Confidence, Leverage, and the Seesaw: Part 5 of a Series

"Too much leverage" is an often-cited and intelligent answer. The question is: "Why are the financial and credit markets, and therefore the economy, in shambles? Leverage is the financial term that relates the level of debt owed by an entity (personal or business) to the amount of capital (unencumbered assets) that it owns. 

Expressed mathematically: Leverage Ratio = Debt/Capital. A broader equation would be: Total Liabilities/Total Equity. Both ratios measure the extent by which an entity relies on debt, as opposed to its own capital, as a source of funds.

The key is to understand that the higher the Leverage Ratio, the greater the risk. Traditionally, entities are able to sustain high leverage ratios to the extent that they have steady, predictable cash flow that is timed in tandem with repayment of debt as it comes due. Consider the high-level of cash flow predictability of a utilities company (we all pay our electric bill, or else). Contrast this with the cash flow predictability of an antiques dealer. The former is in a far better position to load up on debt. 

In times of easy credit, debt is frequently repaid by borrowing elsewhere to pay existing debt and then stretching out the payment terms. This only serves to distort an entities' true debt repayment capacity.

Carrying a large amount of debt with minimal capital is not an easy task, but it can de done if conditions are just right. Think of a seesaw. It is possible to put a very light person at one end of the board (the lever) and have that lightweight (Capital Guy) lift a big, huge heavyweight (Debt Guy) as long as the right physical conditions exist: the relative weights at either end make sense, the length of the lever is appropriate, and the height and the positioning of the fulcrum along the lever is right. 

Over many years, and gradually achieved, that seesaw has managed to be calibrated to the point that the weight being lifted by Capital Guy was immense. We just kept adjusting the physical components of the seesaw, always ever so gradually. 

Then it came: JOLT!!!!! The sub-prime mess, Bear Stearns, Lehman, Freddie, Fannie, AIG, Washington Mutual, and many others. The precision of the carefully distributed seesaw proportions was given a swift and mighty shove. Debt Guy started to swing wildly and let out horrific shrieks. Capital Guy could not add enough heft quickly enough to counter. The lever started to gyrate and the fulcrum slid. Capital Guy can no longer carry Debt Guy. 

All of the "certain" seesaw proportions are a thing of the past and no one wants to trust Capital Guy's ability to carry Debt Guy as in the past. Capital Guy needs to bulk up and/or Debt Guy needs to join weight watchers.

Now we must start to re-set the balancing points in order to regain confidence of debt-carrying ability. But the seesaw first needs to stop its convulsions.