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- [00:01]
David Stein
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host David Stein. Today is episode 547. It's titled Debt is for Managing Wealth, Not Creating It. This is the 42nd episode of Money for the Rest of Us. This year, as I Look back on 2025, we released 31 solo podcast, just me and you discussing various aspects of finance. I conducted four interviews this year and this has never really been an interview podcast. And I also as an experiment we released seven FEG Insight Bridge episodes. These are podcasts put together by Greg Dowling from my former institutional investment advisory firm FM FEG Investment Advisors. When I look back on those 31 episodes, nine of them were on asset classes and vehicles from private credit, bonds, stablecoins, gold, silver. We discussed robo advisors, sports betting. Three of them were on AI including Don't take Financial Advice from AI, the Jobs Impact of AI and the Fight for the Real. Nine episodes came out of various actions actions by the Trump administration this year, including discussions on tariffs, trade, sovereign wealth funds, central bank independence, US debt, downgrade, strategic bitcoin reserves, adding private capital to 401k plans, and the favorite type of episodes I do are what I would call big picture episodes. We discuss geography, demographics, infinite money, uncertainty, risk management, bubbles, and today we're talking about leverage. Money for the Rest of Us is an audio podcast. It is audio first. We've done videos. I released over 60 video shorts this year, two full length YouTube videos, but I prefer audio. Video is not going to replace audio in the sense that audio is unique. You can listen to it while you do other things while you're running, exercising, working in the yard as you drive. I believe there can be added depth with audio and I'll continue to do audio as well as other content. We released over 40 Insider's Guide email newsletters in 2025, six essays on substacks. I continue to work on my next book. Plus we have a ton of premium content that we release for members of Money for the Rest of Us. Plus we have our member forums there. We have model portfolios, investment strategy reports, I share my portfolio, my portfolio trades and this week we have a live stream for members of Money for the rest of us. Plus where I'll answer member questions. When I think about 2026 and I look at the level of output of audio content, video content, written content, much of it free, I come away with a desire to do deeper, more remarkable work. Remarkable in that you're willing to remark on it and share it with others. And so as part of that, as I look at 2026, we'll be releasing fewer ad supported podcast episodes two per month so that the content is better, more shareable. It gives me more time to think about the topics, do more work on them and just make a better audio podcast. And that's one of my goals for 2026. For this episode. It comes from a question in our member forums from a member of Money for the Rest of Us plus and the member was asking about Basic Capital. There's a new startup came out of stealth mode this past May. First investor in this startup was Bill Ackman of Pershing Capital, a hedge fund manager I used to invest with at my prior firm. And this startup is has a unique approach in offering 401k plans and individual relationships retirement accounts. What's unique about it is participants can allocate a portion of their investments to a leveraged product that magnifies their returns on the upside and the downside. Abdul Al Assad, the co founder of Basic Capital, said, if you want to buy a house, you take a mortgage. If you want to buy a car, you take a car loan. If you want to go to school, you take a student loan. When why isn't there a mechanism for me to finance investments in the market? We're going to look at why there isn't and how borrowing money to invest is different than borrowing money to purchase a home, al Assad said. The dream is in 10 years literally there is a Fannie Mae and it's not backing housing, it's backing stocks and bonds backing in it in that it essentially, as I understand it, guaranteeing that debt. Fannie Mae it stands for Federal National Mortgage association was founded by Congress in 1938. In 1970, Congress established a Federal Home loan mortgage corporation that's known as Freddie Mac. Their mission is to create and provide a stable source of funding for residential mortgages across the U.S. including loans for low and moderate income families. Fannie Mae, Freddie Mac do that by purchasing mortgages that meet certain criteria. They package those mortgages into a pool of loans known as mortgage backed securities. They guarantee those mortgages against losses from default and those mortgage backed securities are sold to investors. If you are invested in a bond fund or a bond etf, if it will have exposure to mortgage backed securities. Fannie Mae and Freddie Mac also issue bonds that aren't tied to mortgages. They're just bonds backed by Fannie Mae and Freddie Mac, and they use that capital in order to purchase the mortgages. This government guarantee because Fannie Mae and Freddie Mac are currently controlled by the government, they've always been a government sponsored enterprise in terms of, there was an implicit guarantee of, of Fannie Mae and Freddie Mac, but then they were taken over by the federal government during the great financial crisis. And there's talk about allowing them to go public again. But the reality is both of these entities benefit from a guarantee of their debt by the federal government and certainly the guarantee of these, of these home mortgages. But the US is unusual. Most federal governments don't protect lenders against default in the mortgage market. Yet we have Fannie