Six Degrees of Leverage: Part I
My little look at the implications of pricing-to-market a rate of return for long-term debt in “Milkmaid Investments” really shocked me.
It got me thinking about some bonds my financial advisor had me in and the very brief discussion we had about how they tend to price themselves as interest rates change. When I bought it I think the rate of return to maturity was around 6% and when I sold them it was around 4.5%. I actually paid little attention to investments at the time as I thought financial advisors were both competent and would advise you about relative risks of investments. It had about 10 years to maturity when I bought it and 6 years left when I sold it.
This was actually one of the better investments from my advisor because of the leverage of the interest rate and the bond pricing itself down to a lower rate of return. To make the example simple, say in 2012 it pays $10,000 at maturity. The easiest way to calculate the buy price at each year is to just divide by 1 plus the rate, as I have done for the table at both 6% and 4.5%.
| Year || 6% PV || 4.5% PV |
|2002 || 5,584 ||6,438 |
| 2003 ||5,919 ||6,729 |
| 2004 ||6,274 ||7,032 |
| 2005 ||6,651 ||7,348 |
| 2006 ||7,050 ||7,679 |
| 2007 ||7,473 || 8,025 |
| 2008 ||7,921 ||8,386 |
|2009 ||8,396 || 8,763 |
| 2010 ||8,900 || 9,157 |
| 2011 ||9,434 || 9,569 |
|2012 || 10,000 || 10,000 |
So, in 2002 with it paying 6% I’d have been able to buy the bond at $5,584 and in 2006 with it priced to 4.5% I’d have been able to sell it for $7,679. My return for the 4 years would have been about 37.5% or 8.3% annualized. My rate of return ended up being 38% higher than I expected (8.3/6 – 1), and for me, that was a leveraged advantage of that bond due to the number of years left on it and how the market priced itself down to lower rates of return.
It got me thinking, just how much leverage of debt has the banking system added with not only low interest rates, but also the packaging of mortgages and selling them as bonds? The M2 money supply has been increasing dramatically relative to the M1 money supply. To what degree can the activity of banks explain this?
First, a graph of M1 and M2 money supply (think I could find how to make the pictures show up, play it safe, try two ways...):
I am not sure about all of the calculations of the M1 money supply, but the Federal Reserve printing press working over time increases the money supply and then the banks have always taken that money supply and when they loan it out, it is leveraged. Traditionally the leverage was 12.5 to 1. Apparently the leverage is now 30 to 1 and that has implications of nightmares. The “OMG, what have done? How could they be so irresponsible and negligent?” questions are so long overdue, I personally don’t see how anyone can escape this nightmare without some serious hurting here.
Seriously, if knowing that the leverage has increased this much hasn’t raise enormous concerns in you, you are probably in big, big trouble with your investments.
I also did a graph of the ratio of M2 to M1:
Responsible monetary policy would show this graph as a horizontal line, not something heading into the stratosphere. Where the ratio was close to 2 fifty years ago it is now 5.4. Think of this as increased risk, because that is the implications of it. That’s 250% of increased risk. Think of those mortgage bonds causing the liquidity problems as part of that risk.
So, do I know where all this leverage is coming from? No, but the leverage from my little 10-year example is but one small example. I don’t think that example is particularly serious for the economy. The type of company was very stable and although uncertainty increases with increased time, a 10-year window isn’t too bad.
But, they’ve packaged these bonds with 30-year mortgages based on people’s personal lives. That is so much different than 10-years with ongoing businesses like utility companies. I'll look more at that next post.