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In finance, leverage is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced.

It generally refers to using borrowed funds, or debt, so as to attempt to increase returns. Deleveraging is the action of reducing borrowings.[1]

In macroeconomics, a key measure of leverage is the debt to GDP ratio.


Basel Committee softens bank capital rules, sets leverage cap

The Basel Committee on Banking Supervision softened some of its proposed capital and liquidity rules while introducing new restrictions on how much lenders can borrow in order to rein in their risk-taking.

The panel agreed yesterday to allow certain assets, including minority stakes in other financial firms, to count as capital, according to a statement. The committee set a leverage ratio to apply to banks globally for the first time, which could become binding by 2018, pending further adjustments to the method of calculating banks’ assets.

“Even after all the compromises, the banks aren’t off the hook from tighter capital and liquidity rules,” said Frederick Cannon, chief equity strategist at New York-based Keefe, Bruyette & Woods.

France and Germany have led efforts to weaken rules proposed by the committee in December, concerned that their banks and economies won’t be able to bear the burden of tougher capital requirements until a recovery takes hold, according to bankers, regulators and lobbyists involved in the talks. The U.S., Switzerland and the U.K. have resisted those efforts. The announcement reflects the give and take between the two sides, said Barbara Matthews, managing director of BCM International Regulatory Analytics LLC in Washington.

German Concerns

Germany hasn’t signed yesterday’s preliminary agreement, said Sabine Reimer, a spokeswoman for BaFin, the country’s financial regulator.

“One country still has concerns and has reserved its position until the decisions on calibration and phase-in arrangements are finalized in September,” the committee said in a footnote to its statement.

Sumitomo Mitsui Financial Group Inc., Japan’s second- largest bank by market value, led banks higher in Tokyo after the committee agreed to allow some deferred tax assets to be counted as capital. The nation’s banks and regulators had fought against excluding deferred tax assets.

“The Basel Committee’s easing of restrictions gives investors a reason to take another look at Japanese banks, which have been cheap recently,” said Mitsushige Akino, who oversees about $450 million in assets in Tokyo at Ichiyoshi Investment Management Co.

Sumitomo Mitsui rose 2.8 percent to 2,587 yen at the 3 p.m. close of trading in Tokyo. Mitsubishi UFJ Financial Group Inc., the country’s largest bank, gained 2.5 percent and Mizuho Financial Group Inc. climbed 2.2 percent.

‘Making Concessions’

“They’re definitely making concessions on the definition of capital and the liquidity ratios,” said BCM International’s Matthews, who used to lobby the committee on behalf of banks. “Those were necessary to convince the Germans to accept the leverage ratio. But even though we see a lot of concessions, there are also limits to the concessions. So this isn’t fully caving in.”

The Basel committee, which represents central banks and regulators in 27 nations and sets capital standards for banks worldwide, was asked by Group of 20 leaders to draft rules after the worst financial crisis in 70 years.

Yesterday’s agreements were announced after a meeting of the group of governors and heads of supervision, which oversees the committee’s work. While the committee narrowed differences when it met two weeks ago in Basel, it left most of the final decisions to its board, members said.

The board said some of its proposals might not be completed by the end of this year, the deadline set by the G-20. Liquidity requirements for how much cash and cashable securities banks need to hold against their longer-term liabilities and counter- cyclical buffers, which would raise minimum capital requirements in times of faster economic growth, have to be worked on longer, the board said.

Lobby Efforts

European banks lobbied against the proposed exclusion of minority interests that banks hold in other financial institutions. Japan fought the hardest against the elimination of deferred tax assets, past losses that lenders use to offset tax charges in future years. The U.S. has opposed removing mortgage-servicing rights, contracts to collect payments, which are unique to U.S. banks.

The compromise announced yesterday would allow a bank to count part of a stake it owns in another financial firm in relation to the risk the capital is supposed to cover at the entity in which it invested. Deferred tax assets and mortgage- servicing rights would be included in capital up to a limit. The total for all three could not exceed 15 percent of a lender’s common equity.

