leveraged

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In
finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fin ...
, leverage (or gearing in the United Kingdom and Australia) is any technique involving borrowing funds to buy things, hoping that future profits will be many times more than the cost of borrowing. This technique is named after a
lever A lever is a simple machine consisting of a beam or rigid rod pivoted at a fixed hinge, or ''fulcrum''. A lever is a rigid body capable of rotating on a point on itself. On the basis of the locations of fulcrum, load and effort, the lever is divi ...
in physics, which amplifies a small input force into a greater output force, because successful leverage amplifies the comparatively small amount of money needed for borrowing into large amounts of profit. However, the technique also involves the high
risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
of not being able to pay back a large loan. Normally, a 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 In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that de ...
. Leveraging enables gains to be multiplied.Brigham, Eugene F., ''Fundamentals of Financial Management'' (1995). 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.

# Sources

Leverage can arise in a number of situations, such as: * securities like
options Option or Options may refer to: Computing *Option key, a key on Apple computer keyboards * Option type, a polymorphic data type in programming languages *Command-line option, an optional parameter to a command *OPTIONS, an HTTP request method ...
and futures are effectively bets between parties where the principal is implicitly borrowed/lent at interest rates of very short treasury bills.Mock, E. J., R. E. Schultz, R. G. Schultz, and D. H. Shuckett, Basic Financial Management (1968). * equity owners of businesses leverage their investment by having the business borrow a portion of its needed financing. The more it borrows, the less equity it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result. * businesses leverage their operations by using fixed cost inputs when revenues are expected to be variable. An increase in
revenue In accounting, revenue is the total amount of income generated by the sale of goods and services related to the primary operations of the business. Commercial revenue may also be referred to as sales or as turnover. Some companies receive revenue ...
will result in a larger increase in
operating profit In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses (operating and non-operating) except interest expenses and income tax expenses. Operating income and op ...
. *
hedge fund A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as shor ...
s may leverage their assets by financing a portion of their portfolios with the cash proceeds from the short sale of other positions.

# 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 Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the deb ...
public utilities A public utility company (usually just utility) is an organization that maintains the infrastructure for a public service (often also providing a service using that infrastructure). Public utilities are subject to forms of public control and r ...
are usually less risky stocks than unlevered high-risk
technology Technology is the application of knowledge to reach practical goals in a specifiable and reproducible way. The word ''technology'' may also mean the product of such an endeavor. The use of technology is widely prevalent in medicine, science, ...
companies.

# Measuring

A good deal of confusion arises in discussions among people who use different definitions of leverage. The term is used differently in
investment Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing is ...
s and
corporate finance Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allo ...
, and has multiple definitions in each field.

## Investments

Accounting leverage is total assets divided by the total
asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...
s minus total
liabilities Liability may refer to: Law * Legal liability, in both civil and criminal law ** Public liability, part of the law of tort which focuses on civil wrongs ** Product liability, the area of law in which manufacturers, distributors, suppliers, re ...
.Weston, J. Fred and Eugene F. Brigham, Managerial Finance (1969).
Notional ::''See Notional amount or Notional profit for economic terms '' Notional (born February 1, 2004 in California) is an American Thoroughbred racehorse. He was sired by In Excess and out of the mare Truly Blessed. His damsire, French Deputy, is ...
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:Bodie, Zvi, Alex Kane and Alan J. Marcus, Investments, McGraw-Hill/Irwin (June 18, 2008) * Buy$100 of crude oil with money out of pocket. Assets are $100 ($100 of oil), there are no liabilities, and assets minus liabilities equals owners' equity. Accounting leverage is 1 to 1. The notional amount is $100 ($100 of oil), there are no liabilities, and there is $100 of equity, so notional leverage is 1 to 1. The volatility of the equity is equal to the volatility of oil, since oil is the only asset and you own the same amount as your equity, so economic leverage is 1 to 1. * Borrow$100 and buy $200 of crude oil. Assets are$200, liabilities are $100 so accounting leverage is 2 to 1. The notional amount is$200 and equity is $100, so notional leverage is 2 to 1. The volatility of the position is twice the volatility of an unlevered position in the same assets, so economic leverage is 2 to 1. * Buy$100 of a 10-year fixed-rate
treasury bond United States Treasury securities, also called Treasuries or Treasurys, are government debt instruments issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Since 2012, U.S. gov ...
, and enter into a fixed-for-floating 10-year
interest rate swap In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with ...
to convert the payments to floating rate. The derivative is
off-balance sheet Off balance sheet (OBS), or incognito leverage, usually means an asset or debt or financing activity not on the company's balance sheet. Total return swaps are an example of an off-balance-sheet item. Some companies may have significant amounts o ...
, so it is ignored for accounting leverage. Accounting leverage is therefore 1 to 1. The notional amount of the swap does count for notional leverage, so notional leverage is 2 to 1. The swap removes most of the economic risk of the treasury bond, so economic leverage is near zero.

## Abbreviations

* EBIT means
Earnings before interest and taxes In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses (operating and non-operating) except interest expenses and income tax expenses. Operating income and ope ...
. * DOL is Degree of Operating Leverage * DFL is Degree of Financial Leverage * DCL is Degree of Combined Leverage * ROE is
Return on equity The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on '' ...
* ROA is
Return on assets The return on assets (ROA) shows the percentage of how profitable a company's assets are in generating revenue. ROA can be computed as below: :\mathrm = \frac This number tells you what the company can do with what it has, ''i.e.'' how many doll ...

