Leverage demystified!

Let’s talk about leverage, what it is? Is it dangerous? And how to use it!

You can also watch my video “Leverage demystified!” on my YouTube’s channel. Check it out!

It is a subject that ignites a lot of passion. You will hear some people talking vehemently about how great this is, and some other persons saying with the same intensity how bad and dangerous it is.

Do not get too emotional about leverage. It is just a tool you have that can help you to achieve your goals, like a hammer in your toolbox. You have to learn to use it properly, respect it, and understand its limitations. With a hammer, you can crush your fingers, which can lend you in surgery. With leverage, you can not only wipe out your savings but end up in debts. Though with a hammer, used correctly, you can build a house. Leverage is the same; immense wealth was and continue to be made with it. So there is no need to be afraid of leverage, and avoiding it just because you do not like it is unwise. It is like trying to build a house using a stone to drive nails into the wood, instead of a hammer. Maybe you can do that, but it is not the most efficient and safest way.

Archimedes famously said: “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”

Instead of moving the world, financial leverage moves your net worth for the best or the worse. Alongside with interest rates and capital gains, it is the foundation of your wealth.

First of all, what is leverage? Leverage occurs when you borrow money. When you borrow $5 from a friend to buy a coffee or $500,000 to buy a house, in both case, it is leverage. You control more assets by using somebody else money. In the first case, it is a cup of coffee, in the second case, a house.

In both cases, your net worth did not change. You have a $5 coffee and a $5 debt. You have a $500,000 house and a $500,000 mortgage. However, notice one big difference between the two assets:  one is by nature, income-producing and one is not.

If you drink the coffee, you have now only a $5 debt. Your net worth went down.

The nature of something can be changed. Let’s say your neighbor in the coffee shop does not want to wait to have his cup because he is in a hurry, and you sell your coffee for $7. You give back a $5 bill to your friend, and you have now a $2 profit, with no money of yours down. I can imagine your eyes gleaming. Hmm, two sweet fat dollars, for free. Yes, with leverage, you can make a profit with little or no money of your own. It is the essence of it.

The most direct way to leverage your money is to take a loan. You can take a mortgage and buy a property, from a single-family home to buildings with hundreds of units. You can take a loan to purchase merchandise to resell it.

Even a student loan can be seen as leverage; you are using somebody else money to increase your potential value in the eyes of future employers. You hope to get larger paychecks in the future by investing in your knowledge and intellectual capital today.

There is also another kind of loan you can use: a margin account. If you invest in the stock market, your broker may allow you buying more in value than your cash. If you have $1,000, and the broker enables you to buy for a total amount of $2,000, you have leverage.

Do you know that there are assets that have naturally leverage embedded into them?

Futures and options are like that. You can buy an option on S&P 500 for $2 and sell it a few minutes later for $10. Imagine a 500% profit in minutes, just like that. I love trading options. You can make a lot of money very quickly, though if you don’t know what you are doing (and even sometimes if you do know), you can lose as swiftly a lot of money. As a rule of thumb, if you trade options, you have to treat this kind of investment with a lot of respect and attention, like you would if you were handling a loaded gun. It is as dangerous.

I digress a little, but I cannot resist to tell you one important fact. If you trade futures, futures options, and broad-based index options, you need to be aware of Section 1256 contracts defined by the Internal Revenue Code. Any gain or loss you have from a 1256 Contract is treated for tax purposes as 40% short-term gain and 60% long-term gain, regardless of the holding period. Can you imagine that the IRS will consider the 500% profit, made in minutes, from the example I gave you earlier as being 60% long-term gain? So, taxed way lower than the same profit made in an improbable soaring stock. What do you think about that?

