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Advice - Custom Leverage for BRK


jay21

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This may not be the best forum for this question, but I may be able to obtain some non-margin leverage through a relative and would like some advice.  This relative is risk averse and generally has a lot of cash.  They would prefer this cash make a higher return than a HY savings account.  I mentioned the possibility of borrowing for them and paying interest and the person seemed receptive to lend a high amount relative to my own net worth (which is pretty low).

 

My first thought was to borrow a lot but I want to make sure I offer a fair rate of return relative to my risk as a borrower, but also to make sure that I can achieve a sensible ROE.  What rate do you think would be fair for this risk?  Note that I would pledge my earnings from job to cover interest payments and principal as well.  How much should I borrow relative to my own net worth?  Also, it might be worth noting that my salary is roughly 1/2 of my net worth.

 

Also, they seemed to be flexible on when I can pay back the principal.  One thing I was thinking if I pay them the 10 yr plus 100bps with no maturity, but I can prepay at any time.  Does this sound reasonable?

 

Can you think of any custom transaction that would be beneficial to us both?

 

The reason I placed this in the BRK forum is because I would place all the money into BRK, which I believe to have very little risk in terms of compounding at a sensible rate over a long time.  Therefore, we would have to consider the return of BRK in order to know at what payment rate am I making a negative return.  I also wanted to see what people who are familiar with BRK would have to say and what they would do in my shoes.

 

Thanks for any comments/suggestions.

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How much can and under what terms from a broker?  You can borrow 50% of stock value and you can ask brokers for rates.  I would use this as a base.  This assumes you put up the stock for collateral.  You may want to offer an equity participation in return for a lower interest rate.  I think the rate will be dependent upon how much you leverage the stocks you are planning on buying.  If you want an unsecured personal loan I think you are talking about credit card rates of 10% +.

 

Packer

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I won't speak to the fact that I think this is an awful idea. In terms of the actual proposed arrangement you may want to investigate the margin stock rules. It's been a long time since I dealt with them so don't recall the details but there are (or were) prohibitions on lending money for the purpose of buying stock. It depended on both the purpose of the loan and whether the stock was collateral for the loan. As I said though, my experience is dated and the rules may have changed. You should investigate though.

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I won't speak to the fact that I think this is an awful idea.

 

+1

 

Why lever up on something that is at 90% of IV with recourse leverage deep into a bull market? If you really that confident, why not just use LEAP? You can get 2016 BRK.B $100 strike option for $23.6. That gives you nearly 5x leverage for 2 years at an interest rate of about 4.25%.

 

Vinod

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One thing I was thinking if I pay them the 10 yr plus 100bps with no maturity, but I can prepay at any time.  Does this sound reasonable?

 

A callable loan, secured only by income and not assets, with an indeterminate term? Can I borrow from them, too?  :)

 

How much are you thinking of borrowing relative to your earnings?

 

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This is one of about 5 threads talking about increasing leverage over the past couple weeks. This should be an indicator.

 

Amen brother.  There are so many things wrong with Jay's scenario.

 

1)  Everything needs to be done by a lawyer, properly, and legally, or there will be trouble.  There is no discretion on this point.  None!  And there goes your margins. 

 

2). Even with a legal document you can kiss the relationship goodbye if things go for a dumper.

 

3) Getting wealthy takes time, with or without leverage.  Count on 15 years to self sufficiency, if your a good stock picker, or Ericopoly.  There is no easier way. 

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This is one of about 5 threads talking about increasing leverage over the past couple weeks. This should be an indicator.

 

Amen brother.  There are so many things wrong with Jay's scenario.

 

1)  Everything needs to be done by a lawyer, properly, and legally, or there will be trouble.  There is no discretion on this point.  None!  And there goes your margins. 

 

2). Even with a legal document you can kiss the relationship goodbye if things go for a dumper.

 

3) Getting wealthy takes time, with or without leverage.  Count on 15 years to self sufficiency, if your a good stock picker, or Ericopoly.  There is no easier way.

