What is leverage?
Leverage is using borrowed money to increase your potential return on investment. It is relying on debt in order to speculate. The use of leverage can make you take risks that you would not ordinarily take. The borrower is trying to earn a higher rate of return from investing than the rate in which he borrowed. Leverage can either maximize returns or maximize losses.
American banks, companies and consumers were overleveraged. Banks were leveraged at rates as high as 40 to 1. This means for every $1 of earnings; they borrowed $40. Investment banks and companies used leverage to produce extraordinary profits when the housing marking was booming. These same institutions found themselves overextended when the subprime crisis hit and their losses were magnified by the use of leverage. Banks tried to postpone their losses as long as possible but as is always the case eventually they had to pay.
I like to think of leverage like this. When I was in college and a professor would assign a term paper that was due in 4 weeks. For weeks I would do any and everything but work on the paper. I would know that the paper was due but I would keep putting it off. I kept telling myself I had more time. I figured I could go to the library, research the topic and write the paper in no time. Then the night before the paper was due; I would find myself trying to read the book, write the paper, spell check, print the paper and make it to class by 7:50 am. All I had done was overextended myself and delayed the inevitable.
That is exactly what using leverage is like. You eventually realize that you have to pay the bill. We kept borrowing money all the while knowing that the due date was rapidly approaching. Federal and state governments alike borrowed too heavily. Companies kept borrowing money so that they could fuel growth. Consumers kept borrowing so that they could buy more material goods. And what has finally happened is the bill has come due. Now we are all going through the long and painful deleveraging process of unwinding debt.