Mae, Freddie Mac and also another government sponsored enterprise, Ginnie Mae. We have the FHA, we have federal loans over 90% of the mortgage market. But if we look at, if the whole goal was to allow more people to access homeownership, the homeowner rate in the US is only around 63%. But if we look across other developed markets, the homeownership rate approaches 70%. Back in episode 238 seven years ago we looked at the Danish housing market and here's a housing market where the government doesn't guarantee mortgages. They pay more about, at least at that time, about 80 basis points more for home mortgages in Denmark relative to the US after adjusting for the base interest rates of government debt in those countries. This is a government subsidy. These lower than market rate mortgages because of a government guarantee and then the fact that the interest is, is tax deductible is another subsid given to homeowners. And I'm not arguing against that. It's just something we need to recognize. And I thought of it because here we have basic capital suggesting the government should do something similar for investing in retirement backing debt used to buy investment assets. Now the reality is because of that guarantee, investors can borrow up to 97% of the purchase price of a home. Now that is an incredibly leveraged transaction. And when home prices increase, it really can magnify the returns on that down payment. But if home prices fall like they did during the great financial crisis, then it can lead to being underwater. Yet the government was guaranteeing those home loans against default. There's this idea out there, kind of a myth that the wealthy built their wealth because they used leverage, they borrowed money, they invested it. And, and that's just not true. Most wealth created in the US Much of it was capital investing in businesses. And when we think about startup businesses, the cash flow is uncertain. 75% or upwards of 75% of startups fail. They fail in that they, they just never get traction to generate enough cash flow. And banks won't lend to a small business like that unless there's again some type of government guarantee because the risk and uncertainty is so great. Now once you have an established business and it's generating cash flow, then you can borrow money. But not starting out because of the great failure rate. The minority of these companies are successful and startups and it's really challenging. We always hear about the successes, but there's so many failures. And there's been a lot of wealth created from starting a business. But when we look at how wealthy households use debt, they use it after the wealth has already been created. They'll borrow against existing assets. It could be investment securities they have. And they can take out a margin loan or a line of credit to fund living expenses. And it's a liquidity exercise because it allows them to avoid selling appreciated assets and triggering the capital gains tax. Those investment can continue to compound. But they already have wealth. We talked about it in episode 353 Infinite Banking, where if you have a whole life insurance policy that you've kept for decades, the cash value grows and you can borrow against that cash value, pay an interest of 5 to 8%. And again the whole idea is raise some liquidity from the value of this underlying asset and it can fund living expenses or other purchases. But you're borrowing against an existing asset, you're borrowing against your existing wealth. And wealth is created often without leverage. Owning and growing a business that has generating cash flow, that long term ownership of productive assets like stocks on an unlevered basis. Now companies, again, they'll, they'll borrow, but the company is already generating cash because these businesses have a margin of safety, they have a buffer in order to meet the interest and principal payments. Otherwise no one would lend to them if there was little chance of getting paid back. Now, real estate tends to be a little different. We talked about home mortgages, but when you borrow against real estate, you have this assets that's generating cash. It's a rental unit or an apartment. That asset serves as collateral. You put up a down payment. Oftentimes. If it's a apartment building, it could be, if it's your first building, it could be you need to put up half the value of the building. That certainly was the case when about 10 years ago we lent money to an individual retirement account from a couple that wanted to buy an apartment building in Idaho in a in a university town and we lent half the money because they put up 50% equity. Success depended on the long term cash flow of that asset. And the pandemic hit. There were some scary times. The university shut down. Their rent income dropped. They continued to service the debt. Now it's been paid off. There are some that have created wealth in real estate using leverage, but it's not 97% leverage like you see in the residential home market because of government guarantees. Before we continue, let me pause and share some words from this week's sponsors. For many business owners, tax time's a little scary. Feels reactive. You gather all the paperwork, you send it to your accountant and you hope the numbers work out. I know in our business, taxes can be really frustrating and that's where Gelt can help. 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- [14:22]
David Stein