While the capital ratios allow banks to assign weights to assets based on their risks, the new leverage figure considers all assets without a risk assessment. The committee initially set it at 3 percent -- meaning a bank’s total assets cannot be more than 33 times its Tier 1 capital, which includes securities that could help a lender cover unexpected losses.

Level Playing Field

The new rule also defines how assets are tallied, so as to level the playing field between different accounting standards and bring off-balance-sheet items into the calculation. The ratio will be tested from 2013 until 2017, and banks would be required to start publishing their individual leverage figures starting in 2015.

Bankers including Deutsche Bank AG Chief Executive Officer Josef Ackermann and HSBC Holdings Plc Chairman Stephen Green have said that the new rules may force banks to reduce lending, potentially limiting economic growth.

While yesterday’s announcement resolved several issues, many areas of contention, such as the actual minimum capital ratios that will be set, remain outstanding, said KBW’s Cannon.

“The definition of capital had to be finalized before the numbers can be put on, but there are still many moving parts,” said Cannon, whose research firm specializes in financial companies. The committee is planning to present a final package of reforms to the G-20 leaders meeting in Seoul in November.

Risk-Weighted Assets

Banks currently need to hold capital equal to a minimum of 8 percent of risk-weighted assets. Half of that must be Tier 1, and half of the Tier 1 needs to be common stock. Both Tier 1 and common-equity ratios will be increased, Cannon and other analysts expect. The Basel committee is also revising how the risk weighting will be done.

Like the leverage ratio, the liquidity rules are new to the Basel standards. The liquidity coverage ratio sets the amount of cash that needs to be held by a lender against any payment coming due within a month, while the net stable funding ratio considers liabilities up to 12 months.

The committee announced several modifications to the definition of liquid assets and of how to measure the safety of different types of funding. Government deposits will now be considered the same as corporate cash put in a bank, instead of treated as other banks’ money as originally proposed. Bank deposits are seen as less stable.

The changes should please banks, said Cannon.

“They compromised more on the short-term ratio than we were expecting,” he said.

GAO report calls for U.S. systemic leverage monitoring

Source: GAO report calls for U.S. systemic leverage monitoring Reuters, July 22, 2009

"U.S. lawmakers restructuring the regulation of the financial sector after the most damaging crisis since the Great Depression should ensure that leverage is monitored across the system, a congressional report released on Wednesday said.

Leverage generally refers to the use of debt to fund assets, and is calculated by a ratio.

In a report on the role of leverage in the crisis, the nonpartisan Government Accountability Office said some analysts believe that after being excessively leveraged, firms rushed to shed leverage and intensified the crisis by pulling back from lending and driving asset prices down.

"The crisis has revealed limitations in regulatory approaches to restrict leverage," the congressional watchdog agency said in in its report.

In the current financial crisis, some financial firms used leverage to increase their exposure to assets without using debt, for example by using derivatives, GAO said.

Regulatory capital requirements did not always capture risks, particularly those connected with mortgage-related securities, GAO said.

The Obama administration late on Wednesday sent Congress proposed legislation retooling financial regulation. Lawmakers are expected to grapple with the overhaul in coming months.

The financial crisis also calls into question a capital adequacy measure used by the so-called Basel II international bank capital regulatory structure that allows banks to use complex risk models to measure capital needs, the GAO said.

Reliance on those models could exacerbate regulatory shortcomings revealed by the crisis, the agency said."

Source: Securities Law Prof Blog

The GAO issued a report on Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions and across System. It explains that the purpose of the report is to study the role of leverage in the current financial crisis and federal oversight of leverage. GAO’s objectives were to review

    1. How leveraging and deleveraging by financial institutions may have contributed to the crisis
    2. Regulations adopted by federal financial regulators to limit leverage and how regulators oversee compliance with the regulations, and
    3. Any limitations the current crisis has revealed in regulatory approaches used to restrict leverage and regulatory proposals to address them.

To meet these objectives, GAO built on its existing body of work, reviewed relevant laws and regulations and academic and other studies, and interviewed regulators and market participants.

