The Role of Leverage in the Current Financial Crisis

Topics: Capital requirement, Asset, Debt Pages: 7 (2109 words) Published: October 9, 2010

The United States of America is in the middle of the worst financial crisis in more than 75 years. To date, federal regulators and authorities have taken unprecedented steps to stop the complicated situation of the financial services sector by committing trillions of dollars of taxpayer funds to rescue financial institutions and restore order to credit markets. Although the current crisis has spread across a broad range of financial instruments, it was initially triggered by defaults on U.S. subprime mortgage loans, many of which had been packaged and sold as securities to buyers in the United States and around the world. With financial institutions from many countries participating in these activities, the resulting turmoil has affected financial markets globally and has spurred coordinated action by world leaders in an attempt to protect savings and restore the health of the markets. The buildup of leverage during a market expansion and the rush to reduce leverage or “deleverage,” when market conditions deteriorated was common to this and other financial crises. Leverage traditionally has referred to the use of debt, instead of equity, to fund an asset and been measured by the ratio of total assets to equity on the balance sheet. But, as we can see in the current crisis, leverage also can be used to increase an exposure to a financial asset without using debt, such as by using derivatives. In that regard, leverage can be defined broadly as the ratio between some measure of risk exposure and capital that can be used to absorb unexpected losses from the exposure. However, because leverage can be achieved through many different strategies, no single measure can capture all aspects of leverage. Federal financial regulators are responsible for establishing regulations that restrict the use of leverage by financial institutions under their authority and supervising their institutions’ compliance with such regulations. According to studies, leverage steadily increased within the financial sector before the crisis began around mid-2007, and banks, securities firms, hedge funds, and other financial institutions have sought to deleverage and reduce their risk since the onset of the crisis. Some studies suggested that the efforts taken by financial institutions to deleverage by selling financial assets and restricting new lending could have contributed to the current crisis. First, some studies suggested that deleveraging through asset sales could trigger downward spirals in financial asset prices. In times of market crisis, a sharp drop in an asset’s price can lead investors to sell the asset, which could push the asset’s price even lower. For leveraged institutions holding the asset, the impact of their losses on capital will be magnified. The subsequent price decline could induce additional sales that cause the asset’s price to fall further. In the extreme, this downward asset spiral could cause the asset’s price to be set below its fundamental value, or at a “fire sale” price. In addition, a decline in a financial asset’s price could trigger sales, when the asset is used as collateral for a loan. However, other theories, such as that the current market prices are the result of asset prices reverting to their fundamental values after a period of overvaluation, provide possible explanations for the sharp price declines in mortgage-related securities and other financial instruments. As the crisis is complex, no single theory likely is to explain in full what occurred. Second, some studies suggested that deleveraging by restricting new lending could contribute to the crisis by slowing economic growth. In short, the concern is that banks, because of their leverage, will need to cut back their lending by a multiple of their credit losses. Moreover, rapidly declining asset prices can inhibit the ability of borrowers to raise money in the securities markets.


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