By Rafael Torres & Pavan Sukhdev
Borrowing and lending are as ancient as commerce, and leverage today is a key component of the toolkit for business. Leverage enables a corporation to make investments or incur expenses it would not otherwise have been able to undertake based on its owners’ resources.
Apart from the general advantage of allowing businesses to use resources beyond their subscribed capital and earned reserves, financial leverage has some additional positive effects. It expands consumers’ purchasing power[i]; it enables entities to finance projects that they otherwise would not have been able to execute; it helps corporations grow their scale of operations in order to lower production costs; and it fuels economic expansions through the collective increase in expenditures that it has enabled. From the perspective of an investor, plain vanilla debt instruments (bonds and commercial paper - relatively simple forms of leverage) also provide investment vehicles that have lower risk as compared to equity, and so leverage using debt issuance also contributes to investment diversification.
Notwithstanding the positive attributes mentioned above, the use of high financial leverage also imposes a negative externality on parties not involved in a given transaction when financial distress or default sets in for the levered entity. Employees lose jobs, suppliers and vendors lose sales or collections and possibly face default, governments lose revenue, other enterprises feel the effects of reduced economic activity, and even foreign institutions are affected through trade. Ben Bernanke, current Chairman of the U.S. Federal Reserve, has observed that “firms’ leverage decisions create externalities at both the microeconomic and macroeconomic levels” that will not be taken into account in private capital structure decisions.[ii] The spectacular unravelling of Enron in 2001, for example, had much to do with its excessive use of leverage.
Financial leverage has represented, at the least, an amplifier of financial and economic crises around the world and, at the most, a primary driving force behind some of them. The power of leverage to turn economic stability into ruin when pursued in excess has been proven time and again by corporations, sovereign governments and individuals alike. Many a financial crisis and ensuing economic recession has been either triggered—or its effects significantly worsened—by financial leverage. This includes all of the last four major financial crises experienced around the world, those being Latin America’s debt crisis, the savings and loan (S&L) crisis in the U.S., the Asian currency crisis, and the so-called “Great Recession” of 2008. In all of these cases, leverage played a central role in contributing to asset bubbles that subsequently burst and in prolonging recessionary impacts as a result of the process of de-leveraging[iii].
With such close links between crisis and excessive leverage, one would not exaggerate in suggesting that where there is one, the other is usually nearby.
The Latin American Debt Crisis
Latin America’s “lost decade” of the 1980s was amplified by leverage, in that instance not by corporations, but by sovereign governments. In the 1970s, many developing countries, particularly in Latin America, were hit with balance of payment deficits from higher oil and import prices, as well as lower demand for their commodity exports.[iv] In response, they borrowed heavily, mostly at floating rates. For the lenders, mostly large money-center banks, these assets were attractively priced, although there was an element of “moral hazard” in making loans to sovereign governments, whose risks of default were thought to be insignificant.
Over the late 1970s and early 1980s, Latin America’s debt service load grew significantly as the U.S. dollar appreciated and interest rates skyrocketed, leading to more borrowing just to pay high interest, a common problem created by excessive debt. Banks, in pursuit of profits, continued lending despite warnings by experts and regulators—including Federal Reserve chairman Paul Volcker—regarding the financial risks associated with Latin American countries. Along the way, regulation that would have prevented banks from reaching certain concentrations of risk in foreign sovereign loans was written flexibly to favor the existing lending practices.[v] Mexico defaulted on its obligations in 1982 and many other Latin American countries saw the writing on the wall, approaching banks to restructure their debts. Altogether, twenty-seven countries owing $239 billion attempted to reschedule their loans. Banks suffered significant losses, which had previously been hidden in their balance sheets. The eight largest money-center banks had lent approximately $55 billion to the developing countries, and many of them suffered write-offs of between 30-50%.[vi] Part of the history was governments indebting themselves, but the other side of the story was the banking sector making bad bets against their better judgment, all in the pursuit of profit. Leverage can be mismanaged from both sides of the table, and the impact for Latin America was a lost decade. The banks, with regulators’ aid, were recapitalized over that decade. The idea of “too big to fail”—born as a policy option during the early 1980s over the debate of Continental Illinois’ imminent collapse—grew deeper roots in the response to the Latin American debt crisis.
