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Financial Friday: Leverage – What is it? How is it Calculated? And How it Destroyed One of America’s Largest Businesses in Days.

Formulas on a blackboard.

Leverage has been responsible for some of the most glamorous gains and disastrous declines in the financial world. Here we look at what leverage is, and show an example of its devastating potential.

 

What is Leverage?

Leverage is typically defined as your “exposure” relative to “actual capital”.

Where exposure is the value of your holdings, and actual capital is money paid or invested by you. The additional “exposure” comes from borrowed money, and this is why being “leveraged up” can be so dangerous.

In the most general terms, leverage is:

 

leverage equation 0

 

The most common form of leverage that consumers are familiar with deals with mortgages. Consider a family looking to purchase a $500,000 house. They likely cannot afford to write a $500,000 check. They will most likely go to a bank and put, say, $100,000 down and take out a mortgage for the remaining $400,000.

Here the family’s “exposure” is $500,000, the actual value of their house, but their “actual capital” is just the $100,000 they put down.

 

Or, 5:1 leverage. ($500,000:$100,000) Or said simple, 5x leverage.

 

The Effects of Leverage

This 5:1 ratio can lead to some interesting outcomes if the value of their house changes. Consider 2 examples:

Example 1: House prices rise 20%

Here, the home’s value rises to $600,000, or a gain of $100,000.

The family still has to pay back the $400,000 owed to the bank, but they are left with $200,000 ($600,000 – $400,000). The family doubled their money, even though prices only rose 20%

 

Example 2: House prices fall 20%

Now leverage rears its ugly head. Now the house is worth just $400,000. The family still owes the bank $400,000 for the original loan, and they are left with nothing. The original $100,000 investment is turned to $0 with just a 20% drop.

 

Notice the relationship here. At 5:1 leverage, a 20% rise or drop results in a 100% rise or decline. This can be generalized into the following formula to determine net gain or loss from a leveraged investment:

 

leverage equation 1    (1)

 

 

In the example above, a leverage ratio of 5, multiplied by 20 equates to 100, or a 100% loss or gain.

 

 

We can also calculate the percent drop in the investment that would wipe out 100% of capital based on a known leverage ratio:

 

leverage equation 2                                                                   (2)

 

Or, using our example above – 1 ÷5 = .2, or 20%.

If you are at a 5:1 leverage ratio, a 20% drop eliminates the original investment capital.

 

Keep all of this in mind as we take a look at one of the more recent examples of out of control leverage and the devastation it can cause:

Lehman Brothers – 2007

 

Here we look at Lehman Brother’s 2007 10-k annual report:

(click to enlarge)

LEH_Balance_Sheet_2007

In 2007, this company employed over 28,000 people, had over $19 billion in revenue, $4.2 billion in profit and $282 billion in assets under management (AUM).

 

And yet, in less than a year this company would be declaring chapter 11 bankruptcy.

 

How is that even possible?

 

Look at Lehman’s net leverage ratio – 16.1x, or roughly 16:1 (much greater than our example family buying a house above)!

Using the equation (2) above, a company leveraged 16:1 can afford a 6.25% drop (1/16 x 100%) in its investments before all its actual capital is lost.

 

What was Lehman Brothers investing in? A ton of mortgage bonds and derivatives on those securities, so when house prices did this in mid 2008:

home_prices

Lehman was effectively wiped out. Home prices fell nearly 40% very rapidly, and Lehman experienced a return of about -640%…ouch!

(Chart is of the Case – Schiller Home Price Index, courtesy of multipl.com)

 

And that is how you wipe out a multi-hundred billion dollar company in less than a year. On September 15th 2008, Lehman declared bankruptcy.

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