Borrowing For Investment

Leverage is universal; borrowing just wide spread

As the discussion “Truth In Lending” tried to show, once the myths are cleared away, only one reason for consumer loans remains. For a consumer loan to make sense, having something for the time between when you want it and when you could save enough to buy it for cash has to be so great it swamps the substantial cost of the loan. The main cost being opportunity cost.

Similarly, only one reason for borrowing to invest makes sense. That reason is that the return from the investment is expected to be higher than the borrowing cost. At this level, opportunity costs are very focused on the tradeoff between borrowing for consumption and borrowing for investment. Yet, if one looks at some individual’s total balance sheet, one comes to suspect that the preference for immediate gratification drives some investment borrowing. It seems to be overarching. Numerous people are loaded up with consumer debt, and they have appreciable leverage in their investments, some of the leverage acquired by borrowing.

While in previous postings “leverage” and “borrowing” were used interchangeably, when discussing investing it’s better to be exact. Interestingly, leverage in investing doesn’t always require direct borrowing. In fact, leverage can be bought and sold. A decent discussion of leverage in investing would require a detailed discussion of the virtual plethora of methods of leveraging that are offered to investors. That’s more detail than could possibly be presented in anything short of a book, probably a multi-volume book. (That’s why this discussion of borrowing precedes the discussion of options as investments in the “On Investing” series, and options are just one method of leveraging).

So, one myth associated with borrowing for investing is that it is the only way to leverage returns. That thinking is commonly associated with buying stocks on margin. An individual puts up, or pledges, the stocks he or she owns in order to buy additional stock. However, anyone who has looked into establishing an account where options are allowed knows that a margin account is often required. They also know stocks aren’t the only collateral that will be accepted. They probably also figured out that if collateral is required for options, there must be a potential way leverage is involved.

There is an even simpler way to illustrate the distinction between leverage and borrowing. At the individual’s level, one must consider what is bought as the investment. For example, one person buys a stock of a company (or a closed-end fund) that has no debt. Another buys a stock (or fund) that has piles of debt and a high debt-to-equity ratio. Neither individual has borrowed any money, but one has an investment that creates a lot of leverage. This is because the borrowing is on the balance sheet of the company he or she owns rather than on the individual’s balance sheet. (A technical side note: a firm can have financial leverage – actual borrowing – or operational leverage. In non-technical terms, operational leverage is the ability to produce different levels of output, thus revenue, at about the same cost. Clearly, financial leverage is most relevant to this discussion of borrowing).

So, you say, you don’t own stocks. You think that excludes you from the “everyone” in the subtitle and frees you to “tis, tis” those evil bankers and Wall Street types for using leverage. Well, before you take your noble stand against leverage, ask some questions. For example, does your pension fund use leverage or have debt? Be sure to include unfunded liabilities as debt. How about any mutual funds you own or the assets they own? How about owning Treasury Bonds? Does the government have debt? Even a bank account is the obligation of a lender, the bank. But, I digress. Let’s get back to borrowing by individual investors.

Remember the statement above, “They have appreciable leverage in their investments, some of the leverage acquired by borrowing.” To take a realistic view of borrowing to invest one has to think in terms of the individual’s total balance sheet.

To improve the odds of the return exceeding the cost, it isn’t surprising that investors should, and do, borrow in the least costly manner (i.e., shop for the type of loan with the lowest interest rate). Looked at from that perspective, starting an IRA or 401k, or entering a pension plan, before paying off a mortgage is borrowing to invest. So would the first step in financial management, maintaining a rainy day fund.

Borrowing doesn’t require activating a new loan, just sitting in an existing debt position constitutes borrowing. The individual is in a state of “borrowed,” which may murder the English language, but it makes the point. Starting on a retirement plan before paying off one’s entire mortgage makes sense, especially given the current tax code. Maintaining a rainy day fund should be universal regardless of one’s debt position. So, it’s not surprising “wide spread” was used in the subtitle.

However, the quote about consumer and investment borrowing wasn’t mainly directed at unpaid mortgages. The more potentially harmful example occurs when borrowing is combined with confusion about what an investment is. The classic example is when a cash-out refi is used to “invest” in a consumer durable while leaving other consumer debt unpaid. “I’ve got a decent 401(k) and lots of home equity; so ‘investing’ some of the home equity in a new SUV is OK,” is erroneous reasoning that hurt a lot of people, and it didn’t help many, if any. Given the multitude of techniques available to investors to increase their leverage, it almost requires confusing consumption and investment before one finds oneself forced to borrow in order to get leverage.

There were two important words in that last sentence: “almost” and “forced.” The important thing to remember is that all borrowing involves risk. However, sometimes the risk is low, as in the case of a mortgage on a home where you want to live. Maintaining the un-amortized debt on a mortgage may be the least risky as well as the lowest cost way to “borrow” to invest. So, “almost” is important, especially when combined with “forced.” It depends on how one interprets “forced.”

Any form leverage involves multiple risks. Consequently, the alternatives to borrowing may introduce new risks that aren’t acceptable. For example, if one wanted to leverage real estate investment, one could buy a REIT with substantial debt. That could introduce liquidity risk. It involves sector risk dependent on what the REIT holds. If those risks are unacceptable, one might feel “forced” to borrow in order to get the increased exposure to real estate.

One of my favorite examples is people who want to increase their bond exposure. One approach is to purchase a mortgage REIT (or closed-end fund) that holds bonds which the REIT (or fund) pledges in order to purchase more bonds. Annaly Capital Management, Inc. (NLY), a very well-run REIT, is an example. It’s not a bad investment. It holds mortgage-back bonds, primarily federal government-backed mortgage bonds. It pledges those bonds in order to purchase more real estate-backed mortgages and mortgage-backed bonds. It’s not a high risk approach, but it’s not riskless. Since they borrow short, often in the repo market to get the lower short term rates, holding Annaly involves yield curve risk, market liquidity risk in the repo market, and its own trading risk (volatility) as well as the default and downgrade risk on the bonds it holds. If those risks are unacceptable, the investor may feel “forced” to borrow in order to buy additional bonds. But, in reality, borrowing is just preferable.

Nevertheless, it seems surprising that actual borrowing is used as widely as it is. It probably reflects a willingness to accept a risk the borrower understands. There are just too many other ways to leverage using techniques with less risk. Remember most of the alternatives were developed in order to control risk. Sure they can be used to increase risk or reduce it, but that’s because they give the investor control of the risk. However, control may also be a factor. A borrower has direct control over the leverage. Some, but not all, other techniques can involve delegating control of the amount of leverage.

It seems there is something else at work: confusion between, or relative levels of comfort with, cash flow management and balance sheet management. However, that’s a broad enough topic to just note for subsequent discussion.

A disclosure is in order lest this posting could be misleading. The posting is not a tip sheet. Rather it’s an introductory discussion of borrowing to invest. The Hedged Economist has had and may have positions in any of the assets mentioned.