Book now@vrbo.com the reality is debt increases the optionality for people who already have a margin of safety. They have that that layer of flexibility and they can use that debt to manage expenses, their tax liability. But by and large, debt is not a wealth creation vehicle. It's to manage wealth. And so then when I see a pitch like Basic Capital suggesting that individuals can create wealth by borrowing money and investing it in the stock market and other asset classes, red flags go off because that's typically not how it's done. In the case of Basic Capital, they'll give you $4 for every dollar you save. And it is structured as a limited liability company. It's not traditional debt, it's preferred equity financing. We think about how preferred equity is used. It's sort of a permanent layer of capital where there's a fixed dividend payment that needs to be made. And in this case Basic Capital, you put $10,000 into an individual retirement account or into a 401k vehicle, you'll get $40,000 from Basic Capital structured as preferred equity that you need to pay 6.25% per year on that preferred equity. Now, there is some advantages to preferred equity is that it's not going to be called away. It's not like a margin loan where if the value of the assets fall, that the brokerage firm can force the sale of the assets in order to recover the loan. This is a permanent layer of capital and that's, that is an advantage that makes it interesting. But it's expensive at 6.25%. And basic capital has pointed out that, well, yeah, it's variable, but that's where rates are now and it's 6.25%. And I've invested in preferred equity for years and the lowest coupon rate I've seen on preferred equity is 5%. And that's when other rates were closer to zero. The government, short term government debt. Many of the preferred equity positions I have now, the yields are closer to 8%. So it's not like 6.25% is high, but it is high when we look at what has to happen in order for this strategy to work out for individual investors. In addition, Basic Capital charges a half a percent management fee on all of the assets, both your equity contribution as well as the preferred stock financing that is made available. And then when you pull money out, Basic Capital will get 5% of the gains. So that's their carry. So that's the structure. The IRA custodian is American Estate and Trust. The brokerage firm for custodying the assets is Apex Clearing. There's no setup or origination fee. They just to establish the llc. But if the account is liquidated, the proceeds are distributed according to the agreement, the operating agreement for the llc. There's, there's a waterfall. The preferred equity receives its priority return. It gets, it makes sure it catches up on that dividend payment. 6.25% plus it gets 5% of the gains and any remainder flows to the common equity, the amount of capital that the individual contributed. There's no lockup period, so there's no prepayment penalties. And they're now offering you ability to customize the portfolio. Initially it was just they you were invested in essentially private credit credits that were selected by Basic Capital in order to hopefully generate a yield higher than the 6.25%. Now they offer some customization where you can invest in stocks and bonds so you can adjust the underlying asset allocation. What I like to do at MONEY for the rest of us, and I've done this as an investment professional, is try to simplify it as much as possible and do a spreadsheet. And I do the spreadsheet and I want to understand the numbers. And it's, it's. We talk about AI, which is interesting. So this member had a question on Basic Capital, sounds like they might be considering using it. And they ran it through an AI and they got a lot of responses. And then the member asked me what I thought and then pasted the AI responses. And I find that intriguing in the sense of the AI had an opinion, but she wanted an opinion from a trusted source. And that's what I'm giving. So I did a spreadsheet. $10,000 investment. That's our equity piece. Just once, simplify it as much as possible. Just one $10,000 investment. Basic capital contributes $40,000 in preferred equity financing and that's set up as an llc. And my question was, what return do you need on that investment portfolio in order to earn the same return than if you just invested without the preferred equity financing, without the leverage, there is a number and above that, that hurdle rate, then the returns are magnified, they're higher than they would be otherwise. Below that return, that break even return, the returns will be less than they would have been. Have you just invested in our IRA and didn't use Basic Capital at all? And that's an important number. And it's 7.1%. That's what you need to generate in order to essentially be the same as if you had not done it at all. And that's to pay the 6.25% preferred equity return to Basic Capital. That includes the half a percent per year asset management fee and then the 5% share of the profits in terms of the carry. There's also a return if you earn that on the portfolio where you basically would earn zero after paying all the fees, that returns 5.5%. So if you earn less than five and a half percent on the portfolio, then you're losing money. But around five and a half percent, 5.6%, you're basically earning zero. Which means the cost of this structure over time is about five and a half percent per year because of the large preferred equity base. $4 of preferred equity for every dollar of capital and the fee cost of that with the carry is roughly five and a half percent per year. So the portfolio's got to do better than that. 7.1% annualized in order to do as well as you would have done had you just not used, you not borrowed anything. If you earn 8% return, then, then you start to magnify the return. An 8% portfolio return gets you 10.3% annualized in 10 years, 9.7% in 20 years, and 9.5% in 25 years. If you get a 9% portfolio return, you would earn 13.3% annualized return after all fees in a decade, 11.9% after 20 years, and 11 1/2% in 25 years. Now you notice something. The longer you stay invested with basic capital, the lower the return. When I saw that, I thought, I thought my spreadsheet