 4y ago
> In this case the pertinent question to ask oneself a priori is: "if, as I believe, tether breaks down what are the chances that people will be defaulting on Defi platforms thus turning my clever trade in a catastrophe where I lose my principal?" I am extremely aware counterparty risk in DeFi protocols, which is why I have a toy-sized position and only put that on once someone explained to me, persuasively, that in futures where DeFi explodes I will gain more utility from the story than I will lose from a toy-sized position. I have sometime sardonically referred to this as 'mining comedy gold.' This is also why, when people ask me how to short Tether, I try my darndest to avoid blessing any particular mechanism, because you can be right and still lose everything, as you're aware. I have been saying that on HN since before DeFi existed as a concept.

SevenNation 4y ago

> Your stock brokerage, though, is willing to offer you leverage on your assets. In return for a fee (and to gain your business, because this is considered a high-saliency feature for the customers of brokerages), they will lend you money against your assets, allowing you to buy more Google than you had cash for. They might allow you 2:1 leverage when you buy stock: your $1,000 buys 20 shares now. Not widely known, but it's the US Federal Reserve that tells stock brokers how much leverage their clients are allowed to assume. This is one of the most potent tools in the Fed's toolbox, and it has not used it since 1974: https://www.frbsf.org/economic-research/publications/economic-letter/2000/march/margin-requirements-as-a-policy-tool/ https://www.frbsf.org/economic-research/publications/economi... Forget the sissy Fed funds rates, forget the lamo QE/QT ceremony, if the Fed really wanted to take compulsive gamblers to the woodshed, all it needs to do is raise the margin requirement, thus de-leveraging brokerage customers by force. Whenever the topic of hash-related gambling catastrophes comes up, there's always an outcry for MOAR REGULATION. If history had demonstrated that regulators not only knew when to use their tools but that they could wield them in a wise and timely manner, that would be one thing. But time and again regulators do the wrong thing at the wrong time.

liamYC 4y ago

I liked the article! Thanks

keeganpoppen 4y ago

i must be missing something, but how does this even remotely check out?: > 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. how are you levered 10:1 when assets > liabilities? really feel like i am missing something.

Armisael16 4y ago
You started with $10 million. You took out an interest-free loan for another $100 million, so you have $110 million in assets (the money) and $100 million in liabilities (the debt). You’re levered 10:1 because you have $100 in borrowed assets you have to pay back and only $10 million in assets you fully own.

schizoid 4y ago

This sounds like the ramblings of a schizophrenic to me.

dharmatech 4y ago

Here's a fractional reserve banking simulator that can help to illustrate the concept of leverage and insolvency. https://twitter.com/dharmatrade/status/1553059401975533568?t=pNqcvN2Dy0o_eBTd2l59aQ&s=19 https://twitter.com/dharmatrade/status/1553059401975533568?t... Video demo: https://youtu.be/Kygc8OrTK_A https://youtu.be/Kygc8OrTK_A

random314 4y ago

> It does this by putting a bit of the bank’s own capital at risk and levering that capital using the deposits in the checking accounts. This is not at all how modern banking works!

parentheses 4y ago

> A homeowner who has just made their 20% down payment is levered 5:1 Shouldn’t this be 4:1 @patio11 ?