Investing With Leverage

March 31, 2021 - Max Osbon (5 mins to read)

With the $15B Archegos blowup over the weekend creating headlines, it’s a good time to revisit the role that leverage plays in investing. Leverage is a powerful tool that works both ways as it accelerates wins and losses. With the cost of debt at historically low levels, it can be tempting to borrow as much as possible. What types of leverage are typically applied by successful investors and where do things go wrong? Let’s take a closer look.

Achegos Blowup

By now you’ve likely read about the South Korean family office Archegos owned and operated by former Tiger hedge funder Bill Hwang. It’s rumored that the full $15B net asset value of his family office has been wiped to $0. Archegos had entered into contracts with Goldman, Nomura, Credit Suisse, and others based on the prices of publicly traded securities. Those contracts allowed Archegos to lever their exposure 5:1, more or less. That means if the publicly available price of their positions moved up 20%, they doubled their money. If that price fell by 20%, they lose 100%.

It may seem insane that either party ever agreed to such a deal. However, this contract is fairly common. It’s interesting to note that Bill Hwang had already paid $40m+ in investment-related fines and was banned from trading in Hong Kong. However, for each party involved, the temptations of high commissions and the opportunity for extreme gains were far more interesting than risk management. For context, Bear Stearns was levered 35:1 before their blowup. Lehman Brothers was 30:1 and Long Term Capital Management was levered 25:1. Some part of human nature will always seek excess.

It is interesting to note how many investment banks were linked to Archegos. Goldman and Morgan Stanley unwound their positions first, leaving Credit Suisse and Normura as the bag holders with billions in losses. It raises the question of contagion risk. Too many financial professionals are notorious for leaning on weak statistics for risk management. When trades go south, they claim that a “five standard deviation event” happened that should have never happened. Standard deviation metrics should not be relied on for risk management.

Contagion risk?

Should the same banks that run our global financial system be allowed to enter excessively risky trades with high-risk gamblers like Bill Hwang? The Glass Stegall act attempted to separate these activities from core banking but that was ultimately repealed by President Clinton in 1999. Banks have rallied so far this year and rallies tend to reduce investor perceptions of risk. 

We see much greater upside in the leading fintech firms than the major banks. Paypal doesn’t have the same risks as Citibank where an employee accidentally wired $500m to the wrong address, or Wells Fargo which is paying an estimated $3B fine for their fake account scandal. Both of those issues can be solved with better software and better systems architecture. 

One of the benefits of the rise of the leading fintechs like Square, Paypal, Fiserv, Visa, Fidelity International, etc is they are focused on bringing real innovation and improvements to the finance sector. Most of the technology spend at large banks is spent on maintaining existing systems rather than improving existing ones.

The bank contagion risk is a real risk. The many employees of the large investment banks are incentivized to continue to sell commission-based structured notes of all shapes and sizes. Some of those contracts and derivatives will result in billions of dollars of losses, just like they did with Credit Suisse and Nomura. One client blowup shouldn’t have such a significant impact, but it did nonetheless.

How to apply leverage yourself

Mortgages are the most common household leverage tools. Wealthy families can borrow at rates lower than 3%, which they should take advantage of. Some people prefer, for psychological reasons, to have no debt whatsoever. Given the general long-term stability of housing prices, real estate investors tend to utilize more leverage than any other asset class. The excesses of the housing bubble in ‘08-’09 allowed real estate investors and owners to buy homes with 100% leverage, no money down and fully levered.

Options contracts provide easy access to cheap leverage, but it’s not always clear how powerful that leverage can be until you experience it yourself. Options investing can provide exceptional returns, as well as losses. LEAPs, long-dated in the money call options, are popular tools to invest with low-rate leverage. If you would like to know how LEAPs can be used effectively, please let us know.

Brokerage firms also allow clients to borrow against their portfolios. We typically advise against this as it creates possible negative exposure to extreme events, like the COVID-19 selloff last year. Today, most portfolio lending goes towards financing medium-sized purchases like cars, houses, boats, etc. Buying items on leverage backed by your portfolio assets may seem strange but it’s common practice today. Sometimes it makes sense to explore this avenue. Often it’s better to leave debt out of the portfolio picture entirely.

Take a look at the full picture. Before assessing leverage, start by detailing your expected expenses over the next 5-10 years. We break them into classes of essential, important and discretionary. Compare that to your total assets picture, both current and future assets. As long as you more than cover your expenses, you can afford to engage additional leverage and additional risk to enhance returns and open other financial doors. Risk of ruin is always the most important risk. We don’t often recommend additional leverage unless someone asks about it. Let us know if you would like to dive in deeper on how to use effective strategies.

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