Leverage cycle

Key takeaways

Leverage cycle belongs to science; place it in that map before memorising details.
Learn the definition first, then one example that makes the definition concrete.
Connect Leverage cycle to a quantity you can measure, compute or draw — that is where exam questions come from.
Reproduce the core statement of Leverage cycle from memory before moving on to harder problems.

Reference excerpt

Leverage is defined as the ratio of the asset value to the cash needed to purchase it. The leverage cycle can be defined as the procyclical expansion and contraction of leverage over the course of the business cycle. The existence of procyclical leverage amplifies the effect on asset prices over the business cycle.

Why is leverage significant? Conventional economic theory suggests that interest rates determine the demand and supply of loans. This convention does not take into account the concept of default and hence ignores the need for collateral. When an investor buys an asset, they may use the asset as a collateral and borrow against it, however the investor will not be able to borrow the entire amount. The investor has to finance with their own capital the difference between the value of the collateral and the asset price, known as the margin. Thus the asset becomes leveraged. The need to partially finance the transaction with the investor's own capital implies that their ability to buy assets is limited by their capital at any given time. Impatient borrowers drive the interest rate higher while nervous lenders demand more collateral, a borrower's willingness to pay a higher interest to ease the concerns of the nervous lender may not necessarily satisfy the lender. Before the 2008 financial crisis, lenders were less nervous. As a result, they were willing to make subprime mortgage loans. Consider an individual who took out a subprime mortgage loan paying a high interest relative to a prime mortgage loan and putting up only 5% collateral, a leverage of 20. During the crisis, lenders become more nervous. As a result, they demand 20% as collateral, even though there is sufficient liquidity in the system. The individual who took out a subprime loan is probably not in a position to buy a house now, regardless of how low the interest rates are. Therefore, in addition to interest rates, collateral requirements should also be taken into consideration in determining the demand and supply of loans.

How does leverage affect the financial markets? Consider a simple world where there are two types of investors – Individuals and Arbitrageurs. Individual investors have limited investment opportunities in terms of relatively limited access to capital and limited information while sophisticated “arbitrageurs “ (e.g.: dealers, hedge funds, investment banks) have access to better investment opportunities over individual investors due to greater access to capital and better information. Arbitrage opportunities are created when there are differences in asset prices. Individual investors are not able to take advantage of these arbitrage opportunities but arbitrageurs can, due to better information and greater access to capital. Leverage allows arbitrageurs to take on significantly more positions. However, due to margin requirements, even arbitrageurs may potentially face financial constraints and may not be able to completely eliminate the arbitrage opportunities. It is important to note that the arbitrageur's access to external capital is not only limited but also depends on their wealth. An arbitrageur who is financially constrained, in other words, has exhausted his ability to borrow externally, becomes vulnerable in an economic downturn. In the event of a bad news, the value of the asset falls along with the wealth of the arbitrageur. The leveraged arbitrageurs then face margin calls and are forced to sell assets to meet their respective margin requirements. The flood of asset sales further leads to a loss in asset value and wealth of the arbitrageurs. The increased volatility and uncertainty can then lead to tightening margin requirements causing further forced sales of assets. The resulting change in margins mean that leverage falls. Hence, price falls more than they otherwise would due to the existence of leverage. Therefore, due to the leverage cycle (over-leveraging in good times and de-leveraging in bad times) there exists a situation that can lead to a crash before or even when there is no crash in the fundamentals. This was true in the quant hedge fund crisis in August 2007, where hedge funds hit their capital constraints and had to reduce their positions, at which point prices were driven more by liquidity considerations rather than movement in the fundamentals. During the 1998 Russian financial crisis, many hedge funds that were engaged in arbitrage strategies experienced heavy losses and had to scale down their positions. The resulting price movements accentuated the losses and triggered further liquidations. Moreover, there was financial contagion, in that price movements in some markets induced price movements in others. These events raised concerns about market disruption and systemic risk, and prompted the Federal Reserve to coordinate the rescue of Long-Term Capital Management.

… excerpt ends here. Continue reading the full article.

Worked examples

Example 1 — a first encounter with Leverage cycle

Start with the simplest possible case. Write down what Leverage cycle claims or describes in one sentence, then invent the smallest concrete situation in which that sentence is true. In science, the smallest case is usually a single object, a single equation or a single measurement. Check that every symbol or term in your sentence has a meaning in that case.

Example 2 — changing one variable

Take the situation from Example 1 and change exactly one quantity: double it, halve it, or set it to zero. Predict what should happen to Leverage cycle before you calculate. Comparing your prediction with the result is the fastest way to find out whether you understand the idea or only the words.

Example 3 — an exam-style question

Typical questions about Leverage cycle ask you to (a) state it precisely, (b) apply it to given data, and (c) explain a limitation. Practise writing all three answers in under five minutes; the third part is what separates a full-mark answer from an average one.

Applications of Leverage cycle

In research: Leverage cycle appears in science research whenever the underlying quantities have to be modelled precisely. Papers usually cite it as a starting assumption and then explore where it breaks down.
In technology and industry: Engineering practice reuses Leverage cycle in design rules, simulations and safety margins. Knowing the idea lets you read a specification sheet and understand why the numbers look the way they do.
In the classroom: Leverage cycle is common in secondary-school and first-year university syllabi. It links to neighbouring topics Financial ratios, so understanding it makes those chapters shorter.
In everyday life: Look for Leverage cycle outside the textbook — in sport, cooking, traffic, electronics or the sky above you. An example you found yourself is remembered far longer than one you were given.

How to study Leverage cycle in 20 minutes

Read the reference excerpt below once, without taking notes.
Close the page and write down what Leverage cycle means in your own words.
Compare your version with the excerpt and mark what you missed.
Work through the three examples above with pen and paper.
Explain Leverage cycle out loud to somebody else — or to Teacher Smith in the lgStudy chat.

Frequently asked questions

What is Leverage cycle in simple terms?

Leverage is defined as the ratio of the asset value to the cash needed to purchase it. The leverage cycle can be defined as the procyclical expansion and contraction of leverage over the course of the business cycle.

Why does Leverage cycle matter?

Because it connects several science ideas at once: it gives you a definition you can apply, a quantity you can calculate, and a way to check whether a result is plausible.

How should I study Leverage cycle?

Read the excerpt, restate it from memory, then work through the examples and applications listed on this page. The five-step study plan above takes about twenty minutes.

What does this page cover?

It gives you a compact reference excerpt plus original lgStudy explanations, examples, applications and study material on Leverage cycle.