The US Savings and Loan Crisis
The savings-and-loan (S&L) crisis in the U.S. was driven by unsound and overextended lending practices, coupled with lax regulatory oversight and exemption from more stringent banking standards. S&L institutions were, generally, mutually-owned banks that existed primarily to accept deposits and provide home loans to their members at low cost. These institutions were established under a regulatory structure separate from and parallel to banks, with their own capital rules and regulator—the Federal Home Loan Bank Board (FHLBB). Originally, S&Ls had interest rate ceilings that prevented them from paying competitive interest rates on their deposits when interest rates rose. With the high interest rates of the 1970s and early 1980s significant numbers of depositors began to withdraw funds. The mix of increasing interest rates and an increasing assets-to-liabilities maturity mismatch resulted in large losses for the industry in the early 1980s, with many S&Ls failing in the first few years of that decade[vii] (see Figure 7.1).
With regulators and legislatures under pressure to keep the industry alive and improve its profitability, the S&Ls were gradually given broader powers to invest in a wider array of financial products and to lower their capital requirements ever further. The FHLBB gradually decreased the net worth requirement for federally insured S&Ls to 5% of total deposits, then further lowered it to 3%. It allowed the calculation of this ratio to be performed under the more liberal regulatory accounting principles (RAP) rather than under generally accepted accounting principles (GAAP).[viii] Legislation sponsored by Ronald Reagan in the 1980s eliminated statutory limits on the loan-to-value ratio and permitted investment in commercial mortgages, commercial and consumer loans, and leases. Some state jurisdictions, looking to compete with the federal standards in a regulatory race to the bottom, allowed S&Ls to invest 100% of their deposits in any kind of venture. The FHLBB, plagued by severe understaffing and gaps in statutory authority, was ill-equipped to examine and supervise the institutions’ burgeoning balance sheets.
Massive deregulation had the effect of raising the stakes, allowing S&Ls to grow in size and defer closure as they pursued a high-leverage strategy in the false hope that doubling their bets would enable them to recoup previous losses. It was the classic gambler’s trap, ironically aided and abetted by regulatory relaxations that encouraged more risk rather than less.
The final cost of resolving failed S&Ls was estimated at $153 billion, including $124 billion from federal taxpayers.[ix] Some institutions were effectively treated as too big to fail. Lack of transparency in managing the crisis appears to have been part of the industry and government strategy in order to prevent a loss of confidence and ensuing old-style bank run. The unfolding of the S&L crisis showed patterns of runaway greed, massive leveraging for private economic gain, undue influence over regulators and politicians, negative effects of deregulation, and losses borne by taxpayers and others not party to the transactions.
The Asian Debt Crisis
Asia’s debt crisis provides yet another case study in the dangerous effects of unconstrained leverage. Although Asia’s economic decline in the late 1990s has often been dubbed a “currency crisis,” many experts have noted that it was truly rooted in asset bubbles created by “hot money” that was drawn into the Asian economies and used to incur significant private debts. Often, those private debts were effectively subsidized by implicit guarantees from sovereign governments, creating significant moral hazard.[x] Asia’s growth during the early 1990s was in part fueled by massive borrowing in the private sector, with banks and finance companies pursuing development projects cavalierly under distorted incentives. Worldwide interest in Southeast Asia was fuelled by the promise of its evolving “economic miracle,” attracting large private capital inflows what grew to approximately $93 billion in 1996.[xi] By the end of that same year, over 50% of many banks’ total liabilities were short-term in nature, consisting mainly of un-hedged foreign currency-denominated liabilities.[xii] Corporations and banks were relying heavily on the expectation of stable currency pegs to the U.S. dollar. All of this leveraging drove asset price bubbles and an increase in systemic risk in the Asian economies. Figures 7.2 and 7.3 highlight the extent of lending and of price rises in the region. Over the period 1991-1997, the rates of growth in bank lending to the private sector (year-over-year) averaged 25% across the four countries shown below and in some instances went into the high 40’s, reaching as high as 49%.