 

It's called ERICOPOLENVY - Eric explains his process and use of leverage as if it were as simple as taking his Tesla for a Sunday afternoon spin around the block. His posts should come with the disclaimer in his signature, WARNING: Professional at work. Do not attempt without adult supervision.

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This was presented to me somewhere between 6 months and 1 year ago and I haven't pulled the trigger on it.  The primary reason being that I am always concerned about mixing finances and family. So if the primary concerns are that this will cause family problems, I'm totally understanding and it is something that I am thinking about.

 

To say that I'm going to blow up or I am taking on too much leverage sort of defeats the purpose of the thread.  I can customize the transaction to fit my needs in terms of sizing.  I am asking if you could lever BRK (or another company that you thought was trading at a discount that will grow over time) how much would you do so?  What terms would be acceptable to you and which terms would you avoid? 

 

I can also hedge downside by buying puts (obviously this will create a higher borrowing cost).  IDK, it seems like I can basically create a warrant on what I think is one of the best companies in the world.

 

Overall, I'm still leaning towards not doing it or even waiting until stocks are cheaper before I ask to borrow.  I was curious to see if other people would and if they could think of a good way to do it.

 

Some specific responses below:

 

I won't speak to the fact that I think this is an awful idea. In terms of the actual proposed arrangement you may want to investigate the margin stock rules. It's been a long time since I dealt with them so don't recall the details but there are (or were) prohibitions on lending money for the purpose of buying stock. It depended on both the purpose of the loan and whether the stock was collateral for the loan. As I said though, my experience is dated and the rules may have changed. You should investigate though.

 

Started looking into this and haven't found anything yet.  I'll let you know if I do find anything.

 

Also, feel free to list your concerns.  I'm not closed minded.

 

How much can and under what terms from a broker?  You can borrow 50% of stock value and you can ask brokers for rates.  I would use this as a base.  This assumes you put up the stock for collateral.  You may want to offer an equity participation in return for a lower interest rate.  I think the rate will be dependent upon how much you leverage the stocks you are planning on buying.  If you want an unsecured personal loan I think you are talking about credit card rates of 10% +.

 

Packer

 

Thanks Packer.  These rates would probably be too high for me.  I think securing with my salary would reduce the cost somewhat.  I was also thinking about doing some type of upside sharing as mentioned.

 

I won't speak to the fact that I think this is an awful idea.

 

+1

 

Why lever up on something that is at 90% of IV with recourse leverage deep into a bull market? If you really that confident, why not just use LEAP? You can get 2016 BRK.B $100 strike option for $23.6. That gives you nearly 5x leverage for 2 years at an interest rate of about 4.25%.

 

Vinod

 

The term is flexible and I don't know what BRK will trade for 2 years from now.  I'm pretty sure it will trade much higher 10 years from now, which is the time frame I am thinking of with this.  In terms of recourse, as long as I meet interest payments I wouldn't be forced to sell.  BRK's value is also debatable.

 

I agree with those that say risk in investing is not volatility, but the permanent loss of capital.

 

With that in mind, I think the only way to lose money investing in Berkshire is to use leverage.

 

It probably matters how much leverage. 

 

One thing I was thinking if I pay them the 10 yr plus 100bps with no maturity, but I can prepay at any time.  Does this sound reasonable?

 

A callable loan, secured only by income and not assets, with an indeterminate term? Can I borrow from them, too?  :)

 

How much are you thinking of borrowing relative to your earnings?

 

 

No idea how much I would borrow that's one reason why I posted.  I was thinking a lot, but whenever I actually pull the trigger on something I usually adjust downwards significantly because I know I'm biased.  Maybe 1/2 of my salary, which would allow me to effectively delever in 1 to 2 years and I have more than enough asset coverage for it?

 

Overall, it seems like almost everyone is against, which is the way I was leaning.  Maybe it's not even close and my greed is making it look close.

 

Thanks for the comments.

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Personally, I'd stack Sanjeev up against any manager in the world.

