Leverage
What is it?
Put very (very) simply, leverage is the use of a few assets to raise what is often a lot of debt. That debt may then be used to buy more assets.
Buying a house is the classic example of a transaction that involves leverage. For example, you might fancy a house that costs $200k. However, if you only have $10k in cash, you'll need to take out a loan for $190k. You will therefore have 'leveraged' your $10k cash.
The leverage ratio is the ratio of total debt to total assets. In this case it will be 19:1.
The good thing about leverage is that in a rising market it can magnify the extent of your gains. For example, if house prices rise 10% in a year, the person who's invested $10k of cash into a $200k house will receive an annual return of $20k - or a 100% return on their original investment.
The bad thing about leverage is that it works both ways. In a falling market you can be left with losses that far exceed your original investment.
What's it got to do with the financial crisis?
Excessive leverage is the fundamental cause of the financial crisis. For many years preceding the credit crunch, leverage increased massively in many countries of the world - companies, individuals and, in some cases, governments, all borrowed heavily against their assets.
In America, for example, total credit market debt as a percentage of GDP went from around 170% in 1985 to around 350%. And between 2003 and 2008, UK household debt as a percentage of household income rose from 129% to 173%. 173% is higher than in Japan at the start of the so-called 'Lost Decade', and the highest amount registered in any of the G7 group of countries ever.
Investment banks also have/had leverage issues. In 2004, the US Securities and Exchange Commission (SEC) gave five so-called 'broker dealers' an exemption from its rules, which said their debt to net capital ratios could not exceed 12-1. As a result, Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch and Bear Stearns were able to leverage their assets up to 40 times.
In August 2007, when the credit crunch started, Morgan Stanley had leverage of 33 and Merrill Lynch had leverage of 32. Of the big three, only Goldman Sachs had less debt compared to its assets, with a ratio of just 22.
High leverage is part of the broker dealer business model, but it took its toll. By September 2008, only Goldman and Morgan Stanley remained in existence as independent entities. On 22 September, they converted themselves to 'bank holding companies'. This allowed them to take deposits from both retail and business customers and obliged them to reduce leverage to the much lower levels seen at deposit-taking banks.
The big problem with all this leverage is that it needs to be followed by a period of de-leveraging - ie, debt needs to be reduced relative to assets. This is the case for individuals, companies, governments and banks. As banks seek to reduce their debt, they will be less likely to offer credit to their customers. Hence we have a credit crunch.
In September 2009, US Treasury Secretary Tim Geithner identified excessive leverage as a problem that was still facing banks and released a plan in which he called for simple leverage ratio constraints on banks. At the same time, banks that sensed a thaw in the credit crunch have helped fuel a rapid-fire leverage boom in 2009 -- the fastest rise in systemic leverage since the credit crunch started in 2007.
Last updated on 7 September 2009.
