Friday, September 12, 2008

Optimal Leveraged not Over-leveraged

Bowman, North DakotaImage via Wikipedia If you looked at most of the recent financial crisis (LTCM, Asian Financial Crisis, Subprime), they were all started because of shaken confidence in the financial system. What followed were the credit problems appearing as companies or individuals who over-leveraged began having problem servicing their loan repayment obligation. Firms/individuals who have strong cashflow/income ability were able to survive but there were also numerous cases of bankruptcies or firesales for entities with weak cashflow.

Recently, Peace Mark of HK over-leveraged by pledging their shares in Sincere Watch to get a bridging loan to finance its takeover of Sincere Watch. No doubt the payoff would be great if it was done successfully. However, there were doubts over its ability to service the loans and since then, several banks have applied for a provisional liquidator to restructure the company with an objective to fufil Peace Mark's financial obligation to the creditors.

For individual investors, we hear cases of investors over-leveraging especially on property purchases as property loans are the easiest to obtain and most leveraged at 80% of property value. In good times, you would no doubt be rewarded as rising property prices will magnify your gains. However, when you are caught off-guard by the turn of economic events. You will be stuck with the financial obligations with the bank and might need to suffer huge losses if you do not have the cashflow to service the repayments.

What is an optimal level of leverage then?

The optimal leverage is to always assume a worst case scenario in your leveraged investments and determine whether you have the financial ability to service the repayments. In the case of property, the more prudent means might be your ability to service the repayments with your current income for a year if the rent income is not available for 1 full year.

So, as investors, we need to always keep in mind that while leverage is a good tool to accumulate more wealth, it can also destroy wealth fast. What we need to aim for then is to have an optimal level of leverage. No leverage is the safest but you will not be as effective in creating wealth as a investor who is leveraged prudently.

In my case, the investment portfolio generates dividends & bond payments and I used re-invest a percentage of it into my investment portfolio and another portion to service repayment of leveraged investments in properties.

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