 

1. Incredibly consistent, repeatable process

2. No leverage

3. Concentrated but disciplined position sizing

4. Industry agnostic

5. Unmatched ability, from what I've seen, to average down on a name

 

Give Monish and Sanjeev $1 billion each, I'd take Sanjeev any day of the week.

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Bad idea all the way around.  Market top indicator.  If you recall, Mohnish used to use BRK as a substitute for cash and that didn't work out for him.  Besides the obvious downside, the upside by investing in BRK at this point is not enough when it may create a  hassle within your family.

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You are going to borrow money from a family member, at a high interest rate, and invest it in a large stock after 5 years of nearly uninterrupted bull market. This is like the perfect storm for disaster.

 

What if Buffett dies a day after you invest the borrowed money, and BRK gaps down 40%?

 

You could buy puts to guard against that, but then how are you supposed to make money after the cost of the puts and also the interest rate? Especially considering the fact that BRK is not cheap right now- even more so given its massive size. What if we are on the cusp of a recession, and BRK gets cheap again? Could you handle being underwater on this for 5 years?  Think of the uncomfortable family visits with this relative.

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You are going to borrow money from a family member, at a high interest rate, and invest it in a large stock after 5 years of nearly uninterrupted bull market. This is like the perfect storm for disaster.

 

Given the terms he's described, I think the rate he proposed (TSY + 1%) is insanely low.

 

Just to be clear, I agree this would be a disaster. But not because I think it's a bad deal economically, but because of the inevitable conflict with the relatives.

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You are going to borrow money from a family member, at a high interest rate, and invest it in a large stock after 5 years of nearly uninterrupted bull market. This is like the perfect storm for disaster.

 

Given the terms he's described, I think the rate he proposed (TSY + 1%) is insanely low.

 

Just to be clear, I agree this would be a disaster. But not because I think it's a bad deal economically, but because of the inevitable conflict with the relatives.

 

ah yes, didn't read that carefully enough (a good reason to probably not take my opinion too seriously).

 

But I definitely think with where were are at in the business cycle, plus BRK's size and the risk with Buffett's age, investing ANY borrowed money in BRK at the present moment is dangerous. Much less money from a relative.

 

If one is going to invest in BRK, I think people must be ready for the unfortunate day when Buffett dies, the stock gaps down, and the massive ship that is Berkshire floats through bumpy waters for a while. It is going to take a lot of patience and confidence to hold through that, not something I would want to have to go through if I had a family member's $ invested. And that day is not a matter of if, but when.

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You are going to borrow money from a family member, at a high interest rate, and invest it in a large stock after 5 years of nearly uninterrupted bull market. This is like the perfect storm for disaster.

 

Given the terms he's described, I think the rate he proposed (TSY + 1%) is insanely low.

 

Just to be clear, I agree this would be a disaster. But not because I think it's a bad deal economically, but because of the inevitable conflict with the relatives.

 

ah yes, didn't read that carefully enough (a good reason to probably not take my opinion too seriously).

 

But I definitely think with where were are at in the business cycle, plus BRK's size and the risk with Buffett's age, investing ANY borrowed money in BRK at the present moment is dangerous. Much less money from a relative.

 

If one is going to invest in BRK, I think people must be ready for the unfortunate day when Buffett dies, the stock gaps down, and the massive ship that is Berkshire floats through bumpy waters for a while. It is going to take a lot of patience and confidence to hold through that, not something I would want to have to go through if I had a family member's $ invested. And that day is not a matter of if, but when.

 

I don't really see this as that risky from a financial standpoint, for you. Short of a great depression, I see very little risks to levering up berkshire with long term low cost leverage. Over the long term the trend in corporate earnings power is up and Berkshire takes more than its share of that each year and will likely do so after Mr. Buffett kicks the bucket. The problem is that the very thing that makes it appealing (long term low cost leverage with favorable terms and callability/extension) make it a bad deal for the lender (your family member). It's tough to come up with an appropriate "market rate" for this type of transaction.

