Tan Kin Lian's Blog: Leveraging and greed

Tuesday, October 14, 2008

Leveraging and greed

Businesses are greedy. They like to earn a ROE (return on equity ) of 15% to 20% per year. This can only be achieved by taking excessive risk, through leveraging (i.e. borrowing several times of their equity).

In a competitive market, a business can earn a return of say 8% per annum. If all the capital is funded by equity, the ROE is 8% and the risk is low.

If they issue a bond at 5% of the same amount as equity (i.e. leverage of 1 time), they hope to earn the difference of 3% on the bond. This will give a return of 8% + 3% on the equity, i.e. 11%. This is risky as the interest on the bond has to be paid first from the profit.

If they are greedy and are leveraged 2 times, they hope to earn 8% + 2 X 3% or a total of 14% on the equity. This is more risky compared to a leverage of 1 time.

Some investment banks were leveraged 20 times. This is madness.

To make matters worse, the borrowings were made on 30 or 90 days credit, instead of long term bonds. During good times, the cost of short term credit is lower than the cost of bonds. The businesses were greedy to make higher profits on the spread. This is extreme madness.

During the financial crisis, they were not able to get new borrowings to repay back the old borrowings. This lead to the collapse of the global financial system.

In the new financial system, there has to be regulatory control over the amount of leveraging. especially for financial companies, including hedge funds.

4 comments:

Invest SGX said...: When they multiply their earning by leverage, we are suffering when they deleverage.

Asian financial crisis has not gave Western good lesson.; October 14, 2008 8:42 AM
Unknown said...: Businesses are made up of people, and it is the people who are fundamentally greedy.

The thinking is:
If I earn a better ROE at work, I will get a better bonus.

So I think it is better to say that people are greedy (either at work or in their personal life), rather than "businesses" are greedy.

And people leverage all the time. A mortgage is a leverage. You put 25% down (or less) to buy a house. But the difference with this leverage is there is an actual physical asset behind the leveraging.

Don't you wish that all these mathematical genusis who came up with the complex financial products and models had gone into green technology? Think where public transportation would be today.; October 14, 2008 8:54 AM
Anonymous said...: hope that banks will be conscionable. high hope in these days of evil.
these old people just wanted more interest because there have been so many articles in the newspapers in particular sunday times invest section telling people money will become smaller because of inflation.
it's sad that they lose their life saving because the banks RMs used the higher interest as bait to make them part with their money.; October 14, 2008 5:19 PM
ym said...: jill, your last point shows that bubbles industries' damage goes beyond price plunges..

REAL resources were mis-directed into unproductive assets (property, MBS, CDO, CDS, etc), these "brains" could have created REAL value in productive industries...

Another point which i have stressed very ofen is the central banks and private banks being allowed to control interest rates, forex rates and print money out of thin air.. this is the root of the problem...

debt by itself is not catastrophic, it is money/debt created out of thin air that will collapse the value economic system; October 14, 2008 5:20 PM