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Is ROI leverage sustainable?

For many years we have all heard the different messages that explained us that it is possible to get a much higher return on investment, than one would expect from the economic growth. Many have probably seen that it worked well for years, and even big institutions applied it. We have heard on the other hand the message from specialist that it isn’t possible. These hide and see games have kept me busy thinking for a long time, like who is right who is wrong, what is the mechanism. With all the information that comes available and one investment scandal after the other it becomes easier to make a simple model that we presented in many different ways. 

The Basics

  • Higher return on investment that is based on higher productivity growth isn’t higher risk.
  • Higher ROI on low productivity growth is suspicious, probably higher risk.
  • Not everyone demands the maximal possible ROI of an investment.
  • So there is low cost money available to leverage the still safe high ROI.
  • High risk demands a high ROI possibility.

Let me put it in numbers, if the average economic growth is 2%, there are places where the growth is maybe even 10% and others where it close to 0% or even negative. By borrowing money at a locations where the productivity growth is low and a low ROI is accepted and moving it to places where the productivity growth is higher and a higher ROI is the norm good money can be earned. And with leverage extreme money can be earned.

Example: borrow $900 for 3% and use $100 out of your own pocket and invest/lend it out for 7%. That means you would make 7% on your own $100, but also 4% on $900 you don’t have or 43% on your $100. To borrow the $900 you most likely must warrant it with some asset.

So where is the risk?

  • If the period for loan and the interests are fixed and the same, there is no risk from that point of view.
  • If the currency it is executed in, has a fixed exchange rate, there isn’t a risk either.

In other words, in my mind there is nothing wrong, suspected, or unethical with this approach.

Question is it sustainable? In the long run, I don’t think so, as the more people become aware of this opportunity the more the low rate will be pulled up and the leverage will become 1, meaning, you only get the interest on the money you invest. As more people can be part of it, in effect the same amount of money is available for those high growth location. And as  a result the stream of spending money will slowly cap.

There is however one major effect that needs to be accepted, there needs to sufficient money available to maintain / grow the local community, otherwise you are digging a hole for your local community, so a cap is essential and that can be different than the max possible cap from the investment point of view.

Next Model

The above model was still financed with real earned money from previous productivity growth.  

What if you start to finance the above model with future money (money to be earned, like from stock value, knowing that the value of stock is based upon the future profit of an organization). Then it gets tricky!

  • Let’s assume company Smart Money starts  to attract customers that can borrow through them 5 times the money they put in against the low 3% rate. Smart Money has sufficient initial money to attract thousands of customers that see hefty profits at a monthly basis. 
  • The company wants to earn from this as well and takes 10% from the 27% profit they generate for their clients and they receive of course the normal low interest of 3% of every $ they lend. That is a hefty premium but still leaves 17% for the customers. 
  • With the money Smart Money earns it can borrow money from a bank, as they make a good profit of 5%  on every $ while the cost is 3% and you only need a computer and trust, so a low production cost. The trust you create by living expensive and the high return that is given to the initial customers. In a real implementation such an organization needs to meet a lot standards and satisfy controlling organization, although they all have failed.
  • With that magic,  Smart Money shares start to grow in value bringing in cheap money from investors, and with the share value as asset enough cheap money can be borrowed (even more when the shares are traded on a stock exchange) from banks, that are allowed to issue more money than they have. 
  • So more money can be invested in the high growth location which grows even faster with money that still needs to be earned.

Oops everyone gets it!

  • When in such a situation low interest rises, the profitability of the Smart Money deteriorates fast, so its shares will go down in value, which means the shares don’t cover the bank loan anymore.
  • so Smart Money must liquidate its shares, which due to that action depreciate even further. So now Smart Money must use money from shareholders and customers and Smart Money runs into a downwards tail spin evaporating a lot of future money from customers and shareholders.

Conclusion

Models need to be examined for sustainability and tested for extreme cases as through a leverage approach and super fast financial transactions implosions can happen extremely fast, leaving ample time to control the situation. Particularly leveraged systems need to investigate the leverage for sustainability.

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