Saturday, September 14, 2013

On 15 September 2013, the world will mark the fifth anniversary of the collapse of Lehman Brothers Holdings Inc, one of the largest investment banks in the US. In 2008, the collapse triggered a global financial crisis. One of the biggest reasons behind the financial meltdown in general and the collapse of Lehman in particular was high leverage.

What is leverage?
  • Businesses and individuals do not always invest their own money. 
  • They use various types of debt instruments to fund their business or investment. 
  • In the financial world, this is known as leverage. 
  • Let’s say, a company has Rs.100 worth of shareholders’ capital and it wants to expand its business, which needs another Rs.100 worth of investment. 
  • There are two ways of raising this capital—through equity or debt. 
  • If the company raises equity capital, the shareholder base will increase and the earnings per share (EPS) will go down. 
  • But if it raises money through debt, the EPS will remain intact. In fact, the EPS will go up as soon as the new investment starts generating returns. However, at the same time, the company will have to service the debt taken and the overall risk will go up.


Reasons and consequences
  • Businesses generally use leverage to enhance profitability, but too much debt can also become an existential threat for many. 
  • This is exactly what happened in the run up to the 2008 financial crisis. Both the household sector and the financial world leveraged themselves excessively in the developed world. 
  • While individuals were buying housing properties with borrowed money and had no ability to repay, the banks and financial institutions were leveraging themselves to accumulate junk bonds and derivative instruments based on the housing loans, among other things. 
  • As the property prices started falling, homeowners started defaulting and, suddenly, there were no takers for those junk bonds. 
  • As a result, inter-bank lending froze and the entire financial world came to a virtual standstill.

It was reported that at the time of bankruptcy, Lehman Brothers had leveraged itself 44 times. Simply put, for every $1 of capital, it had a debt of $44. At such high level of leverage, just about 2% change in asset prices can wipe out the entire capital. Interestingly, Lehman Brothers was not the first entity to operate at such a high leverage ratio. Long-Term Capital Management, a hedge fund with two Nobel laureates on board, had to be rescued in 1998 because of highly leveraged positions.

The bottom line
Firms take debt to enhance shareholders’ returns and it is not always a bad thing. However, it is important to know the optimal level of leverage a company can withstand. Too much debt can also destroy shareholders’ wealth.


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