A Cause of Financial Crisis of 2008: Excessive Leverage

A Cause of Financial Crisis of 2008: Excessive Leverage

The financial crisis of 2008 was shocking and caused numerous losses. There were a series of causes contributing to this disaster, such as imprudent mortgage lending, securitization and risk models, deregulatory legislation and poor oversight, and excessive leverage and risk-taking, etc. This essay talks about excessive leverage.

The leverage always comes along with risk. When making profit, the leverage can help to expand the profit. Whereas during a business downturn, the companies which borrow too much money might be faced with bankruptcy or default, while the less-leveraged companies might survive (Bodie et al (2008), p.643).

With the usage of leverage, financial institutions can increase many times the expected gains or losses on a position or investment beyond what would be possible via a direct investment of their own funds. There are three kinds of leverage: economic, balance sheet and embedded. There is not a single measure which can capture all these three dimensions simultaneously. The first definition is based on market-dependent future cash flows. The second one is based on balance sheet concepts. The third one is based on market risk. With the aim of adding their return on equity, banks typically take use of leverage by borrowing to obtain more assets (D'Hulster, 2009).

Here is an example explaining how the leverage works. In a normal deal, a man can buy a table with his own 100 pounds. Then he can sell it to someone else for 110 pounds. Thus, he can earn a 10 pounds profit. But by using leverage, he can borrow 9900 pounds with 5% interest, and he now has 10000 pounds in hand. Then he can buy 100 tables with the money, and sell them to another for 11000 pounds. Then he pays back his 9900 pounds loan and 495 pounds interest. This time, he can earn 505 pounds profit, which is much more than the previous method. We can easily find that leverage has very strong power. But the business is not...