With so much leverage and un-hedged currency exposure in the Asian financial system, the stage was set for a collapse. Bad debts started to pile up in financial companies’ balance sheets. In early 1997, Thai finance companies began to miss payments on foreign obligations. Thailand’s regulatory authorities attempted to prop up the financial system, but capital began to exit the Thai stock market as fear grew into panic, triggering a much wider crisis. Regulatory support from the central bank eventually ended and the Thai baht was allowed to float as the country’s foreign currency reserves were drawn down, increasing the risk that Thailand’s government would not meet its own sovereign debt obligations. Significant devaluation of the baht followed, which increased the value of foreign-denominated debts. Currency speculation began to take a toll on other Asian currencies, most notable being the shorting of Malaysian Ringgit by large funds run by George Soros and others, leading to the “on-shoring” of a currency that was trading internationally. These exchange rate losses triggered a vicious cycle that devalued the currencies while increasing the value of countries’ private and public debts. Financial intervention at an international scale became necessary, as the region saw massive declines in asset values and economic activity that eventually spread to the global economy. Once more, the negative effects of leverage were felt well beyond the borders of the financial contracts that connected leverage-seeking firms. Greed and the misuse of leverage created a massive financial crisis whose effects were arguably felt by most people around the world in one way or another.
The Great Recession
The largest financial crisis of our times, which triggered the most significant recession since the Great Depression of 1929, was the so-called Great Recession of 2008. A high-level analysis of how the 2008 crisis came about figures prominently in any modern-day discussion about leverage, given the strong links between the two. Many detailed analyses have been and will be written on the subject, but the emerging consensus regarding the 2008 financial crisis traces it to the materialization and collapse of a real estate price bubble that was driven largely by rampant credit risk-taking by lenders. This risk-taking was further amplified by highly-leveraged financial instruments in the form of mortgage-backed securities, collateralized debt obligations, and credit default swaps. Low interest rates, easy and available credit, and accommodating regulation represent some of the primary factors that contributed to the asset bubble.[xiii] Additionally, as pointed out earlier,[xiv] providing a context for the 2008 crisis was an increasingly globalized and sizeable financial sector, increased liquidity in preceding years, and increasing complexity of financial instruments driven by decades of innovation and deregulation.
During the late 1990s and most of the 2000s, the housing sector experienced dramatic growth that resulted in housing price increases well beyond normal inflationary pressures. This housing boom was fed by housing demand propped up with free flowing credit. Figures 7.4 and 7.5 show the appreciation in US housing prices and the amount of net domestic credit available in the U.S. economy. Total debt held by the financial sector soared over ten-fold to $36 trillion in 2007, from $3 trillion in 1978, and more than doubling as a share of GDP.[xv]
What was the source of this credit? A large part of the answer is that the financial sector greatly expanded its capacity to lever through a variety of mechanisms. In addition to spending billions of dollars on lobbying to continue deregulating the evolving financial markets, the financial industry developed new instruments[xvi] through which it securitized the mortgage lending business: asset-backed securities. Under this new model, banks would originate thousands of mortgages and then sell these mortgages to an aggregator (usually an investment bank) who would package the mortgages into an asset-backed security. Unlike their underlying mortgages, which were documentation-heavy and cumbersome, asset-backed securities were tradable. Easy to buy, sell, deliver, and settle, their risks and returns could be tailored by the aggregators to suit investor preferences. They would then be either sold to investors or further repackaged into collateralized debt obligations. Investment banks and investors could also buy insurance on these securities’ default risk through derivative instruments called credit default swaps. As this new network of instruments became standardized in the mortgage lending markets, banks and other lenders gradually relaxed credit standards to the point where prospective homeowners could purchase homes with virtually no equity down, often not needing to provide documentation on their income or assets. Some loans were known as NINJA loans, short for “No Income, No Job, or Assets.” Short-term profit seeking became the name of the game, with leverage as a critical enabler.
The amount of leverage in the financial system increased substantially, as mortgage banks ratcheted up their lending and investment banks borrowed heavily to make more money on securitization transactions. The five major investment banks—Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley—became thinly capitalized, with leverage ratios as high as 40:1 by one measure; further, a high proportion of their borrowings were short-term in nature. Fannie Mae and Freddie Mac, the then-private government sponsored entities (GSE’s), exhibited a combined leverage ratio at end of 2007 of 75:1 (including loans they owned and guaranteed).[xvii] From 2001 to 2007, national mortgage debt doubled and amount of mortgage debt per household rose 63% from $91,500 to $149,500, while wages were stagnant.[xviii] The rising levels of debt were not monitored or controlled properly by regulators, thanks to the complacency of institutions like Secretary Henry Paulson’s U.S. Treasury, the Securities Exchange Commission (SEC), and Allan Greenspan’s Federal Reserve. Calls by critics to rein in debt or regulate the markets while the bubble was being created were unfortunately ignored.
