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What is the leverage ratio? The leverage ratio is the ratio of debt to equity in a company, bank, house, etc. A high leverage ratio indicates a company, bank, home

What is the leverage ratio?

The leverage ratio is the ratio of debt to equity in a company, bank, house, etc. A high leverage ratio indicates a company, bank, home or other institution is largely financed by debt. A high leverage ratio also increases the risk of insolvency. In other words, it becomes more difficult to meet financial obligations when a highly-levered company’s assets suddenly drop in value.

Let’s take a look at a familiar, real-world example: the down payment on a house.

When you purchase a home with a mortgage from a bank, the money you put down on the property is known as “owner’s equity” -- the difference between the value of the house and the unpaid amount of your mortgage. As you make mortgage payments, your owner’s equity in the house increases.

Now, imagine that you need to sell your house, and the value of your home is now worth less than when you bought it. If you sell, you won’t make enough money from the proceeds to pay off your mortgage. This is not a good situation for you. It’s also bad for the bank.

In the video, we also cover the example of how a high leverage ratio led to the demise of Lehman Brothers leading up to the 2008 financial crisis.

Want to learn more about financial intermediaries and the Great Recession? Check out our Macro section on Savings, Investment, and the Financial System.

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What is a leverage ratio? Let's use a housing example to break it down. Say you're buying a home that costs $100,000. When you put money down on a house that creates a kind of protective cushion. Now, the difference between the value of the house and the unpaid amount of the mortgage, that's called "owner's equity." So now, when you first buy a house, your down payment is your owner's equity. Over time, as you pay down your mortgage, and if your home value goes up, well, that means your owner's equity rises, which makes the protective cushion bigger.

 

The ratio of debt to equity, which represents how much of a protective cushion is in a home, that's called the "leverage ratio." So a 5% down payment on a $100,000 home would mean you'd have $5,000 in owner's equity, which, when compared to the mortgage of $95,000, would give you a leverage ratio of 19. And, as you pay off more of your mortgage, assuming the value of your home stays constant, your leverage ratio will fall.

 

So what's the effect of high leverage? It means that there's very little room for the price on your home to drop before the value of your house is less than the unpaid mortgage amount. That is, if you needed to sell your home to pay off your mortgage, the proceeds from the house sale would not be enough to pay off the bank. Being underwater is clearly not good for the individual homeowner.

 

But, very importantly, it's also not good for the bank. In the case of foreclosure, say the homeowner cannot keep on paying the mortgage. Well, the bank is going to get a home, but the home isn't worth enough. The bank loses money, because the value of the home is less than what the bank was expecting to receive from the homeowner, in the form of mortgage payments.

 

However, a high leverage ratio is not just a problem in the housing sector. Take the investment bank, Lehman Brothers, in 2004. It had a leverage ratio of about 20, but it continued to borrow more money. And, by 2007, that leverage ratio went as high as 44. So when Lehman Brothers' assets fell in value very quickly, in 2008, they were underwater. That is, their assets were worth less than the debt that they owed and the company was insolvent. So leverage ratio is important because it measures how leveraged a company is. And, in the case of Lehman, highly. And a company's degree of leverage, high versus low, translates directly into a measurement of risk for the shareholders.

 

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