What GAO Recommends

As Congress considers establishing a systemic risk regulator, it should consider the merits of assigning such a regulator with responsibility for overseeing systemwide leverage. As U.S. regulators continue to consider reforms to strengthen oversight of leverage, we recommend that they assess the extent to which reforms under Basel II, a new risk-based capital framework, will address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches used for capital adequacy purposes. In their written comments, the regulators generally agreed with our conclusions and recommendation.

GAO report link

Crisis of '07 -'09 -- double leverage cycle

John Geanakoplos (PDF) (PPT), James Tobin Professor of Economics, Yale University

Using leverage ratio – differences between Canada and US

Katia D’Hustler of World bank has written a nice primer on leverage ratio and the issues in this crisis. There are 3 types of leverage:

There are three types of leverage—balance sheet, economic, and embedded—and no single measure can capture all three dimensions simultaneously. The first definition is based on balance sheet concepts, the second on market-dependent future cash flows, and the third on market risk.

Balance sheet leverage is the most visible and widely recognized form. Whenever an entity’s assets exceed its equity base, its balance sheet is said to be leveraged. Banks typically engage in leverage by borrowing to acquire more assets, with the aim of increasing their return on equity.

Banks face economic leverage when they are exposed to a change in the value of a position by more than the amount they paid for it. A typical example is a loan guarantee that does not show up on the bank’s balance sheet even though it involves a contingent commitment that may materialize in the future.

Embedded leverage refers to a position with an exposure larger than the underlying market factor, such as when an institution holds a security or exposure that is itself leveraged. A simple example is a minority investment held by a bank in an equity fund that is itself funded by loans. Embedded leverage is extremely difficult to measure, whether in an individual institution or in the financial system.

In this crisis, we saw all three kinds of leverage hitting banks. The balance sheet leverage was obviously there for all to see. Then you had these various special purpose vehicles funded by banks equity capital but not on balance sheets. This led to an increase in economic leverage. And then you had embedded leverage in form of various fancy financial products.

The paper points to an interesting case study of leverage ratio being used by Canada and US. Switzerland is planning to introduce leverage ratio in 2013.

There are key differences in use of leverage ration between US and Canada:

Among the three countries, the United States has the simplest leverage ratio, expressed as a minimum ratio of Tier 1 capital to total average adjusted assets. The leverage ratio is set at 3 percent for banks rated “strong” and at 4 percent for all other banks. Banks’ actual leverage ratios are typically higher than the minimum, however, because banks are also subject to prompt corrective action rules requiring them to maintain a minimum leverage ratio of 5 percent in order to be considered well capitalized.

The larger U.S. investment bank holding companies and their subsidiaries were regulated by the Securities and Exchange Commission and thus were not subject to a leverage limit. Instead, there were restrictions at the level of the individual firm on the amount of customer receivables the investment bank could hold as a multiple of capital (net capital rule). Only two of the five investment bank holding companies originally affected by this rule still exist (Goldman Sachs and Morgan Stanley), however, and they have now been converted into bank holding companies.

The Canadian “assets to capital multiple” is a more comprehensive leverage ratio because it also measures economic leverage to some extent. It is applied at the level of the consolidated banking group by dividing an institution’s total adjusted consolidated assets—including some off-balance-sheet items—by its consolidated (Tier 1 and 2) capital. Under this requirement total adjusted assets should be no greater than 20 times capital, although a lower multiple can be imposed for individual banks.

This is more conservative than the U.S. leverage ratio—and the inclusion of off-balance-sheet items strengthens the ratio even more. Indeed, the stringency of Canada’s leverage ratio has been cited as one factor—along with sound supervision and regulation, good cooperation between regulatory agencies, strict capital requirements, and conservative lending practices—contributing to the strong performance of its financial sector during the financial crisis.

Canada’s economic policy framework has been praised highly in this crisis (see urbanomics). The use of leverage ratio is one such parameter.

Read the Swiss version in the paper. BIS has also introduced a leverage ration including many assets and conservative definition of capital.

The author then points to uses (is simple, can be used to prevent build up of leverage and less regulatory arbitrage) and limitations of leverage ratio (balance sheet leverage can be measured but does not capture financial engineering as seen in economic & embedded leverage).

