Leverage and Minsky Theory

Some people asked me where did I get my capital to invest after I'm almost 100% invested by July last year, and my reply is that I borrowed money to invest.

The common reaction i get is, 'Who did you borrow from?', 'isn't that very risky?', 'whoah you very brave hor'(which usually means you very stupid hor given my abysmal result in 08).

To clear up some ideas about leverage, let's introduce the different types of borrowers under Minsky's theory.

There are 3 types of borrowers,
1. Hedge Borrowers
2. Speculative Borrowers
3. Ponzi Borrowers

The hedge borrower can make debt payments covering both interest and principle from the cash flow from investment.

The speculative borrower can make interest payment, but require constant re-financing of capital to ensure solvency.

The ponzi borrower can cover neither principle or interest, but rely on ever increasing capital gain to refinance the debt.

The current financial crises fits this economic model of unsound credit expansion quite nicely. However, like most things in life, it looks only apparant to us in hindsight. But let's leave this issue to another day and continue out discussion on the 3 types of debt.

Imagine you are buying a house to live in, and you pay your mortgage month in and month out with your income. This is not a risky type of borrowing, because as long as you are employed, one day you'll pay off all debt and the house is yours.

However, if you buy a house HOPING that there will be a buyer who will bid a higher price to buy the asset from you such that you can pay off your debt, this is SPECULATIVE in nature, and such borrower may fit the 'ponzi borrower' description. Because if your asset has no buyer, it is likely that you'll not make the monthly payment and lose your house soon.

For my personal borrowing, I have structured it in a way such that I'll amortize my loan over a 2 year period making monthly repay at a higher than usual interest rate. This payment shall be made out of my salary. To decide what level of borrowing is appropriate, I assume that I'll earn the minimal starting pay of most graduate, and I have at least a 4x coverage. I belive that this is sound and non-speculative. Because in the worst case that the asset value falls to zero, it will in no way jeopardize my ability to pay (unless i'm unemployed). Furthermore, i get the capital that i need, my lender gets higher interest on the loan as compared to the paltry fixed deposit interest rate. Essentially my family's total investment portfolio moves towards the 'efficient frontier' (if such as thing truly exist).

Lastly, not all borrowing are risky. If a loan can be structured such that the maturity and cashflow of the loan and asset matches, and there is a small buy meaningful interest spread that can be made, such loans are not risky unless subjected to loan-to-value type of covenants.

Furthermore, a non-recourse debt can actually reduce the risk involved. Imagine you're property developer and the loan is collateralized over the property with non recourse. If every thing works out well, you pay off your debt and pocket the profit. If everything falls through, the bank seize the property and you're not affected financially. Such structure actually reduces the risk of the project instead of increase it.

However, most margin financing is HIGHLY risky. Frist, the cost of financing is highly, currently around 7%. For this financing to be sound, you must expect higher than 7% on your investment. This involves a rather optimistic assumption. But the greatest problem with margin financing is that if your asset value (e.g. stocks) plunge by a certain percentage, you are required to put up more capital or your broker will sell your stock. This type of financing essentially force the investor with liquidity constrain to buy high (when liquidity is ample) and sell low (when you are squeezed by falling asset prices and liquidity is nowhere to be found). Buy high sell low...not the best way to make money aye?