## Corporate finance

: $\mathrm = \frac$ : $\mathrm = \frac$ : $\mathrm = \text \times \text = \frac$ 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: : $\text= \frac$ 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 In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses (operating and non-operating) except interest expenses and income tax expenses. Operating income and ope ...
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 Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the centra ...
, 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 A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital ...
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 (from the right hand side of the balance sheet) that must be held as a certain kind of asset (from the left hand side of the balance sheet). A capital requirement is a fraction of assets (from the left hand side of the balance sheet) that must be held as a certain kind of liability or equity (from the right hand side of the balance sheet). Before the 1980s, regulators typically imposed judgmental capital requirements, a bank was supposed to be "adequately capitalized," but these were not objective rules.Ong, Michael K., The Basel Handbook: A Guide for Financial Practitioners, Risk Books (December 2003) National regulators began imposing formal capital requirements in the 1980s, and by 1988 most large multinational banks were held to the
Basel I Basel I is the first Basel Accord. It arose from deliberations by central bankers from major countries during the late 1970s and 1980s. In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum ...
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.Saita, Francesco, Value at Risk and Bank Capital Management: Risk Adjusted Performances, Capital Management and Capital Allocation Decision Making, Academic Press (February 3, 2007) 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 (there was a clumsy provisions for derivatives, but not for certain other off-balance sheet exposures) and it encouraged banks to pick the riskiest assets in each bucket (for example, the capital requirement was the same for all corporate loans, whether to solid companies or ones near bankruptcy, and the requirement for government loans was zero). 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 Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fin ...
, like many previous financial crises, was blamed in part on "excessive leverage". * Consumers in the United States and many other developed countries had high levels of debt relative to their wages, and relative to the value of collateral assets. When home prices fell, and debt interest rates reset higher, and business laid off employees, borrowers could no longer afford debt payments, and lenders could not recover their principal by selling collateral. * Financial institutions were highly levered.
Lehman Brothers Lehman Brothers Holdings Inc. ( ) was an American global financial services firm founded in 1847. Before filing for bankruptcy in 2008, Lehman was the fourth-largest investment bank in the United States (behind Goldman Sachs, Morgan Stanley, an ...
, for example, in its last annual financial statements, showed accounting leverage of 31.4 times ($691 billion in assets divided by$22 billion in stockholders’ equity).Lehman Brothers Holdings Inc Annual Report for year ended November 30, 2007
/ref> Bankruptcy examiner Anton R. Valukas determined that the true accounting leverage was higher: it had been understated due to dubious accounting treatments including the so-called
repo 105 Repo 105 is Lehman Brothers' name for an accounting maneuver that it used where a short-term repurchase agreement is classified as a sale. The cash obtained through this "sale" is then used to pay down debt, allowing the company to appear to reduc ...
(allowed by
Ernst & Young Ernst & Young Global Limited, trade name EY, is a multinational professional services partnership headquartered in London, England. EY is one of the largest professional services networks in the world. Along with Deloitte, KPMG and Pricewate ...
). * Banks' notional leverage was more than twice as high, due to
off-balance sheet Off balance sheet (OBS), or incognito leverage, usually means an asset or debt or financing activity not on the company's balance sheet. Total return swaps are an example of an off-balance-sheet item. Some companies may have significant amounts o ...
transactions. At the end of 2007, Lehman had $738 billion of notional derivatives in addition to the assets above, plus significant off-balance sheet exposures to special purpose entities, structured investment vehicles and conduits, plus various lending commitments, contractual payments and contingent obligations. * On the other hand, almost half of Lehman's balance sheet consisted of closely offsetting positions and very-low-risk assets, such as regulatory deposits. The company emphasized "net leverage", which excluded these assets. On that basis, Lehman held$373 billion of "net assets" and a "net leverage ratio" of 16.1. This is not a standardized computation, but it probably corresponds more closely to what most people think of when they hear of a leverage ratio.

# Use of language

Levering has come to be known as "leveraging", in financial communities; this may have originally been a slang adaptation, since leverage was a
noun A noun () is a word that generally functions as the name of a specific object or set of objects, such as living creatures, places, actions, qualities, states of existence, or ideas.Example nouns for: * Living creatures (including people, alive, ...
. However, modern dictionaries (such as '' Random House Dictionary'' and ''Merriam-Webster's Dictionary of Law'') refer to its use as a
verb A verb () is a word (part of speech) that in syntax generally conveys an action (''bring'', ''read'', ''walk'', ''run'', ''learn''), an occurrence (''happen'', ''become''), or a state of being (''be'', ''exist'', ''stand''). In the usual descrip ...
, as well. It was first adopted for use as a verb in
American English American English, sometimes called United States English or U.S. English, is the set of varieties of the English language native to the United States. English is the most widely spoken language in the United States and in most circumstances i ...
in 1957."leverage." ''Online Etymology Dictionary''. Douglas Harper, Historian. 7 June 2011
Dictionary.com
/ref>

* Coupon leverage * Homemade leverage *
Leveraged buyout A leveraged buyout (LBO) is one company's acquisition of another company using a significant amount of borrowed money ( leverage) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loa ...
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Margin (finance) In finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty (most often their broker or an exchange) to cover some or all of the credit risk the holder poses for the counterparty. This ris ...
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Operating leverage Operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky, or volatile, a company's operating income is. Definition There are various measures of operating leve ...
*
Repurchase agreement A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and, by agreement between the two par ...