To come back to the margin account, you can have with a broker; it is what I consider a dangerous kind of leverage. Don’t take me wrong, it can be useful, and I will not lie to you guys, I use it also. But you have to understand one essential thing. If the stocks you bought with leverage decline in value, you can get a margin call. What is a margin call? Your broker, feeling uncomfortable with the net value of your account, will kindly ask you to provide more money. If you fail to do that promptly, or if the stocks dip down quickly, your broker will sell your investment automatically. And you end up with a big hole in your portfolio. You may even end up owing money to your broker. So margin accounts are a serious matter.

By the way, I spoke about stocks you bought, but you can end up in the same spot if you a short stocks. Short meaning you sell a stock you do not own. It is leverage also. How do you think it is possible to sell a stock you do not have? Your broker will borrow the stock you don’t have from somebody else, and it is not free, you will have to pay an interest rate. And you see, we are talking about borrowing something, so it is also leverage. In that case, the problem occurs if the stock you sold short is rising. If it goes down, no problem at all. At one point you repurchase it for less money than you sold it, making a nice profit hopefully, and your broker gives the stock back. If on the contrary, the stock is rising, you have an unrealized loss. And if the loss is large enough, the same things will happen. You will get a margin call, and possibly, the broker may buy back automatically the short stocks, realizing the unrealized loss for you.

Do you see the big issue with margin accounts? Your debt can be called, and it will be at the worst time for you, always. And do you want to know the irony of the story? Frequently after your loss is set in stone, the stock will reverse its course. And you will see that the trade would have been profitable if only you could have stayed in the deal. Never forget that truth: the market has deeper pockets than you.

So how much leverage on a margin account should you use? It depends on your risk preference. I, for one, do not like to have too much leverage on a margin account. I am comfortable with 25% to 50% more assets than my cash, which is a leverage of 1.25 to 1.5. And after that, I would definitively closely watch my account. For example, I think you can get away with a leverage of 2. And I would be very uncomfortable with a leverage of 3 on a margin account. I am not telling you what to do guys, but I am giving you the keys to understanding what you do.

Fun fact, with some foreign exchange brokers, you can get a leverage of 100, maybe even higher. It is sheer madness. Why, because a 1% change on the value of the asset can wipe out your entire portfolio, you know 1% times 100 is 100%. Even if it does not occur every day, more than 1% change on a foreign exchange pair is not unheard of. I would say it happens few times a year. So, here it is very dangerous leverage.

I think we had a good overview of margin accounts you can get with a stockbroker; now it is time to talk about the best kind of leverage, mortgages.

Mortgages have excellent features that allow you to use leverage in a very safe way. Though, if you go over-board with mortgages, you can end up also in a tight spot. It is what caused the financial collapse of 2008. You know the bankruptcy of Lehman Brothers, the near-death experience of AIG, and sadly the loss of their home by millions of Americans. More on this later.

One of the significant benefits of mortgages is that they are usually not callable. It means the bank cannot ask for the immediate payment of the balance of your loan in normal conditions. Even if the mortgaged property declines in value.

You see, it is what makes it so safe. Even in 2008 and 2009, if the borrower was able to pay his monthly payment, nothing could happen to him or her. The market price of the house does not matter here.

It is the big difference with a margin account, where the level of stock prices is essential.

By the way, do you know when a mortgage can be called or accelerated by the bank?

When you do not pay it, obviously! There is an acceleration clause in your contract that state that the bank can ask you the balance of the loan immediately.

What else? When you sell, or generally, transfer the ownership of the property. It is called an alienation clause. Usually, the lender would not like you to have a debt, without any collateral securing it.

It makes me think about certain people who invest in real estate. They take a mortgage to buy a property, and then they create an LLC and transfer the ownership to that LLC, by using, for example, a simple quitclaim deed. They took the mortgage in their name because they wanted to have a low down-payment. The LLC, without any credit history, does not have easy access to financing. When the owner transfers the title to the LLC, he or she risks having the loan called due to the alienation clause when the lender finds out. If you want to avoid any headaches in the future and a financial disaster, talk first to your lender, and an attorney. There is a lot of myths about the benefits of an LLC; the biggest one is perhaps the imaginary asset protection. You know someone slips and injures themselves in your property, and you get sued, the LLC should protect your other assets. Believe me or not, but in some states, a judge can “pierce the corporate veil,” leaving all your assets exposed. In this post, I express my opinion and my understandings of how the different aspects work together. It is not legal advice nor financial advice. Consult an attorney, and any professional you have to, to get a clear understanding of the legal and financial aspects of what you are trying to achieve tailored to your own and unique situation.