Once heavily-indebted homeowners started falling behind on payments and facing foreclosure, the price bubble in the housing market began to deflate and eventually unravel. As payment defaults hit the web of financial instruments that the financial sector created, write-downs and losses started piling up and soon unhinged the entire financial system. Credit markets seized up, the cash-clearing mechanisms of the economy became clogged, and what started as a housing/financial sector problem became a broad economic one. Real gross domestic product declined significantly, job losses ensued, and the U.S. government was forced to pass into law a $700 billion financial bailout bill in October, 2008, to protect institutions it deemed “too big to fail.” A further stimulus package of $787 billion was enacted into law to help turn around a downward-spiralling economy, with additional statutory measures enacted over subsequent years. At the time of writing, the U.S. unemployment rate hovered at around 9%. Once again, the negative effects of leverage were felt throughout the entire economic system. Asset price bubbles resulted from excessive leverage, institutions grew to proportions that afforded them TBTF status, and external damages accrued to others not involved in the propagation of unlimited leverage or in any way benefiting from the enabling high-leverage transactions.
Whenever a financial crisis erupts around the world, the fingerprints of leverage are always to be found. For all of the crises outlined above, runaway leverage was a critical factor, the absence of which would have yielded an entirely different, and presumably more stable, chain of events.
Society and its political and business leaders would do well to understand that crisis and leverage are closely linked, as history has shown us time and again, and that this link can be lethal if limits to leverage are not urgently evaluated and implemented. This is the subject of Chapter 7 of our forthcoming book, “Corporation 2020”.
[i] Richard P. Nielsen, "High-Leverage Finance Capitalism, the Economic Crisis, Structurally Related Ethics Issues, and Potential Reforms," Business Ethics Quarterly 20, no. 2 (2010).
[ii] Ben Bernanke, John Campbell, and Toni Whited, "U.S. Corporate Leverage: Developments in 1987 and 1988," Brookings Papers on Economic Activity 1990, no. 1 (1990).
[iv] U.S. Federal Deposit Insurance Corporation, "Chapter 5: The LDC Debt Crisis," Volume I: An Examination of the Banking Crises of the 1980s and Early 1990s (Library of Congress, 1997), http://www.fdic.gov/bank/historical/history/vol1.html.
[v] National banks were, by law, barred from making loans to any single borrower in excess of 10% of the bank’s capital and surplus. In 1979, the U.S. Office of the Comptroller of the Currency (OCC), likely under the pressure of lobbying and against better judgment, issued an interpretation of the law that enabled banks to treat individual agencies of sovereign governments as separate entities for the 10% rule instead of aggregating them and treating them as one entity. Had it ruled the opposite way, many banks would probably have been out of compliance with the law and would have had to reduce their exposure to these loans. Source: ibid.
[vi] U.S. Federal Deposit Insurance Corporation (FDIC). “History of the Eighties — Lessons for the Future,” Volume I: An Examination of the Banking Crises of the 1980s and Early 1990s, Chapter 5: The LDC Debt Crisis, Library of Congress, 1997, accessed October 6, 2011, http://www.fdic.gov/bank/historical/history/vol1.html.
[vii] U.S. Federal Deposit Insurance Corporation, "Chapter 4: The Savings and Loan Crisis and its Relationship to Banking," Volume I: An Examination of the Banking Crises of the 1980s and Early 1990s (Library of Congress, 1997), http://www.fdic.gov/bank/historical/history/vol1.html.
[viii] ———, "The S&L Crisis: A Chrono-Bibliography," http://www.fdic.gov/bank/historical/s&l/.
[ix] Timothy Curry, and Lynn Shibut, "The Cost of the Savings and Loan Crisis: Truth and Consequences," FDIC Banking Review (2000).
[x] Paul Krugman, "What Happened to Asia?," http://web.mit.edu/krugman/www/DISINTER.html.
[xi] Jessie P.H. Poon, and Perry Martin, "The Asian Economic “Flu’: A Geography of Crisis," Professional Geographer 51, no. 2 (1999).
[xii] Giancarlo Corsetti, Paolo Pesenti, and Nouriel Roubini, "What caused the Asian currency and financial crisis?," (1999).
[xiii] The Financial Crisis Inquiry Commission, "The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States," (2011).
[xiv] Chapter 2—The Great Alignment ; Chapter 3—Defining Characteristics of Today’s Corporation
[xv] The Financial Crisis Inquiry Commission, "The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States."
[xvi] See Chapter 2, Great Alignment, for a description of the swathe of these new instruments.
[xvii] The Financial Crisis Inquiry Commission, "The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States."