Leverage

What Is Leverage?

Leverage is the use of borrowed money to increase the size of an investment or business position. By putting up a small amount of their own capital and borrowing the rest, investors and institutions can control much larger positions than their cash alone would allow, magnifying gains when prices rise. The danger is symmetrical: leverage also magnifies losses, and a relatively small decline in the value of a leveraged asset can wipe out the borrower's stake entirely. Leverage appears throughout financial crises, from margin buying and leveraged investment trusts before the 1929 crash to the heavy borrowing behind the mid-2000s housing bust.

Why It Matters

Leverage matters because it is often what turns a market decline into a crisis. When highly leveraged investors face losses, they must sell assets to repay debt, and that forced selling can drive prices down further, forcing still more sales in a downward spiral. In the 1920s, leveraged investment trusts amplified both the boom and the losses that followed. Before Black Monday in 1987, tax proposals limiting debt used for leveraged corporate buyouts added to market jitters. In 2008, excessive leverage across banks and households made the system fragile, prompting later capital rules like Basel III designed to limit how much institutions can borrow.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank:

• What type of leveraged investment vehicle, similar to today's closed-end funds, proliferated in the late 1920s and amplified investor losses after the crash?
  Investment trusts
• Some analysts linked the crash partly to proposed U.S. tax legislation that would have limited the deductibility of debt used to finance what type of corporate activity, common in the 1980s?
  Corporate takeovers (leveraged buyouts)
• What October 13, 1989 stock market decline, triggered by the collapse of a proposed leveraged buyout of United Airlines' parent company, tested the circuit-breaker reforms adopted after Black Monday?
  The "Friday the 13th mini-crash" (the Dow fell about 190 points)