Leverage is a broadly used word. Indeed, its meaning is exploited in a plethora of different topics and environments. Not only in business and finance but also in politics it is a widely adopted word when it comes to explaining what an institution or a government has to abandon in order to receive something else in exchange. Despite all these uses, the most common definition is assets over equity (assets/equity).
When thinking about what this indicator represents, it is useful to imagine measuring the quantity of assets held in excess to the equity in stock. Assets are what a company holds to keep its activity going, whereas equity is the capital subscribed by all the shareholders.
Every time this fraction is greater than one, an institution is “leveraged”. This means that the part of assets exceeding the equity was bought through debt, indeed increasing the leverage. When one talks about leverage then, one is also talking about debt. Hence the leverage ratio indicates the debt ratio of an institution. Of course, when some kind of institution or company increases its debt ratio it becomes automatically riskier. This is due to the probability of not being able to pay its outstanding obligations being directly related to the amount of the larger the volume of debt and the greater the possibility of default
Why Investors Choose More Leverage
Now, why should an institution ever increase its leverage ratio and subsequently its risk, with the direct probability that the more adverse to risk investors could withdraw the capital committed to the investment? It comes down to the primary purpose of exploitation of leverage: the reason why investors choose to become (more) leveraged on certain investments is that they rely on the strong possibility that returns gained from the investment will be greater than the cost of capital required to be leveraged.
An example: imagine having €100 available for an investment that commits capital for one year, paying €110 at maturity. One does not take into account any kind of taxation, so the final values are already net values. Then, the yield of this investment is 10%. Imagine the same situation: €100 available for an investment that commits the capital for one year, paying €110 at maturity but, in addition, having the possibility to borrow another €100 from a lender at the cost of 3%.
The investment would now be called leveraged 2 to 1 (one invests €200 with an initial capital of €100). This way you are going to invest €200 total capital (€100 owned+€100 borrowed) receiving €220 at maturity (like above, a yield of 10%). So, following the €100 of personal capital committed, the gross profit is €20 (€200-€20): a 20% yield, double compared to the previous one. From the €20 profit, one also has to pay back the 3% out of €100 as the cost of the borrowed capital, and that is €3.
The total net profit is then €17 (€20-€3) and that yields a 17% net profit on the investment. This is the reason why leverage is used: the aim is to increase the yield of an investment. Also, it is very risky because if the investment that one is putting their money into is not safe (like most of these), this could lead to a loss that in the case of leverage would be much bigger than in the case of plain investment.
This principle is also the main idea behind derivatives contracts. Almost all of these assets are leveraged, which in turn means that the yield received from the investment in the derivative is believed to be bigger than the one received by investing in just the underlying asset.
How Has Leverage Developed?
Usually, when one takes into consideration companies that produce consumption goods, leverage is never too high. If this should exceed the ratio of 2, the company could be either undercapitalised or have too much debt. Of course, it all depends on a lot of factors such as the business model, the sectors in which it operates and its history. Instead, when looking at financial institutions, these are usually extremely leveraged compared to the ‘standards’. Actually, the financial system has set a new standard for leverage with some big banks touching peaks also over 100 as a leverage ratio and with the hedge funds being the most leveraged institutions in the financial system.
With this premise, one can now understand what happened in recent years. Due to progress, innovation and technology, the financial sector has become much more active and fast, with the development of new trading strategies such as High-Frequency Trading (HFT), the fastest way traders can execute orders. Through this, new assets have been developed, and new sales techniques experimented.
One example is securitisation: banks sold mortgage-backed securities (MBS) subscribed by their clients and divided into tranches (diversified by categories of risk) to other investors, to have an immediate cash flow and remove risk from their balance sheet.
Banks also bought a huge amount of derivative contracts called Credit Default Swap (CDS) that worked as insurance against the risk of other asset-backed securities subscribed from other banks. Of course, the same contracts were extremely leveraged. In this incredibly new, growing and extremely leveraged environment, where financial institutions always more and more linked with each another, it is easy to foresee how anything going wrong would make the system collapse, with a consequent domino effect.
This is exactly what happened in the subprime financial crisis. One of the most significant issues was the exponential leverage environment generated. This is due to the fact that all the institutions that were buying and selling assets to one another were leveraged, and their same derivatives contracts were leveraged while building up debt at an exponential pace.
What Is The End Point?
Right after the financial crisis, whose brutal effects are still struggling to fade, a whole pool of plans and techniques to upgrade regulation on the financial markets and make lending less riskier was set up. The final aim of all these strict bonds and regulations was to decrease relationships among financial institutions and so to reduce the stock of leverage that was accumulated during the crisis. Many prime ministers and financial ministers believed that the main direction of regulators was to make sure that a crisis like this could never again be triggered, and the reduction of debt was one of the first objectives to reach.
The reality is that this is an extremely leveraged environment and with time, it can only be controlled and in no way can be stopped. One will have to adapt to a riskier kind of assets and a more and more geared economy. Preservation of capital should always be the primary objective of an investor since this is one of the few instruments that can be used against the risk of defaulting on leverage.
The Chinese Example
One of the most outstanding examples of how leverage has been managed after the crisis is China. The country had a superb 10% (on average) GDP growth ratio over the past 30 years, building important financial hubs like Hong Kong and a strong economy based on consumption. One of its biggest problems, though, is that all this growth has been possible only through a huge amount of debt that was stocked at the corporate and public levels.
After the crisis, China’s economy was meant to deleverage, with a lot of recapitalisation programs set up and strict regulations on lending. As soon as the situation got better, though, China forgot most of these bounds and continued increasing its leverage to grow and push back to a high level its GDP. Of course, growth is essential to decrease safely the stock of debt, but many economists criticise how this matter has been managed since the leverage ratio is still very big and has to be lowered to safer levels in order to dissipate the fear of collapse.