Friday, April 13, 2012

General: What is leverage?

We hear about leverage all the time, so what is it?

It's quite simple actually, leverage can be define as multiplication of money by any means.
Banks make their profits on that, what you ask for a loan you the bank gives you the loan, let's say 1000$ to buy a car, the car owner deposits the same 1000$ on the bank, so from 1000$ that the bank had, it has now 2000$, later the same happens and by some time the bank has 10.000$ but there is only 1000$ in cash, this is a very simplified explanation but you get the point.

In a certain stage all banks have some leverage, for example 3:1 leverage means that the bank has 1/3 in cash off all that the account of the bank conveys, before the financial crisis that we are on right now the bank were operating in a 15:1 leverage which is extremely risky. The risk is basically in unpaid loans, just because you count on the money it doesn't mean that it will come.

Most banks, due to deregulation in many aspects didn't even had to worry about that, the risks were basically on the people, it's basically the choice of taking a risk and in case things go wrong the people will pay; the result is on plain sight.

Don't get me wrong, the financial market needs some leverage to work (sometimes mistaken with risk) but enough is enough, when is the time to stop and say: "We've done enough, haven't we?", but like one of the CEO's responsible for the financial crisis that we are on right now once said: "We have to dance until the music stops", ironical the music had ended and we had stopped dancing a long time ago, but i guess that when you are lying to yourself for so much time it comes easier.

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