In the end:

The proposals at an international level to supplement risk-based measures with an internationally harmonized and appropriately calibrated leverage ratio are welcome and could lead to its adoption by a wide range of countries in the future. A leverage ratio cannot do the job alone; it needs to be complemented by other prudential tools or measures to ensure a comprehensive picture of the buildup of leverage in individual banks or banking groups as well as in the financial system. Additional measures to provide a comprehensive view of aggregate leverage, including embedded leverage, and to trigger enhanced surveillance by supervisors need to be developed.

Credit booms gone bust

This is one of the most comprehensive papers linking monetary, credit and leverage cycles I have read so far. It is written by Alan Taylor and Moritz Schularick and what a paper.

The crisis of 2008–09 has focused attention on money and credit fluctuations, financial crises, and policy responses. In this paper we study the behavior of money, credit, and macroeconomic indicators over the long run based on a newly constructed historical dataset for 12 developed countries over the years 1870– 2008, utilizing the data to study rare events associated with financial crisis episodes.

We present new evidence that leverage in the financial sector has increased strongly in the second half of the twentieth century as shown by a decoupling of money and credit aggregates, and we also find a decline in safe assets on banks’ balance sheets.

We also show for the first time how monetary policy responses to financial crises have been more aggressive post-1945, but how despite these policies the output costs of crises have remained large.

Importantly, we can also show that credit growth is a powerful predictor of financial crises, suggesting that such crises are “credit booms gone wrong” and that policymakers ignore credit at their peril. It is only with the long-run comparative data assembled for this paper that these patterns can be seen clearly.

The linkages between rise in various monetary aggregates – credit, assets, money- across two periods of globalization is fascinating stuff.

There are three views of money and credit:

The experience of the late nineteenth and early twentieth century, including the disruptions of the 1930s, formed the foundation of the “money view” which is indelibly associated with the seminal contributions of Friedman and Schwartz (1963). In this account, the level of the narrow and broad money supplies strongly influences output in the short run.

In the second half of the twentieth century the “irrelevance view” gained influence, associated with the ideas of Modigliani and Miller (1958) among others, where the details of the debt-equity financial structure of firms was inconsequential. Finance was a so-called veil. In this view, real economic decisions became independent of financial structure altogether.

Starting in the 1980s, the “credit view” has gradually attracted attention and adherents. In this view, starting with the works of Mishkin (1978), Bernanke (1983) and Gertler (1988), and drawing on ideas dating back to Fisher (1933) and Gurley and Shaw (1955), the mechanisms and quantities of bank credit matter, above and beyond the level of bank money.

In their analysis they look at the two eras of financial capitalism. First from 1870 to 1939 and then 1945 onwards. Findings:

during the first era of finance capitalism, up to 1939, the era studied by canonical monetarists like Friedman and Schwartz, the “money view” of the world looks entirely reasonable. Banks’ liabilities were first and foremost monetary, and exhibited a fairly stable relationship to total credit. In that environment, by steering aggregate liabilities of the banking sector, the central bank could hope to exert a smooth and steady influence over aggregate lending.

The relationships changed dramatically in the post-1945 period. First, credit began a long recovery after the dual shocks to the financial sector from the Great Depression and the war. Loans and bank assets took off on a very rapid upward trend in the Bretton Woods era as seen in Figure 1, and they managed to surpass their pre-1940 ratios, compared to GDP, by about 1970. Second, credit not only grew strongly relative to GDP, but also relative to broad money after WW2, via a combination of higher leverage and (after the 1970s) through the use of new sources of funding, mainly debt securities, creating more and more non-monetary bank liabilities.

The authors also point how credit has delinked from money growth from 1970 onwards and has zoomed. Read the whole thing. Plenty of graphs and interpretations.

This is what Paul De Gruawe et al also say in their paper on ECB strategy. The increase in money supply did not show in inflation as much of it was going in credit and assets. So ECB was complacent.

Creating a leverage ratio

"Shortage of capital has been a key issue for the banking system since the beginning of the credit crunch.