More generally, your mortgage can be accelerated if you do not respect the terms of your contract. You may have a “Preservation and Maintenance of Property” clause in your mortgage. Which means you have to repair your property, and not let its value decline by not fixing it when needed. Did you know that?

Anyway, the cases where your mortgage can be accelerated are limited. And if you can pay your mortgage each month, nothing can happen, usually.

Then, think about it, with only a fraction of the price of a property, you control a significant asset. If it increases in value, you profit from it. If it declines temporarily in value due to market forces, who cares? The bank cannot do anything about it.

Now, what do you think happens to rents when there is a dip in property values like in 2008?

In 2008, on average the rent went slightly down, but not by much. People still needed to have a roof over their heads.

You have to pay attention to the location of the house you are buying, but if you exercise caution, a mortgage is the best way to build a significant net worth.

By the way, your tenant is paying your mortgage for you. It means you can have a fantastic return on the cash you invested, especially if you have a positive monthly cash-flow and when you factor in the long term appreciation of your property.

One important thing, I am mainly talking about fixed-rate mortgages, with the monthly payment set in stone. I do believe that adjustable-rate mortgages are more dangerous. Do you know where the interest rates will be in 5 years, or 10? I don’t. And you know, banks can protect themselves against a movement of interest rates. They buy and sell futures on treasury notes, T-Bills,  T-Bonds, every day. They can make forward rate agreements with other financial players, do swaps, swaptions, and a lot of other exotic financial products. Banks are very sophisticated players that can protect themselves against an adverse move in interest rates. You and I, as brilliant we are, we do not play in the same league. So take a fixed rate if you can, it is the safest bet.

So if it is so safe, what happened in 2008?

The main problem in 2008 is that people who were not qualified to get a mortgage were able to get one. Did you hear of the NINJA loans? It means “No income, no job, and no assets.” At that time, lenders were careless. They also made a lot of ARMs, adjustable-rate mortgages, with low teaser rates to entice people with sub-par credit to buy. When the full rate kicked in, they were not able to pay.

The 2008 financial collapse happened when banks were not able to bury their head in the sand anymore.

I like this quote from Warren Buffet: “Only when the tide goes out, do you discover who’s been swimming naked.” In 2008 the tide went out, and a lot of banks have been without swimsuits.

Was it inevitable? I don’t know; I was already working on the financial markets at that time, and, boy, the signs that something was rotten in the subprime space were all over the place.

For example, in August 2007, more than one year before Lehman Brothers’ collapse, BNP Paribas froze three multi-billion funds due to liquidity issues in the subprime market. It was a global event.

 I did not yet explain what implied volatility is, think about it as an indicator of the risk perceived by options investors. So this measure of risk, implied volatility, embedded in option prices, went up steadily from September 2007 to before the Lehman’s event. Everyone displayed a level of complacency that I cannot understand.

To come back to our subject, can it happen again?

Maybe. However, the house prices are still lower today, and the borrowing guidelines lenders apply are way more stringent. So, I do not think we will have a 2008 event soon. We can still have a bubble that pops somewhere, but probably not in the real estate market. It doesn’t mean houses cannot decline in value, it can happen, but it may be slow and not too consequential.

I am not a doomsayer for real estate right now. A correction can happen, but it should be limited. We are not in 2008. And who cares if the real estate market goes down a little, you invest for the long term. You know guys, if you wait for the best moment to invest, you may end up never investing. The best way to invest is to do it regularly.