Behavioral finance FAQ / Glossary (Overleverage)
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08/9i + See optimism,
If I gain, I keep the gain, if I lose, the loss is for others.
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
* 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.
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%
The real share of equity in B is .5 x .5 x .5 = .0125 (1.25 %)
No, don' worry, your calculator, is OK
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
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
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
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.
Leveraged until over ...the cliff
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
That causes a to a lack of cash, a difficulty to find new l
oans and, in the worst cases, total ruin.
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).
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