Cash, Debt and the magic of Leverage.

In the world of finance there are roughly three things you can have. Cash, Assets or Debt. Love doesn’t appear anywhere – sorry. They run on a spectrum marked in increments of risk and return. 

I want to tell you this because it relates to posts I want to write later.Cash is the most conservative thing to have. Like food and shelter it is low return but very low risk. It’s what you want in an emergency. If you have cash you’re not earning anything, you have no return, it’s just sitting there in your hand. But if you think you might need to pay someone or are worried that assets are all going to lose value then cash is safest. This move to cash is where we are headed at the moment.

If you want a return on your money, however, you buy an asset that you think might appreciate in value. Like a stock or a share. It might, of course, lose value. That’s your risk. But the flip side of that risk is that if you bought wisely, it will go up in value and you have made a return.

However, being one step removed from cash, if you suddenly need to pay someone, you will have to sell quickly, perhaps at the wrong moment, and this could jeopardize your profit. Part of the risk. But a sale isn’t the end of the world. Your loss, if there is any, may not be great. Some risks, some reward.

But if you really want to go for profit, a big return, you don’t want to buy an asset. Not straight away at least. What you want to do is use your money not to buy an assert, but as collateral to borrow a larger amount of money from a bank, to buy a bigger asset. You buy debt with your cash.

It might sound odd to say ‘buy debt with your cash’ but it’s just another way of saying ‘take out a loan’. And remember banks love to lend to people who already have money. In fact they rarely lend to anyone else. Banks don’t lend to you when you are skint and really need a loan, do they? That’s the fallacy of the banks ‘helping the recovery’ nonsense. If you’ve ever been broke you’ll know, there is zero chance of the bank ‘helping’. Banks lend to people who already have money. They want those people with cash, to use their cash to buy debt.

So you do. You take your cash and use it to get a loan. You then use this larger amount of money to buy a larger asset. Now, if you have bought wisely you will get a larger return. Simple? You are now a financial genius. You have discovered leverage.

You may pass Go, and apply for a job in the city. Of course, if you bought unwisely and the asset loses value you are in trouble. Your money is gone and you owe the bank  interest payments on what you borrowed. A problem if you’re a little person. But if you got that job in the city I mentioned, and the money you lost is the bank’s, don’t sweat it, that’s what bail-outs are for.

Anyway, I digress. You have discovered leverage. Or the foothills of leverage at least. Real leverage is when you take the income from the asset you bought with your loan and rather than bank your clever, larger profit to repay your loan, you do the whole magic trick again. You take this larger income and use it to borrow some more money. Believe me it will work. You see, you used to be a person with some cash. The bank liked you for that, and loaned you more money than you had. BUT NOW, you aren’t just a bloke with some cash. You are a gent with an income from an investment. Doesn’t that sound better? Of course it does.

The bank thinks it does too. It will now lend you more money on the basis of that income. I know some of the income is spoken for to pay back the first loan BUT – think about it – if your new asset does as well as the first one you bought – you will still be getting the income from that first asset – Yes? AND you will now get an income from this new asset. Which will pay off the new loan. Still with me?

OK, NOW you are leveraged! And is there any reason to stop there? Of course there isn’t. Leverage away. The banks are making loan after loan and all of them to a respectable, wealthy gentleman – no, cancel that – not a just a gent, but now a ‘thrusting city speculator’. You aren’t just wealthy. You are building a financial empire. A pyramid of debts all servicing other debts, each larger than the one below it. You have a level of growth, a rate of return, that no asset, on its own could ever give you. Leverage is the magic and you’ve got it working for YOU.

One more thing comes from this leverage. The unprecedented growth in your business and income will get noticed. Others will want to emulate your success. They too will leverage. The result will be money moving faster and faster, everyone getting richer and the perceived desirability and therefore, value of the underlying assets you keep borrowing to buy, be they houses or stocks or securities, will go up. This will add to the positive feedback loop and voila, ‘Huston, we have a bubble.’

A wonderful by-product of leverage is bubble formation. In fact the essential ingredient for bubbles is leverage.

Of course the problem is if your rents or property values go down. A decrease on one mortgage is nasty. Multiplied by a large number of rents and mortgages and even a very small decrease is multiplied up to become a very large loss of capital and a larger loss of income. This is leverage in reverse. Leverage is like gearing, great for going faster and faster but a killer if you get stuck in a high gear when you suddenly have to go up hill.

Leverage in a falling market is what has killed the banks. Small losses multiplied by leverage become bank killers. So now I hope you have grasped leverage and why it kills when it goes in reverse.

All of this is a preamble, I’m afraid.

Cash and debt are inversely related. Cash is low risk/low return, debt is high risk/high return. Assets are the hinge in the middle.

What I want you to see now, however, is that opposite though they are, cash and debt are conjoined. Debt needs cash. The banks need cash in order to lend it to you. You need them to have cash in order for you to get a loan. And after a while banks need to borrow cash from each other and anyone else for that matter, to cover their own loans and lending. Now when asset values are increasing, your assets are making returns, cash is flowing freely and we are all making money, and its not crucial for you to get a loan anyway. You are doing fine.

BUT, and here is the killer and world crusher – if your assets start to play up a little – you might need a loan -just to cover your next payment until your assets start behaving again. A temporary dip in your income, nothing to worry about. A little loan – on the basis of your vast assets, shouldn’t be a problem, should it?

In this situation the bank lends you money. But imagine this temporary situation either lasts or worse, it spreads to lots of other people. Now something interesting happens. The bank’s situation changes. The bank needs money in order to make loans. It would also like you to get a loan because it doesn’t fancy you having problems paying back what the bank already lent to you. BUT, where is the bank going to get the cash from, for yet another loan? From you? Other people who need loans but whose income is ‘impaired’? The bank could go to another bank and say, look I want to make a few loans but I need a little liquid cash to do so. All my cash is tied up in loans. Lend us a tenner would you?

The other bank says what collateral have you got? The first bank points at all your properties and mortgages and says – that lot. You can see how this is going to end can’t you? The second bank looks at your predicament and says to your bank – ‘sorry mate, don’t like the look of those loans you made, they look like bad loans to me, bad loans equals poor collateral, equals no loan.

But you can’t NOT get a loan. If you don’t get it, you won’t pay off what you owe on your assets. The loans on those assets will default, you will lose that asset and that in turn will leave you short of income to pay the loan underneath it and so on back down the line. Like railway carriages behind a derailed train they all start to shunt one into the back of the other.

The bank will find itself in exactly the same position. It has made loan after loan and is itself leveraged to the hilt just as you are. Banks learnt leverage before you did. They don’t get money in, then just lend it out and wait for you to pay them back. They use the loan agreement (the mortgage) as an asset to go and borrow more money to make more loans. But when it all goes Pete-tong (wrong) and the bubble bursts – suddenly, at precisely the time when cash is not around, everyone absolutely HAS to get a loan. That is what happens when a bubble bursts and leverage goes into reverse.

When the bubble is inflating, cash and debt have an easy relationship. But when the bubble deflates they have an acutely difficult relationship. Everyone needs cash but no one will lend it on the basis of the loans made on those bubble, leveraged assets. This kills the banks. This is what happened to 08 and it is happening again now in Europe and in China and will happen in Australia and Canada.

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