10 ms·

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

by 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.
  - pooper 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. 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_articles#State_the_obvious https://en.wikipedia.org/wiki/Wikipedia:Writing_better_artic... 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".
deleted 4y ago
[deleted]
em500 4y ago
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."
- lisper 4y ago
  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.
- shafoshaf 4y ago
  “I’m not so much interested in the return ON my money as I am in the return OF my money.” — Will Rogers
  - deleted 4y ago
    [deleted]
  - NovemberWhiskey 4y ago
    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.
    - infinite8s 4y ago
      Can you say more on that error?
      - liamYC 4y ago
        In New Zealand, most fund platforms have a custodian - an entity that holds the assets you buy on the platform. If the platform busts, you’re safe because your assets are held with the custodian and not the platform. But that then begs the question, what happens if the custodian goes bust? Well custodians also have a custodian, diversifying the risk one step further (but not completely). Custodian inception! Further on this here: https://moneykingnz.com/what-happens-to-your-money-if-investnow-or-sharesies-go-bust/ https://moneykingnz.com/what-happens-to-your-money-if-invest...
rabidonrails 4y ago
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.
- Out_of_Characte 4y ago
  This is a bad example because no broker would force you to sell your own equity. You had 100 dollars, you're leveraging 50 cents for every dollar you put in giving you a .5:1 leverage ( or 50%, or 1.5/1 as a fraction) Only if the stock loses more than 100 dollars in your equity would the broker be worried and ask for margin. This means your $150 dollars of leveraged stock would have to drop to $50 dollars before the broker would be worried and sell your stock to get their $50 back. This means your stock could drop 66,7% or 2/3 as a fraction. All fees are paid upfront and the rest from your margin. Not your stock.
  - rabidonrails 4y ago
    Perhaps you're arguing that the leverage ratio I used as an example was extreme, but otherwise you are wrong that "no broker would force you to sell your own equity." If there's a margin call and you don't deposit additional cash, then a broker will force a sale of the stock. "Brokers may force a trader to sell assets, regardless of the market price, to meet the margin call if the trader doesn’t deposit funds." [1] https://www.investopedia.com/terms/m/margincall.asp https://www.investopedia.com/terms/m/margincall.asp
hn_throwaway_99 4y ago
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 4y ago
  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 4y ago
    > 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.
    - Enginerrrd 4y ago
      >knows exactly how mortgage leverage can work on the downside. Sorta... Usually when people talk about that, it's mostly in the context of balloon payments and variable rate mortgages where the value of your house dropping coincided with sudden increases to your monthly mortgage payment or large bills coming due.
      - hn_throwaway_99 4y ago
        Partially, but a big difference is that tons of lenders were giving out mortgages in the mid 00s with no or very little money down. When things turned south, people were underwater really quickly, so was easiest/best to just mail the keys to the lender, especially in non recourse states.
divbzero 4y ago
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.
pdonis 4y ago
> supplementing your own funds with lots of borrowed money This is the piece that appears to be missing from the article, or at least from the bank example.

by em500 4y ago

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.
- pooper 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. 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_articles#State_the_obvious https://en.wikipedia.org/wiki/Wikipedia:Writing_better_artic... 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".

deleted 4y ago

[deleted]

em500 4y ago

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."

lisper 4y ago
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.
shafoshaf 4y ago
“I’m not so much interested in the return ON my money as I am in the return OF my money.” — Will Rogers
- deleted 4y ago
  [deleted]
- NovemberWhiskey 4y ago
  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.
  - infinite8s 4y ago
    Can you say more on that error?
    - liamYC 4y ago
      In New Zealand, most fund platforms have a custodian - an entity that holds the assets you buy on the platform. If the platform busts, you’re safe because your assets are held with the custodian and not the platform. But that then begs the question, what happens if the custodian goes bust? Well custodians also have a custodian, diversifying the risk one step further (but not completely). Custodian inception! Further on this here: https://moneykingnz.com/what-happens-to-your-money-if-investnow-or-sharesies-go-bust/ https://moneykingnz.com/what-happens-to-your-money-if-invest...

rabidonrails 4y ago

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.

Out_of_Characte 4y ago
This is a bad example because no broker would force you to sell your own equity. You had 100 dollars, you're leveraging 50 cents for every dollar you put in giving you a .5:1 leverage ( or 50%, or 1.5/1 as a fraction) Only if the stock loses more than 100 dollars in your equity would the broker be worried and ask for margin. This means your $150 dollars of leveraged stock would have to drop to $50 dollars before the broker would be worried and sell your stock to get their $50 back. This means your stock could drop 66,7% or 2/3 as a fraction. All fees are paid upfront and the rest from your margin. Not your stock.
- rabidonrails 4y ago
  Perhaps you're arguing that the leverage ratio I used as an example was extreme, but otherwise you are wrong that "no broker would force you to sell your own equity." If there's a margin call and you don't deposit additional cash, then a broker will force a sale of the stock. "Brokers may force a trader to sell assets, regardless of the market price, to meet the margin call if the trader doesn’t deposit funds." [1] https://www.investopedia.com/terms/m/margincall.asp https://www.investopedia.com/terms/m/margincall.asp

hn_throwaway_99 4y ago

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 4y ago
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 4y ago
  > 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.
  - Enginerrrd 4y ago
    >knows exactly how mortgage leverage can work on the downside. Sorta... Usually when people talk about that, it's mostly in the context of balloon payments and variable rate mortgages where the value of your house dropping coincided with sudden increases to your monthly mortgage payment or large bills coming due.
    - hn_throwaway_99 4y ago
      Partially, but a big difference is that tons of lenders were giving out mortgages in the mid 00s with no or very little money down. When things turned south, people were underwater really quickly, so was easiest/best to just mail the keys to the lender, especially in non recourse states.

divbzero 4y ago

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.

pdonis 4y ago

> supplementing your own funds with lots of borrowed money This is the piece that appears to be missing from the article, or at least from the bank example.