Leverage

Many big banks in US went out of business recently. If you dig through the reasons for it most of it is attributed to leveraging. I was thinking of the consequence of leveraging in our traditional businesses.

One of the traditional businesses for Chettiars community is money lending. Money is lent to people in exchange for a collateral. Usually only about 60% of the value of the underlying asset(which is usually gold jewellery) is lent. So if the borrower defaults then the lender gets the principle and interest back. Also this is an insurance in case the price of the underlying asset falls. So even if the price of the gold falls 40% the lender could still get back the principle.

I was thinking how one could leverage in money lending business and the following is one way of leveraging that I could think of(and there are many ways you can leverage!!):
Let us say you have $1000 to lend. When a borrower presents the lender with a jewellery the lender lends him the $1000. Now the lender has the jewellery and the borrower has the money. Lender can theoretically mortgage the same jewellery with another lender(Let us call this person the second lender) and get $1000 for it. Also let us assume the first lender can get a lower interest rate from second lender compared to the rate he lends the money to his borrower. So with this additional $1000 he can lend it to another borrower and make the profit on the difference of the interest rates. Also the first lender can mortgage the new jewellery "again" with another lender and can get another $1000 back and the cycle can continue.

On the surface it looks like a good plan. The first lender always lends money against gold. So even if the borrower defaults the first lender can ask the second lender(s) to sell the underlying jewellery and get his interest and principle back. It looks almost too good to be true!!

But the worst case scenario is: If the borrower defaults and at the same time the value of the underlying property falls. For simplicity let us assume all the borrowers of the first lender default and also the price of the gold falls to zero. Now if the first lender has leveraged 3 times it means he has invested $1000 of his own money and also has lent $3000 of borrowed money from other lenders. Assuming the first lender to be a law abiding citizen there are only 2 things he can do:

1) pay the other lenders the other $3000 making his total loss to $4000
2) Declare bankruptcy.

This is one way of leveraging!! There are multiple ways of leveraging in the international financial markets. They are complex to understand too. In the name of innovation all these high risk products have been introduced by these US banks. This just reminds me of a famous quote by warren buffett(this was quoted much earlier to the financial meltdown. I don't remember the words exactly but let me try to recollect the meaning of it!): " I don't understand why many new methods of "losing money" are being invented when the old method work just fine".

I also read somewhere that many of the big investment banks have leveraged in the ratio of 1:30. Meaning for $1 of their asset, they have a potential $30 of liability(meaning if the absolute worst case scenario happens then they owe 30 times their net worth). One thing to note here is that although these wall street firms lost a ton of shareholder money(and brought the western financial system to its knees) they did not do any thing technically unethical.(Although I am pretty sure they will be portrayed as villains just to satisfy the general population. In fact there is a good chance some of these executives might go to jail in the next several months). They reported all their transactions in their annual audit as per the law. But it just turned out that these deals were so complicated that most of the shareholders did not even know what the risk of these transactions were.

In finance I am generally suspicious if somebody comes up with a complex model to explain something. In general if it requires any thing more than high school math(and may be some accounting skills) and common sense I get suspicious. But the funny thing is even now people in wall street are coming up with these insane mathematical models that use calculus and many other complicated math to predict the future market returns!!