And as the clear-up from the financial crisis accelerates, regulators and bankers are hammering out new measures to strengthen supervision and reduce the probability of future bank collapses.

In the years prior to the crisis, banks expended large amounts of effort adopting the Basel II accord, which determined how much capital banks must hold against their books. Yet such measures still failed to prevent banks from collapsing. It is now clear that many financial institutions used higher leverage and excessive risk-taking to bolster profits. So when the capital markets froze, they had insufficient capital to absorb the incurred losses.

A programme aimed at strengthening Basel II has been proposed, which includes higher capital requirements on riskier activities. Only last month, agreement was reached on key measures including plans to raise the quality and consistency of tier one bank capital, which acts as a financial buffer to absorb losses.

In the future, the predominant form of tier one capital, which is the key measure of financial strength, is likely to be common shares and retained earnings, rather than hybrid capital, which is less able to absorb losses. The changes would create a “leverage ratio”, which will also take into account off-balance-sheet activities in order to limit the amount of borrowing conducted by institutions outside the formal banking regime. This would ensure that banks do not borrow too much money. Analysts expect it will put a ceiling on borrowings of about 25 times assets.

Further measures are also likely to include a minimum global standard for funding liquidity that includes a stressed liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio.

Future regulations could also compel banks to hold additional capital if they trade with their own money, known as proprietary trading, which would further lower returns.

Nout Wellink, chairman of the Basel Committee, said recently that the proposed changes would result in “higher capital and liquidity requirements ... less leverage in the banking system” and greater “resilience to stress”, while Moody’s has predicted “significant impact for the long-term business of many banks and their risk profiles”. According to the credit rating agency, banks with large investment banking activities will be the most affected, suggesting that return on equity could be “significantly reduced”.

A recent report by JP Morgan argued that regulatory changes could, on average, slice 30 per cent off banks’ 2011 profitability, adding that capital requirements at some banks could rise by three or four times or more.

The big question then is: will the proposed measures work? Moody’s points out that the details of many of the proposals have not even been finalised, let alone implemented. The market recovery of the past six months will, in all likelihood, also further delay an already painfully slow implementation processes."

Make leverage transparent

"...I think the ultimate objective for financial reforms is to make leverage transparent. There are many reasons that a bubble forms. Debt leverage, however, is always at the center of a property bubble -- the most damaging kind. Leverage within a financial system's assets-to-equity capital ratio is a driving force for an asset bubble. Complex accounting rules and varying treatment of different financial institutions make it difficult to measure leverage. The international standard for a bank's capital is 8 percent, which allows 12 times leverage. How off-balance sheet assets are treated can make a huge difference. A lot of big banks had 30 times leverage at the beginning of the crisis due to off-balance assets.

Other institutions such as finance companies are harder to regulate. Some industrial companies such as General Electric and General Motors took advantage of loopholes and created finance companies that are essentially banks. Hedge funds, mutual funds, private equity firms, etc., are even more lightly regulated. When they purchase securitized debt securities and engage in lending, they are like banks.

One interesting phenomenon is how money market funds wreaked havoc after Lehman crashed. These funds are supposed to be ultra safe for buying triple-A, short-term, liquid debt instruments. The problem was their demand for liquidity. Self-manufactured liquidity provided a false sense of security despite the risks of underlying securities, such as short-term paper issued by investment banks. When that false sense of security was jolted by the Lehman collapse, all rushed to exit at the same time. Without government support, they wouldn't have been able to get their money back.

The problem with financial regulation is not the banking system per se, but the shadow banking system. It provides leverage with much less capital than the banking system. When leverage in the economy is rising, asset prices rise, too. Rising asset prices boost collateral value and, hence, more borrowing. A surge in earnings among financial institutions usually accompanies such a spiral of rising leverage and rising asset prices. It is extremely difficult for an established regulatory regime to stop such a spiral. Usually new financial institutions or products come on the scene, and then a new leverage game begins. It would be impossible for an existing regime to be comprehensive enough to anticipate future institutions and products. Governments may need to install principle-based, not just rule-based, regulatory agencies that could take action to control new financial creations.

