What is leveraging?

You may want to give this a read (if you haven’t already) before starting in on today’s post.

In my fourth semester while I was a Masters student at Gokhale Institute, I took this paper called Econometrics-II.

Let’s just say that it wasn’t the best decision ever. The paper was theoretical, abstruse and full of jargon, even by the standards of academia. And because it was my fourth semester, we weren’t exactly a motivated bunch. Placements had happened a little while earlier, you see, and the fourth semester was essentially us killing time until we joined whichever company we had been placed in.

And the combination of a difficult paper and a lack of motivation is a dangerous thing. By the time I and the rest of my batch trooped in to the examination hall for writing this particular paper, we knew it wasn’t going to be a pleasant experience.

And as it turned out, even adjusting for our expectations, it was a truly difficult paper. By the time we left the examination hall, all of us felt that there was a very real chance we wouldn’t pass this particular paper.

The trouble was, I had already entered into a forward contract with a firm to sell my services to them, five hours a day, eight hours a week. My services, that is, as a Masters student.

I had promised, in other words, to sell them something I didn’t possess: the services of a person with a Masters degree.

I was, in other words, leveraged.

What is leverage? The technical term is slightly different than the context in which I am using it over here, but I was in effect betting on the fact that I would be a Masters student by June 2006, in the month of January 2006. And I had promised (in January 2006) to deliver to the firm a service I didn’t have in my possession at that point of time.

To use the language we learnt about yesterday: I had shorted my services, when I didn’t actually have what they wanted.

The firm that had decided to hire me had also used leverage. It had promised to deliver (had sold) to its client a team of analysts. These analysts (one of them being me) would be ready to start work in 2006. So if you think about it:

  • the client was going to pay money to a firm…
  • …assuming that the firm would have a team ready to go in June 2006.
  • The firm, in turn, had assumed that the person they had hired in January 2006 would actually be a Masters student come June 2006.
  • And the student had blithely assumed that Trix-II (which is how all students at my college referred to that horrible paper) would be dealt with one way or the other.

When this last assumption breaks down, so do all the others, causing a chain reaction of sorts. In financial markets, this chain reaction can grow monstrously large, with extremely unpleasant consequences.

<Cough> Subprime <Cough> Crisis <Cough>

When a bank assumes:

  • that a loan that it has made will be repaid, with interest…
  • …and uses those presumed profits to buy an asset…
  • …and uses that asset as collateral to buy something else,
  • exactly the same thing is happening!

When the first loan ain’t repaid, bad things happen.

So is leveraging bad?

As I said yesterday, it depends on whom you’re asking. The student in question is unlikely to view leveraging as a very bad thing. That’s what got the student the job!

The firm will have a rather more bleak view of the affair, but so long as they can find a replacement easily enough, this won’t be an out and out disaster.

In the case of financial markets, leveraging is a (really big) problem when the losses are systemic. That is if all graduates from all colleges suddenly flunked in one year, they’d all be in trouble. As would the firms that had decided to hire them. As would the firms who had hired these firms. And so on.

But as today’s post hopefully makes clear, leveraging itself isn’t bad, so long as it isn’t overused, and that too systemically.

This is a rule that gets broken in a rather prominent fashion every now and then in financial markets the world over, with the attendant mess gaining a lot of attention.

But leveraging itself? It’s used all the time, and by all of us, one way or the other.