EFA (34): Leverage

Many experts argue that leverage was a key cause of the recent financial crisis. But what exactly is leverage? This is the subject of the 34th item of our Economics for Amateurs (EFA) series, which you can find here each Monday.

The literal meaning of "leverage", according to the Oxford Dictionary of English, is "the exertion of force by means of a lever". In a figurative sense, leverage is "the power to influence a person or situation".

Recently, "leverage" has also come to be used a verb, meaning "to make the most out of something". For example, a company might want to "leverage its brand image" or "leverage its market position". For another example, see here.

None of these meanings, however, is the one that relates to the recent financial crisis. In this context, leverage refers to the use of borrowed money to finance investments.

In the US, leverage has traditionally described the ratio of a company's loan capital (debt) to its ordinary shares (equity). In the UK, the traditional term for this has been "gearing".

A highly leveraged (or highly geared) company is therefore one that is financed to a great extent through borrowing rather than equity. Similarly, a leveraged takeover bid is one that is financed through borrowing — the aim being to generate profits that are higher than the interest due on the loans.

A key feature of the recent financial crisis was a very high degree of leverage, as companies and individuals borrowed large sums of money to invest in financial assets.

Normally, lenders, such as banks, require a high degree of security for their loans. This is known as collateral, which often takes the form of a physical asset, such as a house.

During the financial bubble, lenders became willing to lend ever-higher percentages of the value of such physical collateral. They were also willing to accept less secure assets as collateral, including financial assets such as the expected payments from a mortage or from a credit card.

Many economists, including John Geanakoplos from Yale University, believe that this high level of insecurely backed leverage was a main cause of the financial bubble and crash. For more details of his criticism of leverage, see this recent article in The Wall Street Journal.