Leverage and leveraged finance

Leveraged finance usually means funding a company with more debt than it is worth. Leveraged finance is used to gain specific, short term objectives like acquiring a company through buy outs or buy-ins, or parking funds in assets which generate fast and excessive returns over the cost of funding.

The Sub – Prime crisis of recent times makes it important to keep the above definition in mind. Implicit in all finance deals is the ‘down-side ‘or risk that a lot of value (money in plain terms) would simply disappear if the wrong calculations are made. In finance a lot of calculated instinct is based around the capacity of an entity to service or repay its loans. This also raises the question of faith – on the organization’s capacity to perform and therefore repay its debts along with associated costs, chiefly interest related, and returns.

Putting a lever to something means firmly positioning it to perform a task. In the language of finance, leveraging would mean to strengthen the power of a company’s funds to attract more returns by borrowing yet more funds – usually short term.  Leveraged financing is the issue of high yielding bonds or funds borrowed from banks to fund the takeover of companies or buy outs by existing members (buy in) or an outside stakeholder (takeover).

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The ratio of the company’s debts (borrowings) and the company’s return on equity (money borrowed and invested elsewhere) decides the risk rating of a borrowing entity. Simply put, the company has to earn enough to repay the cost of its borrowings and make an extremely high profit for its stakeholders. If the cash flow from the operation is negatively affected by the high cost of debt servicing or interest for borrowed funds – the position of the lender is riskier. Therefore the interest or the ‘risk cost’ will be higher. (Fletcher, 288-92)

The principle is utilized in investing in stocks. The price of a stock is a reflection of its debt to equity ratio at its market or book value.  Financial leveraging calculates the varying effects of one or the other in arriving at a ratio. It allows higher return to the investor. The loss may be higher too, for the company has to pay servicing costs for borrowings even if its stock is completely eroded.

There are levels of leverage financing - either secured bank loans or bonds or comparatively ‘less senior’ subordinated bonds or loans. A leverage financier has to calculate how the finance is to be raised. If he overestimates a company’s capacity pay back the loan, he might lend too much at very low margins. The outcome of this would be that the financier will be unable to sell these loans or bonds. Then again, if a company’s value is underestimated, then the transaction results in a huge loss. The objective of leveraged buy outs is to acquire assets without utilizing its own capital.

The following case studies illustrate the impact at different periods in recent times.

The Sub Prime Crisis

Sub Prime borrowers are those whose debt rating is ‘high risk’ – their ability to pay back their loans is considered weak by banks or financial companies. As compared to ‘prime’ borrowers like companies who are financed with ease, a sub prime or non prime borrower’s credentials are considered poor. This is because they are likely not to repay due to insufficiency of funds. They are then financed at sub prime or higher rates of interest than normal. This makes it profitable for lending institutions.

In the USA, the bulk of sub prime borrowers are people who seek to buy houses. The majority has no stable income or is in employment which does not earn enough.

Only some months back, in the USA debt was freely available to those who asked – in fact, banks fought among themselves to offer loans to leveraged takeovers and hired the services of agents to ferret out possible borrowers. But now, the markets are talking of credit squeeze. Banks are scrambling to tone up their balance sheets. What led to this problem? It is good to remember that householders, commercial banks, brokers and companies all use leverage differently.

Homeowners are said to be ‘anti cyclical’ in their leverage. When assets (in this case, property values) appreciate faster, leverage – a factor of debt to equity, decreases. When asset values shrink, leverage rises. This is because householders keep paying mortgages regardless of cycles of increase or decrease in property values or share prices. When a householder takes, say, $300,000 on a $400,000 house, he has equity of $100,000 or a leverage ratio of 3. Supposing the house price was to increases to $500,000, his equity doubles to $200,000 toning down the leverage ratio to 1:5 (Kar, 165-71)

Banks and companies are neither strongly anti nor pro cyclical, choosing fixed leverage ratios whatever happens to the market.

Investment banks and broking houses are extremely pro cyclical, ramping up their leverage as asset prices move upward. Brokers employ specialized risk based accounting which allows increased borrowing while prices are rising. Conversely, they have to borrow less as prices fall. While adjusting to risk is natural, these brokers acted against what would be prudent judgment. To explain this – an amateur might think that high priced portfolios run a higher risk. On the other hand, a ‘calm’ market would make him cautious in anticipation of a storm.

The finance professionals turn this judgment on its head through an instrument which they have devised called ‘Value at Risk’ (VAR) which considers current market values, no matter how unpredictable the market is. For example, in the valuation of complex portfolios, brokers tended to assume only recent history. A short calm period is taken to project future ‘tranquility’ for more years. So, when a real market risk is present, the ratio of VAR to valuation of assets is low. Companies would consequently be compelled to leverage more when, in fact, they should not have.

Till 2007, brokers kept increasing their portfolios of householder finance, apparently because there was apparently less risk. Just as the signal would have been to buy when prices were high, the now confusing indications, based on wrong models, led to prospects of selling when  the housing markets was turbulent. As result, brokers are left with assets of almost $300 billion of hung deals- householders had simply walked away. (King, 68-71)

The Long Term Credit Management Crisis of 1998

Another example of the failure of valuation models and the intervention of leveraged funds this crisis had a major impact on global markets.

Long Term Capital Management (LTCM), founded in 1994 by John Meriwether, decided to deal in US and other government bonds. The idea was that over time government bonds would be identical in value if released within short gaps of each other. The rate at which these bonds appreciated would be different as in the case of US government bonds which would rise in value faster. The profit would be taken from selling costlier bonds and buying cheaper bonds.

The profits did come to such an extent that LTCM had to look around for areas to invest its capital .It went into risk arbitraging -this was outside their expertise. They had to resort to highly leveraged finance to sustain return on equity. Their equity was almost 5 billion dollars against borrowings of $125 million. The proceeds were also used in investing in equity derivatives. By end August 1997, the company had lost most of its capital due to some downtrends which its managers could not read earlier –specially the Great Asian Meltdown of 1997 – and still had to pay the huge borrowing costs. Leverage had doomed the company.

The Dot Com Bubble

Through the early 90’s and till the first years of 2000, information technology was surging forward on extremely encouraging forecasts about its future in the world. Entrepreneurs were able to float technology companies, financed by venture capital which was riding on the prospects of fantastic returns. No one realized that these companies had nothing up front to offer which could be valued in rational terms. Huge leverage was sought in order to follow this boom around the world. The bubble was pricked as fast as it had been blown up – and companies and capital vanished. (Lamb, 434-38)

Works Cited

1. Fletcher, Robert. Art of Financial Economics: Beliefs and Knowledge; Believing and Knowing. Christchurch: Howard & Price. 2006
2. Kar, Pranab. History of Modern American Finance. Kolkata: Dasgupta & Chatterjee 2005
3. King, Herbert. Fiscal Fitness Today Vol. IV Plymouth: HBT & Brooks Ltd. 2005
4. Lamb, Davis. Cult to Culture: The Development of Civilization on the Strategic Strata. Wellington: National Book Tru

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