Leverage is getting a bad rap
Anyone listening to the news these past few months has heard about the role of leverage in the economy’s collapse. Riding the housing boom, individual families were allowed to over-leverage themselves by taking mortgages that they couldn’t afford to pay. New homeowners were gambling, with money they didn’t have, that their houses would continue to appreciate in value. Then, financial companies joined the party by gambling heavily on mortgage-backed securities with money that they didn’t have. The housing bubble burst, and the rest is history.
The natural reaction might be to think that leverage is a bad, bad thing. But, as your parents probably told you: “it takes money to make money.” In the US, we hardly pay for anything with cash. We take out 30-year mortgage loans for our homes. We take out 5-year car loans. We finance our education with student loans. Companies routinely issue short- and long-term debt to finance their growth ambitions. Done sensibly, credit is a means to accelerate your personal or corporate growth objectives.
In 1991, Michael C. Jensen wrote in Montgomery and Porter’s Strategy: Seeking and Securing Competitive Advantage:
Debt is a powerful agent for change. For all the deeply felt anxiety about excessive borrowing, “overleveraging” can be desirable and effective when it makes economic sense to break up a company, sell off parts of the business, and refocus its energies on a few core operations. Companies that assume so much debt they cannot meet the debt service payments out of operating cash flow force themselves to rethink their entire strategy and structure. Overleveraging creates the crisis atmosphere managers require to slash unsound investment programs, shrink overhead, and dispose of assets that are more valuable outside the company. The proceeds generated by these overdue restructuring can then be used to reduce debt to more sustainable levels, creating a leaner, more efficient and competitive organization.
I’m not sure that the sentiment is welcome in the aftermath of this economic meltdown, but I agree in principle with Jensen’s concept that debt is a powerful agent for change. Re-read the passage and reflect on how it applies to sensible leverage (instead of over-leverage) and personal strategy (instead of corporate strategy). By taking out a mortgage for my house and student loans for my MBA, I am acutely aware of the need for adequate cash flow to service my debt. The financial burden forces you to focus on determining what is important to you and instills a sense of urgency to deliver on those objectives.
Oh, how I recall with fondness the glory days of a fellowship-funded, graduate school PhD program: single, debt-free, sharing a rented house, and no pressure to wrap up my thesis.
. I am really enjoying his analysis of our new (early 2000’s) economy; Professor Reich does a great job explaining how the things that we love as consumers — like the great deals we’ll get tomorrow on Black Friday — end up affecting us as the workers that make these products. If you wonder why you work harder in today’s technology-enabled society, you may also enjoy this book.