Financial crises are often preceded by rapid increases in leverage, known as a credit boom. But what exactly is leverage? And why can it leave the economy more vulnerable to an economic downturn?

Leverage is a strategy used by businesses and individuals to maximise the potential of their investments by using borrowed funds instead of their own funds, essentially borrowing to invest. In other words, it is the ratio of assets (investment) to equity, and involves the use of debt to finance business operations or investment projects, allowing them to invest more capital than they have thanks to the loan they have taken up.

This method is based on the idea that the cost of borrowing can be lower than the return generated by the investments that are financed with these loans. The leverage effect is positive when the economic return on the investment is higher than the cost of financing, or negative when the return is lower than the cost of financing. This implies that leverage carries a risk, since if the investments do not generate sufficient return to cover the cost of borrowing, the investor may have difficulty repaying his debt.

This is a practice that, when applied in a macroeconomic context, can be a double-edged sword. On the one hand, it can stimulate GDP growth or economic recovery during an economic downturn, but on the other hand, a high level of leverage can expose the economy to a slowdown in activity or an increase in asset prices. Thus, creating a debt bubble fuelled by what is known as a credit boom.

A cyclical dynamic of asset accumulation, crises and asset devaluation

The excessive leverage accumulated by the banking sector significantly aggravated the 2008 financial crisis, which originated in the bursting of the housing bubble in the United States in 2006. An economic disaster that ruined millions of people and triggered a liquidity crisis that led to the bankruptcy of large companies.

Banks were forced to reduce their leverage as a result of rising funding costs – largely due to defaults – and because of regulatory pressures to achieve an adequate level of capital. Some financial institutions such as Lehman Brothers were unable to cope with the collapse of their huge mortgage-backed investment portfolio, four times the value of their shareholders’ equity.

But this unprecedented banking collapse did not come as an equal surprise to everyone. Nouriel Roubini, professor emeritus at New York University’s Stem School of Business, warned at an International Monetary Fund seminar in September 2006 that sustained home appreciation had induced many homeowners to take out second mortgages, which they would now be unable to pay, and that the country was therefore heading for “the worst housing crisis in decades”.

Unsustainable long-term debt

Roubini himself warns that even today, banks are one of the most highly leveraged sectors and that supporting greater liquidity will not prevent a financial crisis and economic recession. Moreover, unlike the 2008 scenario, it is not only banks but the investment market sector that could be affected.

Banks are facing much higher capital costs due to higher interest rates on new loans and on liabilities they have already sold. These higher rates are causing massive losses to creditors holding assets with long-term yields, which may cause a debt crisis, with high public and private deficits.

This increase in the cost of credit together with the generalised rise in prices is undermining the purchasing power and solvency of households and businesses. It is foreseeable that many of them will default on their loans and defaults will soon spread throughout the financial ecosystem. Moreover, Roubini argues that “most depositors are fools and will keep their money in accounts with an interest rate close to 0% when they could be earning 4% or more”.

And it is true that the market offers highly secure investment options that give higher returns than bank deposits, but whether we opt for safe securities such as precious metals or insured investment products, it is imperative to protect our savings in the face of a crisis that seems inevitable.

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