The U.S. government is proposing a consumer protection agency for financial products. Such an agency could at least respond to new financial products sold to consumers and, therefore, could be an effective mechanism for stopping some future bubbles. The proposal has met vehement opposition from the financial industry. It may not get through.

What can we speak for after spending trillions of dollars? Not much. Few major players went to jail. The U.S. government sent many more to prison in the 1980s after the junk bond bubble burst. This bubble is 10 times bigger. Yet, apart from the most obvious criminals such as Bernie Madoff and Allen Stanford, who ran multibillion-dollar Ponzi schemes, none of the big shots have landed behind bars. Indeed, a lot of the big shots who brought down the world are still out there running things. The lesson from the Lehman collapse seems to be, "Take whatever you can and, when it crashes, you get to keep it." How governments and central banks have dealt with this bubble will encourage more people to join bubble making in the future..."

Leverage and credit ratings

Study suggests firms target minimum rating levels

Firms reduce leverage following credit rating downgrades. In the year following a downgrade, downgraded firms issue approximately 1.5% 2.0% less net debt relative to net equity as a percentage of assets compared to other firms.

This relationship persists within an empirical model of target leverage behavior. The effect of a downgrade is larger at downgrades to a speculative grade rating and if commercial paper access is affected.

In particular, firms downgraded to speculative are about twice as likely to reduce debt as other firms.

Rating upgrades do not affect subsequent capital structure activity, suggesting that firms target minimum rating levels.

Fitch on accounting changes and ratings

Several recent accounting pronouncements provide enhanced disclosure and transparency that can reveal early warnings relating to corporate cash flows and liquidity, according to a Fitch Ratings report.

Changes in accounting disclosure by itself will not have an immediate effect on credit ratings. However, careful analysis of the early warning signs could lead to credit ratings changes if liquidity becomes constrained or leverage increases due to higher cash outflows.

The report provides analysis on five key areas of recent accounting changes and their implications:

'More robust disclosures for pensions and derivatives can lead to the identification of potential liquidity issues and allow for better comparison across peer groups,' said Judi Rossetti, Director at Fitch.

The accounting changes for off-balance-sheet-entities, convertible debt and revenue recognition do not alter the underlying economics of the transactions, and consequently Fitch's credit analysis will not change.

The report also includes a summary of common accounting red flags that analysts should be aware of when reviewing financial statements.

Manipulating the timing of revenue or expense recognition, or reducing balance sheet liabilities can distort financial results.

The full report 'Demystifying Recent Accounting Pronouncements: An Analytical Guide for Reviewing 10-Ks and 10-Qs' is available on the Fitch Ratings' web site.

Financial leverage

Financial leverage (FL) takes the form of a loan or other borrowings (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest. If the firm's rate of return on assets (ROA) is higher than the rate of interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow because assets = equity + debt (see accounting equation). On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential returns to the investor that otherwise would have been unavailable but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.

Margin buying is a common way of utilizing the concept of leverage in investing. An unleveraged firm can be seen as an all-equity firm, whereas a leveraged firm is made up of ownership equity and debt. A firm's debt to equity ratio is therefore an indication of its leverage. This debt to equity ratio's influence on the value of a firm is described in the Modigliani-Miller theorem. As is true of operating leverage, the degree of financial leverage measures the effect of a change in one variable on another variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (earnings per share) that occurs as a result of a percentage change in earnings before interest and taxes.

Risk and overleverage

Employing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. Interest and principal payments (usually certain ex-ante) may be higher than the investment returns (which are uncertain ex-ante).

This increased risk may still lead to the optimal outcome for the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and security purchases, is the subject of a discipline known as financial engineering.

There are economic periods when optimism incites to a widespread and excessive use of leverage, what is called overleverage. One of its forms, associated to the subprime crisis, was the practice of financing homes with no or little down payment, playing on the hope that the price of the assets (the property in this case) will rise. Another form involved the five largest U.S. investment banks, which borrowed funds to invest in mortgage-backed securities, increasing their leverage between 2003-2007 (see diagram). During September 2008, the five largest firms either went bankrupt (Lehman Brothers), were bought out by other banks (Merrill Lynch and Bear Stearns) or changed to commercial bank holding companies, subjecting themselves to leverage restrictions (Morgan Stanley and Goldman Sachs).


