Leverage (finance)


In finance, leverage is any technique involving the use of debt rather than fresh equity in the purchase of an asset, with the expectation that the after-tax profit to equity holders from the transaction will exceed the borrowing cost, frequently by several multiples ⁠— hence the provenance of the word from the effect of a lever in physics, a simple machine which amplifies the application of a comparatively small input force into a correspondingly greater output force. Normally, the lender will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan.
Leveraging enables gains to be multiplied. On the other hand, losses are also multiplied, and there is a risk that leveraging will result in a loss if financing costs exceed the income from the asset, or the value of the asset falls.

Risk

While leverage magnifies profits when the returns from the asset more than offset the costs of borrowing, leverage may also magnify losses. A corporation that borrows too much money might face bankruptcy or default during a business downturn, while a less-leveraged corporation might survive. An investor who buys a stock on 50% margin will lose 40% if the stock declines 20%.; also in this case the involved subject might be unable to refund the incurred significant total loss.
Risk may depend on the volatility in value of collateral assets. Brokers may demand additional funds when the value of securities held declines. Banks may decline to renew mortgages when the value of real estate declines below the debt's principal. Even if cash flows and profits are sufficient to maintain the ongoing borrowing costs, loans may be called-in.
This may happen exactly at a time when there is little market liquidity, i.e. a paucity of buyers, and sales by others are depressing prices. It means that as market price falls, leverage goes up in relation to the revised equity value, multiplying losses as prices continue to go down. This can lead to rapid ruin, for even if the underlying asset value decline is mild or temporary the debt-financing may be only short-term, and thus due for immediate repayment. The risk can be mitigated by negotiating the terms of leverage, by maintaining unused capacity for additional borrowing, and by leveraging only liquid assets which may rapidly be converted to cash.
There is an implicit assumption in that account, however, which is that the underlying leveraged asset is the same as the unleveraged one. If a company borrows money to modernize, add to its product line or expand internationally, the extra trading profit from the additional diversification might more than offset the additional risk from leverage. Or if an investor uses a fraction of his or her portfolio to margin stock index futures and puts the rest in a low-risk money-market fund, he or she might have the same volatility and expected return as an investor in an unlevered low-risk equity-index fund. Or if both long and short positions are held by a pairs-trading stock strategy the matching and off-setting economic leverage may lower overall risk levels.
So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly levered hedge funds have less return volatility than unlevered bond funds, and normally heavily indebted low-risk public utilities are usually less risky stocks than unlevered high-risk technology companies.

Effect on rates of return

Here is an example showing the calculation of the expected return resulting from leverage. There is a short-form calculation and a long-form that is more intuitive. Given:

The following example is for an investor who seeks to purchase shares of a well performing asset. The investor seeks to increase the total amount purchased by leveraging the purchase with borrowed money. A lender and the investor establish the following terms: the lender will permit the investor to leverage the purchase by agreeing to a loan that is equal to eight times the equity investment; for every 1 dollar invested, the lender will lend 8. The cost of the loan is 4% of the loan amount.
+5% asset return

−4% leverage cost

8:1 leverage ratio
LONG-FORM math

The gross total amount of asset performance following the leveraged purchase is equal to the total quantity of asset purchased multiplied by the Asset Return. In this case, the quantity of asset purchased is equal to 9 and the Asset Return is +5%. So the gross total profit from the leveraged asset purchase = 9 times +5% = +45% gross total profit from leveraged asset purchase. To arrive at net profit, the leverage cost is subtracted from the gross total costs. The cost of the loan is 4% of the loan amount, and the loan is 8 per dollar of equity or 8 times −4% = −32% cost. So the sum of total profit and total cost is +45% profit minus 32% cost = 13% net profit from the leveraged purchase per dollar of equity investment = expected leverage return on equity investment.
SHORT-FORM math

Asset Leverage Differential = sum of Asset's Return and the Cost of Leverage Debt = +5% − 4% = +1% Rate Leveraged Asset Return

Leveraged Debt to Equity Investment Ratio = 8 divided by 1 = 8 Leverage Factor

Multiply first two lines = Rate of Leveraged Asset Return x Leverage Factor = + 1% × 8 = +8% Return on Leverage

Add Return on Asset's = 5%
Equals Rate of Leveraged Asset Return = sum of Asset Return and Leverage 8% + 5% = 13%

Measuring

A good deal of confusion arises in discussions among people who use different definitions of leverage. The term is used differently in investments and corporate finance, and has multiple definitions in each field.

Investments

Accounting leverage is total assets divided by the total assets minus total liabilities. Notional leverage is total notional amount of assets plus total notional amount of liabilities divided by equity. Economic leverage is volatility of equity divided by volatility of an unlevered investment in the same assets. To understand the differences, consider the following positions, all funded with $100 of cash equity:
Accounting leverage has the same definition as in investments. There are several ways to define operating leverage, the most common. is:
Financial leverage is usually defined as:
For outsiders, it is hard to calculate operating leverage as fixed and variable costs are usually not disclosed. In an attempt to estimate operating leverage, one can use the percentage change in operating income for a one-percent change in revenue.
The product of the two is called Total leverage, and estimates the percentage change in net income for a one-percent change in revenue.
There are several variants of each of these definitions, and the financial statements are usually adjusted before the values are computed. Moreover, there are industry-specific conventions that differ somewhat from the treatment above.

Bank regulation

Before the 1980s, quantitative limits on bank leverage were rare. Banks in most countries had a reserve requirement, a fraction of deposits that was required to be held in liquid form, generally precious metals or government notes or deposits. This does not limit leverage. A capital requirement is a fraction of assets that is required to be funded in the form of equity or equity-like securities. Although these two are often confused, they are in fact opposite. A reserve requirement is a fraction of certain liabilities that must be held as a certain kind of asset. A capital requirement is a fraction of assets that must be held as a certain kind of liability or equity. Before the 1980s, regulators typically imposed judgmental capital requirements, a bank was supposed to be "adequately capitalized," but these were not objective rules.
National regulators began imposing formal capital requirements in the 1980s, and by 1988 most large multinational banks were held to the Basel I standard. Basel I categorized assets into five risk buckets, and mandated minimum capital requirements for each. This limits accounting leverage. If a bank is required to hold 8% capital against an asset, that is the same as an accounting leverage limit of 1/.08 or 12.5 to 1.
While Basel I is generally credited with improving bank risk management it suffered from two main defects. It did not require capital for all off-balance sheet risks and it encouraged banks to pick the riskiest assets in each bucket.
Work on Basel II began in the early 1990s and it was implemented in stages beginning in 2005. Basel II attempted to limit economic leverage rather than accounting leverage. It required advanced banks to estimate the risk of their positions and allocate capital accordingly. While this is much more rational in theory, it is more subject to estimation error, both honest and opportunitistic. The poor performance of many banks during the financial crisis of 2007–2009 led to calls to reimpose leverage limits, by which most people meant accounting leverage limits, if they understood the distinction at all. However, in view of the problems with Basel I, it seems likely that some hybrid of accounting and notional leverage will be used, and the leverage limits will be imposed in addition to, not instead of, Basel II economic leverage limits.

Financial crisis of 2007–2008

The financial crisis of 2007–2008, like many previous financial crises, was blamed in part on "excessive leverage".
Levering has come to be known as "leveraging", in financial communities; this may have originally been a slang adaptation, since leverage was a noun. However, modern dictionaries refer to its use as a verb, as well. It was first adopted for use as a verb in American English in 1957.