Lessons to be learnt from Lehman Brothers going bust

"Time flies," she said. "Doesn't it?"

We were sitting on Marine Drive and staring into the darkness, as the wind hit our faces.

"Yes. It does," I replied. "The last time we were here together was a decade back."

"You and your memory."

"Well, I remember because of a reason."

"Ah, now there is a reason to remember as well?"

"There always is."

"Tell me."

"The last time we came here was on the night of September 17, 2008, two days after Lehman Brothers went bust."

"And it has been 10 years since then."

"Yes Mam."

"So, tell me what happened to Lehman Brothers?" she asked, ten years later.

As they say, what goes around comes around.

"Well, they went bust because of excessive leverage," I replied.

"There is leverage in finance?"

"Yes. Let me explain."

"Please do."

"Before Lehman Brothers went bust they had a leverage of around 31:1."

"Which means what?"

"It means for every $1 of their own money invested, that is their capital, they had borrowed $31."

"Oh."

"And that meant a leverage of 31:1."

"How did that help?"

"In good times it spruced up returns."

"How?"

"So, for the sake of simplicity, let's assume that Lehman Brothers invested $1 of its own money and $31 of borrowed money. It invested $32 in total."

"Right."

"Let's say it earns a return of 10% on their investment. Their $32 investment is now worth $35.2 ($32 plus 10% return on $32)," I explained.

"Okay."

"This means a gain of $3.2 ($35.2 minus $32)."

"Yes."

"An interest has to be paid on the money that has been borrowed. Let's say the interest is a flat 1%. That works out to $0.31 (1% of $31)."

"Hmmm."

"Now after this interest is paid, the gain is down to $2.89 ($3.2 minus $0.31)."

"Yes."

"This means that Lehman Brothers earned $2.89 on an investment of $1."

"That's a huge amount of return," she said.

"Yes, that's how leverage works when the times are good."

"And when they aren't?"

"Well. Let's say there is a 2% fall in the value of assets. What happens then?"

"You tell me."

"You remember that a total of $32 had been invested. A 2% fall would mean that the value of the investment was $31.36 (98% multiplied by $32). This meant that the value of the investment had fallen by $0.64 ($32 minus $31.36)."

"Yes."

"This fall in value would be be adjusted against Lehman Brothers' original capital of $1. This means that only $0.36 ($1 minus $0.64) of the original capital is left."

"Oh."

"This means that the leverage has now increased to 87 from the original 31."

"How?"

"The value of the investment is now down to $31.36. The value of Lehman's equity is now down to $0.36. If you divide the first number by the second, you get a leverage of 87."

"Okay."

"Basically, just a 3.1% fall in the value of investment would have wiped out the capital of Lehman Brothers."

"That's how dangerous leverage can be?"

"Yes. And there is a learning in this for you and me," I said.

"What is that?"

"The simple fact that leverage can eat into your capital when times are not so good. This is something most people don't realise."

"I didn't know this until you explained it to me."

"Also, there is a lesson in this for real estate investors."

"As in?" she asked.

"Let's say you take a home loan of Rs 50 lakh and invest Rs 10 lakh of your own money into buying a flat as an investment."

"Now let's say that the price of the flat isn't going up. So every time you pay an EMI out of your pocket, you are eating into own capital, that is, the Rs 10 lakh that you invested into the house."

"Yes. I never saw it that way."

"Yes, people don't look at it that way," I replied.

We were still on Marine Drive. It was close to midnight. The silence that followed was beautiful.

(The example is hypothetical)

Vivek Kaul is the author of the Easy Money trilogy