Photo: Bloomberg
Photo: Bloomberg

Golden rules of investment and debt

The problem with leveraging for financial investment is that debt can be serviced only through speculative gains

It is close to a decade since the first rumblings of the global financial crisis that culminated in a credit freeze in Western financial markets. The world economy is still to fully recover from the devastation in its wake. Growth remains sub-par, governments are broke, central bank balance sheets have expanded in spectacular fashion, interest rates are still stuck near zero, even entering negative territory, and a “helicopter drop" of money is mooted every now and then. With fears of continued financial excess and shadow banking triggering yet another financial crisis, this is perhaps a good time to reflect on the cardinal sins underlying the global financial crisis. These are really elementary. At their heart lies the relationship between money, investment and leverage.

Money and investment are not the same thing. Investments are by nature risky and speculative, as they need to be converted back to money at some stage by clearing the market. But investments can also yield high returns. This is why financial advisors recommend that individual savings should be weighted towards risk assets when young, gradually shifting towards safe assets as one ages. Modern banking has at least partly attenuated the inflation risk in holding money through saving and time deposits. But the returns are not comparable with what can be earned from investment. In the biblical parable of the talents it is the servant who invested and multiplied the money given to him who was rewarded by the master, not the one who buried it.

Since the three servants were held to account by the master, the money given to them was in a sense a loan. The first servant frittered away the money by leading a dissolute life. He had nothing left to return to his master. The second servant simply returned what his master gave, the real value of which would have diminished.

Investments can be made either from your own savings (equity), or by incurring debt. There is nothing inherently bad or imprudent about incurring debt. The banking system was devised so that small, individual savings could be aggregated for investors to leverage large investments. Industrialization is inconceivable without banking finance.

There are, however, three golden rules of leverage, stated below in rather extreme terms to underscore the principle.

Golden Rule No. 1 is calibrating the leverage for investment in real economy assets to the stability of the income streams generated by the investment. The higher the volatility, such as in commodities, the higher should be the equity component, as debt servicing becomes difficult if profits are unstable.

Golden Rule No. 2 is never leveraging for consumption, except to smoothen it. Manifest in the parable of the talents, it was violated in the run-up to the global financial crisis, with Americans running up huge credit card debt and borrowing against unrealized or notional profits from financial investment for consumption, eventually ending up in the proverbial debt trap.

Golden Rule No. 3 is never leveraging for investment in financial assets. This should be only through savings. Investments can be in real economy or financial assets. The former are those where returns are primarily from income streams, such as producing cars, consumer durables and the like, or from services like shopping complexes, cabs, airlines, shipping and electricity.

Financial assets are claims on real economy assets where returns are expected primarily through increase in nominal valuation, such as stocks, real estate and, increasingly, commodities such as gold. These claims can be made over and over again on the underlying income streams of the same real economy assets through derivatives. The infamous collateralized debt obligations (CDOs), one of the chief villains of the piece behind the global financial crisis, were serviced by housing mortgages, credit card and other receivables pooled together, ostensibly to reduce the risk of default. The claims of higher-rated CDOs were senior, with the default risk supposedly concentrated in the lower-rated CDOs. But the latter were in turn pooled to structure other senior and junior synthetic CDOs. This conjuring away of risk could go on indefinitely, limited only by the demand for financial assets. This demand rose exponentially through leverage.

Real economy assets are subject to inflation on account of demand-supply imbalance. Their output, however, is intended for actual consumption, which increases only gradually over time. Their prices are therefore relatively stable compared to financial assets. Where the prices of real economy assets become volatile, such as real estate or particular commodities, the odds are that they are becoming financialized through increased trading of claims on such assets.

The real problem with leveraging for financial investment is that the underlying debt can be serviced and repaid only through a speculative increase in the price of the underlying asset, instead of through stable income streams generated by the asset itself. If capital gains could be booked only by actually clearing the market—that is, converting risk assets into money—instead of through notional gains through periodic marking asset values to market through indices based on relatively thin trades, the prices of financial assets, including their underling real economy assets, would never approach bubble territory. Leverage would also be kept in check.

This cardinal sin has been left untouched under the new Basel III framework, in the regulatory reforms attempted by the Financial Stability Board and the G-20, and also in nation-specific reforms such as through Dodd-Frank, the Vickers Commission and the Liikanen Report, despite dire warnings by persons like by Sheila Bair, who witnessed the crisis close up as chairperson of the Federal Deposit Insurance Corporation.

Alok Sheel is a retired civil servant.

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