Derivatives allow leverage without borrowing explicitly, though the "effect" of borrowing is implicit in the cost of the derivative.

  • Buying a futures contract magnifies your exposure with little money down.
  • Options do the same. The purchase of a call option on a security gives the buyer the right to purchase the underlying security at a given price in the future. If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security. However if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument. Generally speaking, a put option allows the holder (owner), the investor, to achieve inverted-leverage and/or inverted enhancement--- sometimes called inverse enhancement and/or inverse leverage.
  • Structured products that exist as either closed-ended funds, or public companies, or income trusts are responding to the public's demand for yield by leveraging.

Tax code and leverage

Among the most prophetic voices prior to the economic crash was UCLA economics professor Harold H. Somers, who warned in 1991 that revisions to the tax code would increase leverage, which could lead to economic disaster:

The result is to tilt the well-worn playing field even more in favor of leveraging, leading to the possibility of another leverage frenzy and debacle at some time in the future. Professor Sommers explained:

The complete history of the causes of the junk bond debacle of 1989 and 1990 is yet to be written. But the tax incentive must have a prominent place in any comprehensive work. This comment applies to long-term debt where the interest deduction can be a major factor; short-term debt may be dominated by other considerations.

What is involved is essentially the shield against income tax that is provided by corporate debt compared with the shields that are provided for equity by the income tax rules ...

Former President of the St. Louis Federal reserve Bank - William Poole - agrees in a new paper:

A straightforward fix for excessive leverage can be achieved through the tax system. Companies borrow, in part, because they believe that debt capital is cheaper than equity capital. That is certainly the case under the U.S. corporate tax system because interest is a deductible business expense in calculating income subject to tax whereas dividends are not deductible.

Excessive leverage is highly destabilizing to the financial system (see this, for example). If a simple fix to the tax code could substantially reduce leverage, I'm all for it.

Poole recommends the gradual phasing-in of changes to the tax code to reduce leverage: Interest deductibility could be phased out over the next 10 years. Next year, 90 percent of interest would be deductible; the following year, 80 percent would be deductible, and so forth, until interest would no longer be deductible at all. The same reform would apply to all business entities; partnerships, for example, should not be able to deduct interest if corporations cannot. With this simple change, the federal government would encourage businesses and households to become less leveraged. We have learned that leverage makes not only individual companies more vulnerable to failure but also the economy less stable. We use tax laws all the time to promote socially desirable behavior; eliminating the deductibility of interest would reduce the risk of failure of large companies—especially, large firms—and thereby reduce the collateral damage inflicted by such failures."

Operating leverage

Operating leverage reflects the extent to which fixed assets and associated fixed costs are utilized in the business. Degree of operating leverage (DOL) may be defined as the percentage of leveraging.

Combined stand-alone leverage

If both operating and financial leverage allow us to magnify our returns, then we will get maximum leverage through their combined use in the form of combined leverage. Operating leverage affects primarily the asset and operating expense structure of the firm, while financial leverage affects the debt-equity mix. From an income statement viewpoint, operating leverage determines return from operations, while financial leverage determines how the “fruits of labor” will be divided between debt holders (in the form of payments of interest and principal on the debt) and stockholders (in the form of dividends). Degree of combined leverage (DTL) uses the entire income statement and shows the impact of a change in sales or volume on bottom-line earnings per share. Degree of operating leverage and degree of financial leverage are, in effect, being combined.

Correlation leverage

Correlation leverage is a third concept that captures the degree to which the variability in the firm's value is correlated with the variability of the universe of all risky assets.

Negative gearing

Negative gearing is a form of financial leverage where an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan. A negative gearing strategy can only make a profit if the asset rises in value and creates enough future capital gains to cover the shortfall between the income and interest that the investor suffers. The investor must also be able to fund that shortfall until the asset is sold. The tax treatment of interest expenses and future gain will also affect the investor's final return.


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