Leverage, Inflation & Total Rate of Return

Leverage, inflation and total rate of return, three concepts and how they have brought us to where we are today.

The term leverage as it is used in the field of finance and banking is something that has been with us since the beginning of time. Leverage is simply borrowing, but big leverage is borrowing big and this is where the trouble comes in. Most of us borrow to buy a house or a car, businesses borrow for an assortment of reasons. The more you can borrow, in most situations, the more you can make for the bottom line. Problems emerge when the ability to meet current debt service (interest payments) becomes a problem. Leverage enables the economy to grow. How many of us would own our own home if we had to save 100% of the purchase price of our home before we could buy it. Businesses use leverage to expand, build new plants and buy equipment. Developers of real estate borrow money to build homes or offices. They too use leverage. Banks use leverage too, as they borrow from individuals and others that buy certificates of deposits known as CDs. Some of these CDs can be for several years. Smart banks match assets with liabilities and this is called asset/liability management. Banks can leverage too much just like individuals and corporations. In an ideal world, the Federal Reserve Bank and the Federal Reserve District Banks would monitor the leverage of commercial banks in their district very closely. Yes, more regulation and oversight, but we would not be bailing them out either if we had had decent regulatory authority.

Inflation is a concept that is not too difficult to understand. Money has purchasing power, and if all else remains the same, but the cost of goods and services go up in price, then we say that we have inflation. Economists have broken down inflation into different types, but for our purposes that is not important. What causes the inflation, whether it is too much money in circulation because the government prints too much money, and we have too much money chasing too few goods is not the point here. Inflation eats into the purchasing power of our dollars. Where once we spent 30 cents for a gallon of gasoline, we now spend over $2. The gas at $2 is essentially the same gas, chemical composition, as the gas we once bought for 30 cents. This is inflation. Deflation is the flip side of the coin. Prices can come down in a recession, or prices can come down as a result of better productivity. Prices can come down for a number of reasons. Look at the prices of TVs and their improved quality over the years.

Total Rate of Return is an investment concept and is also fairly easy to understand. The difference between what the cost of an investment is, less the expenses to make that investment, minus taxes, equals the total rate of return over a specific time frame.

Under an inflationary environment, leverage works for those that use leverage in a big way. Let me explain. Developers borrow to develop real estate and they realize that over time, under mild inflationary conditions, they can pay back what they have borrowed in inflated dollars. While at the same time, the value of their development has gone up in price (market value). This then translates into a bigger total rate of return for the developer and those that invest with the developer. The developer can then go and borrow more money based on the “market value” of their developments and create more leverage. This process can go on until a recession hits, or the developer decides it is time to cash in his chips.

Banks enable developers and for this reason, banks need to be supervised. Executive compensation, salary and bonus, is based on the growth of the bank’s bottom line, but lack of oversight by the Fed can mean bailout. How much is too much regulation? In my opinion, this whole financial crisis could have been avoided if the Congress had met their responsibility to the American people.

If inflation is a fact of life in our monetary system, and if fiscal policy is going to make sure that inflation is a problem, then the least we should expect from the government is a sound and well regulated banking system. to fall down on both counts is inexcusable. We all deserve a better regulated banking system and that starts with a more active Federal Reserve Bank.

Stay tuned.