"let's see what debt does to our excel model"

in the years following the financial crisis, with Bernanke suppressing the cost of money through quantitative easing, the yield of corporate bonds collapsed and stayed low for a long time. This artificial environment pushed bond investors "out the curve" (i.e., take on more interest rate risk) and "down the spectrum" (i.e., take on more default risk). I was managing a bond portfolio at the time, and that is exactly what we did.

Before making these decisions, my colleague Tim and I would model the portfolio in Excel. The model showed that these moves out the curve and down the spectrum would increase expected returns by a meager amount (we're talking less than 1% per year), while magically maintaining, if not lowering, the aggregate risk of the portfolio. The model confirmed that Tim and I, indeed, were "smart money". We had built in the commonly accepted assumption that adding lower quality bonds to our investment mix would reduce aggregate risk because junk bonds moved in the opposite direction of high-quality bonds.

When it came to those junk bonds, however, we were a bit timid. We chose a sleeve oxymoronically called "high-quality high-yield" that did not have the same return potential as the lower grade stuff.

That is when Tim said:

"we can keep it high quality AND generate the returns of lower grade bonds IF we add some leverage... let's see what debt does to our excel model"

leverage in the natural world and in normal life

Leverage is the mechanical advantage gained by using a lever. An asymmetry between inputs and outputs. Once you internalize this idea, you start seeing it everywhere.

For example, there is operating leverage in businesses, where small increases in revenue produce large jumps in profit due to a high fixed-cost base structure.

There is the more amplified technological leverage, where one person with a tractor can produce 1000x the output of a manual worker.

Beyond that lies biological and ecological leverage, where scale and effects can be vast and systemic. Remove a single apex predator and reshape an entire ecosystem, or shout too loud in your next backcountry ski expedition and die buried by an avalanche.

Leverage exists, but is always paired with constraints. Physical limits (think size or speed), cultural friction (including bureaucracy), slow feedback loops, or some other limiting factor that prevents scaling out of control and keep the thing going (i.e., alive, not extinct, not permanently ruined).

But alas, in our wonderful world of finance, the constraints are removed.

the TNT: financial leverage

When Tim started typing numbers in cell C12 ('debt') of his Excel model:

  • the predicted portfolio return improved instantly
  • we could overwrite cell C12 with any number we wanted
  • we did not feel any physical discomfort, if anything, we felt a quiet exhilaration
  • we saw the opportunity to launch our own fund

And there it was: financial TNT. A form of leverage detached from the leverage of our natural world. Nature had always contained amplification and convexity (long before we put names on them), but finance may be the one domain we invented where the amplification is unbounded and 'unfrictioned', leaving the door open to terminal risk.

financial waters and the strait of messina

Our ancestors have always lived with dangerous convexity. Their response hasn't always been to outsmart it.

In The Aeneid, Book 3, Aeneas and his Trojan fleet had to sail through the Strait of Messina. There lied monstrous Charybdis, she would create whirlpools or engulf entire islands in water.

Surprisingly (for an epic adventure) Aeneas does not plot to deceive, defeat, or destroy the monster. No, he does one simple thing. He avoids the Strait of Messina altogether and takes the much longer route by Pachynus point.

So, dear friend, be measured when building your and your family's balance sheet.

on the excel model

As for Tim and I, we did not have the audacity to go on our own, but when we backtested our "strategy", we would have made "consistent" profits for 4.5 years and then blown up in 2014 when Russia invaded Crimea and oil prices crashed from $120 to $40 in six months.

Without us noticing, the unconstrained nature of "cell C12" would have collapsed the distance between wealth and ruin.