Overleverage: excessive debt
as a financial risk

Living and playing on other people's money.

The "debt vs. equity" game is a main element of what some  call 
financialization.
Using other people's money to make the financial stew is a chef's
trick, but it can make the dish too salty

The proportion of debt to own capital is the financial leverage.
When it gets excessive, we have overleverage.This is highly
dangerous as any glitch might ruin the plate, serving bankruptcy.

The trick to make a larger stew
is to use other people's money.

Adding a horse of debt to a bird of equity

oBut for how long the horses will agree?

The process:
from leverage to overleverage

Debt
is one of the engines of economic development, money itself is
created as a counterpart of short term bank credit.
But too much of those goodies becomes indigest and noxious.

lever
Leverage is using debt in complement to one's own invested
money.

As for overleverage, it is thus an excessive use of debt (*) for investing
or spending.
=> Such a debt overhang / overflow can foster a crisis.


(*) either direct borrowing, or indirect commitments through derivative

      instruments.

Now some precisions:

Leverage

The "leverage" or "gearing" is the proportion between debt and own
capital
to finance an organization, an operation, or a project.
This goes from purchasing a washing machine with a down payment to
starting a business or to building a high speed train line with the help of
a bank pool.

Example:

To finance a business or personal operation of 120k Euros with 50k own
capital or savings (and therefore 70k debts) gives a leverage of
120 / 50 = 2.4

Overleverage

As for overleverage, it occurs when an investment is financed on the
basis of:

- A very small amount of own capital (also called "equity"),
- An excessive amount of borrowed money
- For uncertain gain / risk prospects

It can be called "capitalism without capital", as it plays mostly with
other people's money (bank loans and bonds issuing) and use the least
possible one's own savings (or at least equity financing), in the hope:
  • If things wealth turn favorably (a highly profitable venture),
to pocket a large share of the gain (example below).
  • If things poor turn bad,
to leave the lunch's bill to the invited lenders... This dubious chef's trick
to make a bigger and spicier plate by adding more debt ingredients might
bring unpalatable results if the proportions get excessive.
Other, often hidden, ingredients are financial derivatives.

Those tradable assets or contracts create debt commitments that
are either potential (as linked to the variation of some market prices)
or indirect.

An intensive use of such not too visible market instruments by
an
institution or a business
makes it difficult to get a right picture of 
how
this entity is leveraged, and therefore of the financial risk involved

As seen in th
e bank traders' bonuses article, banks can be
tempted to overuse this "market trading" that might put at stake
more than their own capital, therefore also depositors' money.
Extreme cases, 
and layered or pyramidal leverage

The extreme case is of course 0% own funds vs. 100% debt, as was
seen in some real estate financing that led to the
subprime lending crisis.

That
distortasymm imbalance was compounded, as if it was not bad enough,
by the use of highly leveraged derivative instruments.
But the excess can start with 15-20 % debt for high risk / high reward
projects that should normally be fully funded by equity venture capital).

Overleverage get worse, with lack of fog transparency added,
when many layers of leverage accumulate
in the whole ownership
chain (debt pyramid). For example:
  • Asset A (a business...) belongs to asset B
(B being another business... that belongs to asset C
= that belongs itself to asset D.
  • But A, B and C used only 20% equity to invest and 80% debt.
    The C asset funding is therefore atrociously over levered.

The incentive lures

What makes overleverage attractive is that, when everything works
nicely and the investment profitability is above the interest rates
payed on the debt, this
practice boosts the investor's incomes
or gains
(...but also its losses)
For example,
if the asset give a 10% return
and the debt costs 5%,
=> the investor pockets the difference.
If its commitment on a 1 million investment was only 20%,
thus 200k,

* the lenders of the 800k gets their 40k interest
* the investor gets 100k - 40 k = 60k, thus a 30% return
   on its 200k investment.

If on the other hand the asset's return is only 4% at the end,
the same calculation shows that the investor does not gain one
kopeck.
And if it is under 4%, it will have a negative return and the
lenders will repay themselves on a piece of its equity.
=> This trick is sometimes used to create - artificially and hopefully (if
        things turn out well) - what is called "shareholder value".

Also such an element of "financialization" is (*) a "cash cow" for
many financial institutions that serve as intermediaries of leveraged
investment for a fee.
(*) or was, until the
last crisis, but it did not fully disappeared after it.

The traps

But any glitch (*) can make that practice ruinous, making it i
mpossible to face debt charges (interest and repayments) when incomes
are not large enough.

(*) loss of revenues, higher interests charges, unforeseen accident or
financial need...

The default is made worse and a rescue becomes highly improbable
if the
asset that was pledged has lost market value so that
its sale does not
cover the amount of the outstanding loan.
The mortgage subprime disaster comes here again to mind.

This makes overleverage one of the factors that explain:

* At the microeconomic level,
    many individual and corporate bankruptcies. Even a wealthy person
    or a profitable business can suffer a
liquidity liquidity crisis.
* At the macroeconomic level, most  sous 
crash financial crashes.

The subprime crisis was an example of "financialization" in
which a
pyramid of debts hided a lack of own capital (meagre
savings by the buyers) in real estate investments.

Moreover the financial risk was transmitted to many players
in the
leveraging chain.
The liquidity crisis became a systemic crisis.
Usually such a risk pyramid ends in deleveraging, a soft or hard
landing in which
  • Players with excessive debts sell assets to repay them,
they do it under their own initiative, or under a bankruptcy
process... that cancels at least partly those debts
(lenders
might also agree on a debt restructuring, accepting a
"haircut" on the debt value).
  • People with real own capital buy those assets at rock bottom price
and if necessary they bring more equity to alleviate the
debt burden.
Far from being the end of capitalism there is a (drastic)
"
back to capitalism" phase.
More on financialisation

The spread of financialization
(an hypertrophy of the financial
sphere) is not just a matter of business practices or market
practices
.

The key factors, which
contributed to that evolution that is largely
responsible for the financial and economic troubles of the last
decades,
were
:

* Of course, the "debt vs. equity" game in business
   financing
* The excessive use of esoteric financial techniques 
   not really mastered.
* The expansion of sovereign debt,
* And as
the main drivers of the global financial herd and a
   common source of the overflow,  the l
axity of official
   bodies
, notably the US Treasury and the Federal
   Reserve Board (the US central bank)

The State as a savior?
Or an arsonist ?
In extreme (and mammoth) cases, this situation lead the State itself
tries to use capitalist tools
. It gets hold of those assets at a low
price with the intention to sell them later at a better price, after doing
the cleanup and recapitalization.

But then a second problem surges if the State is already in bad financial
shape
(see sovereign debt) and has to borrow heavily to inject the needed
rescue funds.
It becomes itself overleveraged (a situation defined in that case as a lack
of potential fiscal means to ensure the repayment of its debt).


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M.a.j. / updated : 03 Sept. 2015
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