Finance Lessons From Shakespeare’s Novels – Part 1
An old tale which still continues to inspire financial professional is Merchant of Venice. From the spectacles of finance, it provides profound insights about the securitization of assets, borrowing or leveraging, and uncalculated risk.
In the great tale, Bassanio and Portia loved each other and wanted to marry. There was a condition though, imposed by Portia’s father, which required bounty of money which Bassanio could not arrange.
Bassanio sought help from his friend Antonio. Antonio did not have money, however, he was a true friend of Antonio so Antonio did not want to return Bossanio hopeless. Antonio advised Bossanio to approach Shylock, a rich money lender (the typical bank), and get a loan that will be repaid after Antonio’s merchant ship returns with ample wealth (securitization and mortgaging).
Shylock was not in good terms with Antonio and had harbored deep animosity in his mind. Shylock did not want to lose this opportunity to settle the score.
Shylock agreed to lend money to Antonio, on the guarantee of Antonio that Antonio will pay the loan once his ship returns. If Antonio fails to pay the loan, he has to provide a pound of flesh from his heart, nowhere else but from the heart to Shylock – that was the agreement – remember this to understand leveraging later. Bassanio and Portia got married and everything was good until the fateful night when the news broke that the ship of Antonio is sunk in the deep sea. Antonio was bankrupt.
Shylock sued Antonio and demanded one pound of flesh from the heart of Shylock. This shocked the lovers – Bassanio and Portia – there loved cost Antonio his life.
Portia was a lawyer – she rushed to court and urged Shylock to be human. But Shylock was a true lender; he was adamant.
Portia, having no other option, read the contract loud – she explained – the contract allows Shylock to take a pound of flesh but without wasting a drop of blood.
Shylock lost the case. The justice prevailed – but it left behind many lessons for finance professionals.
This is the case with modern leveraging. Leveraging allows us to buy an asset worth $100 with only @10, by borrowing $90.
Imagine,
1st scenario: stock goes to $150: the profit is $150-$100= $50. Return $90 of loan to lender, final profit = 50-10=40. Percent of profit: 40 (profit)/10(investment) = 300% – well done.
2nd scenario: Stock goes to $ 50; the loss is $100-$50=$50, Return $90 of loan to lender, final loss = -50= -50/10. Percent of loss: -50 (loss)/10(investment = 500%; a disaster.
There is a great chance of making 50% losses in a certain financial crash like above and hence there is a significant chance of making such magnified losses.
While leveraging can magnify the return (300% in the given example), it can balloon the loss (500% in the same example above).
Many businesses and empires are made through leveraging and several more are destroyed. Then the question is why leverage is used and why the mention of this raises eyebrows?
Levers can do magic. It can do things that we can not imagine doing. One can buy and stay in houses that we can not buy in dreams. One can run the business using this which is beyond wildest dreams. Basically, it multiplies force.
Archimedes explained it well, saying ‘Give me a lever long enough, and a fulcrum to place this, and using these two, I can move the world’.
Hence, the world is still in love with leverage – which provides levers in business – though this should be handled with care.
Lessons: This great novel is not just about love, loan, and legality, but also reminds us of the fundamentals of finance:
1. While leverage is useful in a certain situation, and if carefully used, it can also bring disaster when the situation turns against you. The Merchant of Venice explains well, that certain debt taken without calculating the risk, can cause havoc. So, always calculate downside risk, what can go wrong, and what will be repercussions before using leverage and borrowing.
As Warren Buffet once said – I have seen many people fail because of liquor and leverage – if you are smart, you can make a lot of money without borrowing.
2. Securitization is not always a guarantee of repayment of the loan. The security may or may not exist at the time of repayment.
3. The illegal condition in the agreement may not be enforced in the court of law. Some conditions are null and void if that stands against the basic tenets of the law.
