Risk of Financial Leverage

Risk of Financial Leverage
••• money money money image by Tribalstar from Fotolia.com

Leveraging is a general financial term for any technique used to multiply gains and losses. There are several definitions of leveraging, depending on context and field. However, in virtually all cases leveraging tends to increase the possible gains from the asset but also increase the risks associated with the transaction. These risks are many and varied, but usually begin with the risk of an unexpected asset depreciation.

Types of Leverage and Leverage Terms

Leverage is achieved in different ways in different circumstances. A public firm may lever its equity position by borrowing money, which increases returns without increasing the equity capital of the firm, but does so at the risk of not being able to pay back debts. A hedge fund achieves leverage by either borrowing or trading on margin so as to buy more investment than the actual capital it controls, but does so at the risk that price movements will wipe out the investment. There are also several definitions of leverage, each leading to different "leverage ratios." These different definitions are notational leverage, economic leverage and accounting leverage.

Risks of Leverage: Multiplication of Losses

The most obvious and apparent risk of leverage is that if price changes unexpectedly, the leveraged position can end up leading to severe losses. For example, imagine a hedge fund, seeded by $50 worth of investor money. The hedge fund borrows another $50, and buys an asset worth $100, leading to a leverage ratio of 2:1. For the investor, this is neither good nor bad -- until the asset price changes. If the asset price goes up 10 percent, the investor earns $10 on $50 of capital, a net gain of 20 percent, and is very pleased with the increased gains from the leverage. However, if the asset price crashes unexpectedly, say by 30 percent, the investor loses $30 on $50 of capital, suffering a 60 percent loss. In other words, the effect of leveraging is to increase the volatility of returns, and increase the effects of a price change on the asset to the bottom line, while increasing the chance for profit as well.

Risks of Leverage: Unending Loss

Leveraging can begin with increasing losses and end with these losses being "locked in," in a remarkably short time. Long-Term Capital Management (LTCM) was a hedge fund in the 1990s that imploded spectacularly, thanks to leveraging and the 1997-1998 financial crisis which reduced asset prices. Originally a hedge fund with a leverage ratio of 25-to-1, as prices fell during the 1997 Asian financial crisis, LTCM had to borrow more and more to stay afloat, liquidating assets as much as possible, and effectively leveraging itself to 250-to-1. The Federal Reserve Bank of New York, fearing a market collapse, eventually bailed out the LTCM in 1998 with more than $3.625 billion in creditor funds, leading to a total net loss of $4.6 billion. This illustrates how leveraging can quickly get out of hand and end in bankruptcy very quickly.

Other Risks of Leverage

There are several other risks associated with leverage. Model risk occurs when firms hedge their investments by taking a similar position on the opposite side, to reduce risk, on the assumption that these positions actually hedge against each other; if this assumption is incorrect, losses can occur. For example, a firm might be comfortable leveraging a long position in steel by shorting a position in iron, as when steel prices go down, the value of the iron short increases. But if this assumption is untrue, the hedge can backfire and leveraging will lead to greater losses. Another risk is counter-party risk, the risk associated with dealing with firms that are leveraged. If a leveraged business partner goes under, it can create costs for the firms it deals with.

A Caveat

Not all leveraging is inherently bad. Many news outlets report that high leverage ratios were the true cause for a specific collapse, and that high leverage ratios are always risky. While it may be true that leverage inherently increases risk, it isn't true that a leveraged company is always more risky than a non-leveraged company. For example, many highly leveraged hedge funds have less volatility in returns than bond funds without leverage. The real risk of leverage is that a firm or entity will leverage itself fully, such that virtually any price downward change in the asset must prompt liquidation, leading to increased losses and possibly a locked-in loss and bankruptcy if price continues to drop.