was wrong. And I looked at it again, I verified the formulas and actually I ran it through AI just to see. And the reason is your fixed financing compounds faster when you have moderate asset class returns like an 8% plus, there's that 5% carry, the gain is growing. And I checked the math numerous times and yeah, the longer the holding period, the lower the return. And the longer compounds at 5% carry becomes more of a penalty. And what's, what's interesting, you would think that if, if the structure is to my benefit, wouldn't longer compounding periods help me generate a higher return? When in fact, the longer I stay invested in this structure, the lower the, the return. Not by much, but it is there. There's another concept that will impact the return. We, we mentioned at five and a half percent annual return, you would make zero. But when I did the modeling in the spreadsheet, I just assumed the return was the same every year. Very, very stable return. But that's not the way financial markets work. You get up years, you have down years. And so I wanted to do a simple analysis. Well, what about volatility? Drag, the impact of volatility. Recall that with an 8% portfolio return, you earn roughly 10% annualized over 10 years, 20 years, 25 years. Now it falls slightly the longer your holding period. But what if you earned an 8% portfolio return, except in year seven, the portfolio fell 25%, but you continue to hold it for 10 years, 20 years and 25 years. Well, if that happens, your 10 year return is negative 8% annualized compared to 4.1% annualized for the 10 year period without the preferred equity financing. But with the preferred equity financing, if you indeed lost 25% year seven, your 10 year return would be negative 8% over 20 years. With that loss in year seven, you would have earned 3.8% versus 6% if you hadn't used basic capital at all. And then over 25 years, the basic capital you would have earned 3.8% annualized versus 6.4% annualized had you not used them. So just, just one loss, and that's important that the symmetry is to the downside because of this permanent capital cost. As long as the portfolio returns are consistently above that preferred equity financing rate, 6.25%, everything just goes swimmingly. But as soon as we inject some volatility, as soon as the return is lower below the break even amount of 7.1% or worse, if the overall return is less than 5 1/2% on a straight year by year basis, then you lose money and then the potential loss if there's actually some volatility. Now basic capital has said, well, yeah, but it's variable rate preferred equity if it's lower, they haven't said that, but I, I did the math. If it's actually lower, let's say the preferred return is 5%, that does lead to a higher return, 12.9% annualized for 10 years rather than 10.3% annualized, if the portfolio return is 8% and the preferred financing rate is 5%. And so yeah, the lower that rate for leverage, the greater the potential upside and the lower portfolio return to break even or not lose money. And so the key here is that if you're going to borrow money to invest in the stock market or other assets, the lower the rate, the greater the margin of safety in the buffer, which is why hedge funds borrow at very, very low interest rates. You want to borrow as low as you can because it provides a greater buffer, but that's not what's being offered here. And that that compounded cost of 6.25% gives very little wiggle room for this to work out. I wouldn't do it because the downside's too great. It's easier just invest straight up in the asset markets without using leverage. If the leverage cost is that high, an 8% return is a reasonable expectation for the stock market. But there's no guarantee, especially given US stocks are priced at 2 standard deviations more expensive than average. Now there are there are other things that impact whether you should do this or not. Certainly sequence of return risk when the losses occur, when they do occur, cause they will occur. There's always the risk that the rules change or the tax code changes and then there's behavioral risk. How will you behave if indeed Your portfolio drops 25% and now your equity is wiped out because of the need to pay back the preferred stock? You have to be in this for the long term and hope that over the long term the compounded return on an annualized basis is over 7%, ideally over 8% or over 9%. But there's no guarantees with that and there are a lot of scenarios where it doesn't work out. You just need a lower cost of capital is what you need for me to be convinced to do that if you have to be lower than 6.25%. So our takeaway is don't leverage up portfolios unless the cost of financing is very low or you get a give a government guarantee on it and it's going to be low. It's like, yeah, I'll do that. Sometimes people will borrow against their house and they got a 3% mortgage on and then that rate on an after tax basis. That's what we have. I'm not paying off my mortgage because I can easily earn more than that cost of capital. I don't have to pay off the mortgage. But that argument doesn't hold if you're paying 6.25%. Debt is for managing wealth, not creating it. This is not there's no shortcuts there. And when you're starting out and you're investing, you don't have that margin of safety. You don't have that buffer and you can get wiped out your equity that you put in this limited liability corporation easily if the markets work against you. That's episode 547. 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The Insider's Guide is the best next step to get the most out of your investment journey. If you're not on the list, go to moneyfortherestofus.com and subscribe right there on the homepage. Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money investing in the economy. Have a great week. Sa. Sam.