 

Too high an interest rate and you must assume a very aggressive growth rate in book value per share of Berkshire in order to break even. Too low and you are basically taking advantage of your family member who has access to low cost indices of corporate bonds. I am going to go out on a limb and say that many corporations represent a superior credit risk.

 

Berkshire's own 10 yr bonds yield 3.63% (t+70). Are you (at the proposed t+100) 30 bps riskier than Berkshire Hathaway? Are you offering shorter duration?  Rather than propose something of this nature, why not take the opportunity to educate your relative about the capital markets and the investment opportunities that exist besides intrafamily loans at below market rates

 

As a side note, if this is being proposed as a method of intergenerational wealth transfer, then now is a good time to do it because you can take advantage of low rates in order to avoid gift tax stuff, but that wasn't mentioned.

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Berkshire dropped about 46% from the 2007 high to the 2009 low. 

 

The at-the-money puts today cost less than 5% annualized for the first couple of years.  Should Berkshire continue to climb in price, the annualized cost of the puts will drop as you roll them (due to skewness).

 

This skewness thing is interesting.  The gains from the leverage don't come  in the early years, they come in the later years.  Initially, Berkshire will climb at only a token amount higher than your cost of borrow (inclusive of the put).  But over time the cost of that put comes down -- it only costs 1% annualized to hedge at $80 strike for example.  So after 4 or 5 years, perhaps your $115 strike put will cost a similar amount.

 

Right, so because it costs so much less after the stock has risen a great bit, I like the idea of using this approach with deeply-discounted situations.  That way, you have a spring that will elevate the price up a good deal such that in future years your gains will come (still fully hedging the loans).  So I liked that approach quite a bit for BAC where you have this catalyst over the next couple of years that bring it up to normalized earnings.  Before then, the at-the-money puts eat up 2/3 of the net income.  After then, they will be very cheap relative to net income -- likely more than covered by the dividend.

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Hi, I have done this type of thing before with an older family member who was earning nothing on savings. I felt it was a win-win. As for interest rates, ignore the nonsense about if you are worth x bps over treasuries.

 

If they agree and you agree that is the rate.

 

One thing I kept in mind was the scenario where I did lose money. I asked myself if I did lose it all could I pay the individual back and under what type of time frame. After determining that I borrowed the money. That said I do earn a decent salary and could easily pay the money back. Unemployment in my profession is near zero. It did work out well for me, but I was fully prepared to take full responsibility for my actions good or bad.

 

Good luck. My only other advice is make sure you know what you are doing. If you are young and inexperienced I wouldn't recommend it. If you can consistently out perform the market, are independent and have firm convictions then do it.

 

PS BRK is undervalued. Not hugely but it is undervalued and well positioned for the housing recovery in the next 2-3 years.

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Those of us on this board such as Eric and I, and a few others, took on alot of risk when we had the high conviction with the options on FFH.  I did that once using alot of margin.  I had held FFh for 6 years to that point and was picking it up at prices lower than Markel, and Longleaf paid, in provate placements.  Had it gone to zero at the time I would have been out a year of pay max.  We all had to sleep with our risk.  It wasn't an easy time.  It was even tougher staying the course after big gains had been realized. 

 

There have been other times of high conviction but never so great as that: BAc at $5, JPM < 35, SBux <10, GE at 10, AXP in low double digits, etc.  Each time, taking a big position has been really uncomfortable - everyone is against you. 

 

I see nothing in the market remotely as compelling at the present time.  There is nothing with Pabrai's "heads I win big, tails I dont lose much" right now.  It is simply a really lousy time to be taking on debt to buy stock, in a big way. 

 

Dont worry.  The time will come again, and in the interim we will all have honed our skills. 

 

My worst mistakes have come when I have gone down the quality curve.  Any student of Buffett's knows that he has made this mistake as well.  I find the waiting to be the hardest part, but perhaps one of the most important things to try and master.  It does not come naturally to ambitious people. 

 

I got self sufficient overnight, in the last 15 years. 

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