| In the world of finance and economics there are two | | | | be helped. Nevertheless, just like the company that |
| broad types of leverage that can be used to | | | | calls back its equity from longer term growth |
| enhance return on equity: financial leverage and | | | | prospects, your financial security is put in jeopardy as |
| operating leverage. | | | | you fail to accumulate enough equity for your future. |
| In the domain of finance, equity capital is by far the | | | | While the comments above are general in nature, |
| scarcest for individuals and corporations. Most people | | | | there is a sub component of the household cost |
| and businesses cannot finance all of their needs and | | | | structure that plays a big role in the loss of operating |
| requirements with equity alone - there just isn't | | | | leverage. A closer examination shows that it's the |
| enough to cover every project or initiative. This is | | | | involuntary or compulsory costs of living that are |
| when the use of debt comes in, such as in the way | | | | affecting individuals and heads of households the |
| you finance the purchase of your home. You make a | | | | most. Compulsory costs are the fixed, non scalable |
| down payment using your equity and take out a | | | | costs you incur to keep your current standard of |
| mortgage for the difference with the house | | | | living and pay for public services. For the most part |
| earmarked by the lender as the collateral, or security | | | | these costs are involuntary; they are expected to be |
| for the loan. The conventional structure of this | | | | paid no matter your income status. They also |
| financing is one part equity (20%) to four parts debt | | | | continue to take a larger portion of your income. In |
| (80%). As you know, mortgage interest is tax | | | | my calculations and research, compulsory costs are |
| deductible so it lessens the total cost of the debt. As | | | | estimated to consume 103% of household earned |
| your property increases in value (the conventional | | | | income.To the extent that income is not sufficient to |
| view) and as the outstanding debt declines the return | | | | meet compulsory costs causes you to borrow |
| on your equity is enhanced. One hundred percent of | | | | (leverage up) or call back equity being used to |
| the equity gain flows to your bottom line and you | | | | finance longer term obligations such as retirement. |
| only had to put up twenty percent of your own | | | | Without having adequate equity the household |
| money to realize this. As long as you are able to | | | | becomes burdened with these present day |
| keep making the mortgage payments, this equity | | | | compulsory costs, avoids funding longer term |
| gain does not have to be shared with the lender. It's | | | | obligations and uses debt to finance their standard of |
| all yours. This is the power of financial leverage. | | | | living at the margin.The future has been put on hold |
| When the cost of debt financing is low or negligible, | | | | as a consequence. |
| as it has been for most of the 21st century, it | | | | There is another class of entities - local, state and |
| provides an incentive to use more of it and less | | | | federal governments - that also has a compulsory |
| equity to finance short term projects and normal | | | | cost structure that is highly dependent on financial |
| business operations. In effect, debt becomes a | | | | leverage to meet incremental or marginal costs. This |
| substitute for the equity portion of the financing | | | | class has virtually no operating leverage given that |
| structure. The shareholder benefits because the gains | | | | these organizations are seemingly not able to absorb |
| from financial leverage do not have to be shared | | | | any new effort without requiring additional capacity |
| with the lender. This allows the scarce shareholder | | | | and raising their fixed costs as a result. Their |
| equity to be allocated to finance riskier longer term | | | | operations were never designed to scale with growth |
| and more strategic projects. All-in-all, this is a wise | | | | or scale to meet increasing demand for services. |
| and fundamentally sound way to use leverage, as | | | | Every dollar of new cost has to be financed 100 |
| long as the value of the enterprise is growing. | | | | percent at the margin - by debt (leverage), taxes |
| For highly levered entities (including households) when | | | | (compulsory costs) or eliminating other expenditures |
| their asset values fall faster then the amortization of | | | | (calling back equity). However, since this class has |
| the debt, equity has to be called back from other | | | | monopolistic pricing power, to the extent they can |
| initiatives to make up the difference. This degrades | | | | extract more tax from their constituents then these |
| the future value of the enterprise as growth is seen | | | | organizations can transfer new compulsory costs to |
| as contracting, which becomes evident by a lower | | | | the citizen. |
| current stock price, the proxy of the enterprise's | | | | Herein is the fundamental advantage of the highly |
| present value. This is very much the condition we've | | | | valued enterprise: its operating leverage gives it |
| been living with for the past two to three years. | | | | flexibility and scalability. Until governmental entities |
| Operating leverage has to do with the relationship | | | | adopt a scalable cost structure similar to that used |
| between an entities embedded fixed costs and the | | | | by the highly valued enterprise for their compulsory |
| impact on it from the cost of introducing a new | | | | costs, every incremental effort will require debt or |
| venture or initiative. Operating leverage is a measure | | | | cost transference to the household, raising their debt, |
| of the scalability of an enterprise that comes into | | | | until reaching the point where the capacity for either |
| play mostly at the margin, the decision point when a | | | | to borrow no longer exists. Without restructuring the |
| new or incremental project or initiative is being | | | | manner in which existing and new compulsory costs |
| considered. The extent by which the new project | | | | are incurred and managed, neither the government |
| can use the enterprise's existing resources, or current | | | | class nor the household can accumulate sufficient |
| production capacity, and limit or avoid additional fixed | | | | equity to support their futures. Under these |
| costs will result in higher gross margins for the | | | | conditions the cost structures of the household and |
| enterprise. If additional costs are incurred from the | | | | government mimic each other. |
| new venture it should be variable in behavior, | | | | Revamping the cost structure of the government |
| meaning that if the venture were discontinued these | | | | class requires serious, draconian measures starting |
| new costs would cease and there would be no fixed | | | | with overhauling their supplier relationships - mainly |
| costs left over affecting the bottom line. Highly | | | | the cost of human capital in the delivery of services |
| valued enterprises rely on their operating leverage to | | | | and adopting pay for performance, which is one of |
| scale its size during a contracting market so equity | | | | the hallmarks of the highly valued enterprise. Other |
| does not have to be called back, keeping shareholder | | | | changes are needed in restructuring the costs for |
| returns stable. | | | | benefits, viewed by many who work in the public |
| From the citizen perspective, as a head of a | | | | sector as an entitlement for having accepted a job |
| household, the use of debt to finance 100% of an | | | | that if done in the private sector would pay more. |
| incremental need, because your income has already | | | | This is a carryover of 20th century thinking that the |
| been earmarked to meet your daily costs of | | | | 21st century highly valued enterprise has abandoned |
| existence, constrains you in this simple way - you | | | | long ago. For example, many private sector |
| have no operating leverage. The implications of this | | | | employers have transferred their pension funding |
| on your current and future net worth are profound | | | | obligation to the employee through the 401(k) |
| and difficult to overcome. The cost of the debt has | | | | mechanism. Employees are on their own for virtually |
| to be met from your income, which means it may | | | | every detail of managing long term investments to |
| need to be taken away from some other project, | | | | meet their future retirement obligation. They have no |
| i.e., calling back equity, such as funding retirement or | | | | recourse for recovering market losses, whereas their |
| the children's college tuition. | | | | counterparts in the public sector never incur |
| Common sources of household equity that are often | | | | investment losses as the public pension administrators |
| called back to meet present day obligations comes | | | | are allowed by law to transfer these losses as a |
| from homes and retirement assets set aside for the | | | | compulsory cost to the household. |
| future. Those who turn to these sources of funds to | | | | Material, meaningful governmental cost reform and |
| meet daily household cash requirements generally | | | | restructuring may take decades to achieve. That is |
| have no return on that equity. They are using | | | | understandable and probably acceptable to most of |
| leverage the wrong way. I know for many it cannot | | | | us. The question is when will it start? |