Behavioral finance FAQ / Glossary (Overleverage)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Overleverage


08/9i + See optimism,
overconfidence, liquidity
squeeze

If I gain, I keep the gain, if I lose, the loss is for others.

Definition:

Overleverage is an excess of debts.

The "lever" (= arithmetical ratio) between borrowed funds and own
funds
is too high.

This financial imbalance brings a too heavy
debt burden
on a person, a business,
a country, a project, or even a whole economy.

Under that weight, the financial engine might break
to pieces
at any moment.

In practice, to create an overleverage on a project, an asset or a
business is to finance it with:

A very small amount of own capital

An excessive amount of borrowed money,

While facing high risk prospects that the money get lost 
    and expecting important but highly uncertain gains,
    thus with not much chance to face the massive interest 
   
charges and repayments


What motivates it?

To understand the

motivation (or temptation)

of overleverage, let us take the case in which

* The total investment is 1 million

* The investor's own money commitment is only 20%, thus 200k,

* The rest (800k) is financed by debts (therefore the leverage is
   800 / 200 = 4x).

* The debt costs 5% interest,

1) If the asset gives a 10% return, the investor pockets the
    difference.

* The lenders of the 800k get their 40k interest

* The investor gets 100k - 40 k = 60k, thus 30% return

on its 200k investment


2) If the asset's return is only 4%  the same calculation

shows that the investor does not gain one kopeck.


3) And if that return is under 4%, the lenders will have to
    pay themselves by taking a piece of the equity, thus

bringing a loss to the investor.

Extreme cases

Making a pheasant pâté
with one pheasant and one horse.


The extreme case
is of course 0% own funds vs. 100% debt, as
was seen in the subprime lending crisis,


But the problem can start with 10-20 % debt for high risk / high reward
projects that should be normally fully funded by equity (venture capital).

Also, there can be a pyramid of overleverage, when for example:

An entity A owns an entity B which owns an entity C.

And each company A, B and C is funded with 50% debt (thus 50%
equity).

The real share of equity in B is .5 x .5 x .5 = .0125 (1.25 %)

No, don' worry, your calculator, is OK

Possible causes

Is it just a lack of money?
Or a rational practice to enhance profitability ?
Or might some behavioral biases hides behind it?

Overleverage might have practical causes such as

A lack of financial means to fund a crucial project.

Some mishaps affecting an initially sound project / business, but

that after a while suffered an unexpected loss or
overspending.

But apart the above motives based on hard realities,there are often
biased attitudes
behind overleverage:

It might signal overconfidence and overoptimism (see those
  
words), a trait (which has its good sides also) often found among
   enterprising people

It can shows a neglect of the cost of debt and of the
  
vulnerability entailed (as the history of bankrupcies show)

It is gambling with other people's money (the
  
lenders' funds).

The borrower expects the maximum gain with a
minimal investment and, if the lunch is a failure,
to leave the bill to the invited lenders.

It might seem rational,
but with a pervert, and a bit illusive, rationality.

It can be seen philosophically as a diversion from sound
capitalism,
a system in which to take risks is quite respected,
even in some aspects admired, on condition those risks be
taken by the equity investor itself.

Possible consequences

Leveraged until over ...the cliff

Individual consequences

When a business (or a family) is already over-levered,

* new investments, however necessary, get hard to finance.

* worse still, if losses happen, there is not enough equity to absorb
   them.
That causes a   to a lack of cash, a difficulty to find new l
oans and, in the worst cases, total ruin.


General consequences

Overleverage is commonly found in financial bubbles (and the
related crashes).
Overleverage can end into a liquidity crisis.

Here the 2007- ... financial crisis comes to mind
     (see bubble / crash).

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

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This page last update: 09/08/15  

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