An individual investor can use "leverage" to increase profit from stock market speculation. While the strategy magnifies possible profits, it also magnifies possible losses. The investor takes his or her own money, or "capital," and then leverages it with "debt"--loans from a broker--and purchases more stock. The size of the investor's "bet" on changes in "the market" can be increased by leverage.
How does this relate to leverage in financing a business? Leverage in business finance is the ratio of debt to equity. If a firm has a net worth of $100 million, and has borrowed $200 million, then its leverage is $200 million/ $100 million = 2.
Surely, if firms are over-leveraged, they are gambling with economic disaster?
How does excessive leverage of firms supposedly relate to recession? The theory is simple. Suppose corporate America is over-leveraged. Firms whose debt is already excessive cannot borrow additional funds to purchase capital goods--machines, buildings and equipment. Worse, existing cash flow must be used to pay down excessive debt rather than purchase capital goods. Firms in capital goods industries suffer reduced sales and respond at least partly by reducing production. Workers are laid off. The result is recession.
However, this theory is based on a fallacy of composition. When an individual firm borrows less or repays debts, it may purchase fewer capital goods. However, the potential lenders have the funds they didn't lend. The creditors receiving repayment have additional funds.
When thinking about the capital expenditures of a single firm, what happens to the funds it doesn't borrow or that it uses to pay down its debts can be ignored. But when considering the entire economy, all funds must be accounted for. What do the potential lenders or former creditors do with the funds? They don't have to spend them on capital goods. Certainly, it is possible for there to be a shift of expenditure away from purchases of capital goods by firms and towards purchases of consumer goods by households.
But leaving aside an imbalance between the quantity of money and the demand to hold money, "over-leverage" by firms does not cause reduced nominal expenditure by all firms and households.
Oddly enough, if the firms are truly "over-leveraged," then those receiving the debt repayments "should" purchase equity claims against firms. The firms should continue to fund purchases of capital goods exactly as before, but financed by equity rather than debt. In fact, the obvious solution to over-leveraged firms is debt-to-equity swaps, with former debt-holders becoming stockholders!
Before trying to explain that odd assertion, there is also a theory by which "over-leveraged" firms are associated with excess capacity and overproduction. The firms borrow money to expand productive capacity. When they attempt to use that capacity and produce goods and services, there is over-production. The over-leverage has caused excess capacity.
Why is the theory of over-leverage, overproduction, and recession so seductive? It applies to the individual firm nicely. Suppose a businessman or woman, a sole proprietor, is making profits and sees an opportunity to expand his or her operation. Much of the profit is being plowed back into the firm as new investment, adding to productive capacity, and earning more profit.
Perhaps this businessman could leverage the operation, by borrowing money and expanding even more. Assuming the profit generated by the additional investment covers the interest cost of the funds, the proprietor adds to his or her profit. Unfortunately, if operations are unprofitable, interest on the loan must still be paid. This added expense will magnify losses as well.
The proprietor, then, is in a similar situation to the stock speculator who seeks to "leverage" his or her capital, by borrowing from the broker, purchasing more stock, adding to the size of his or her "bet" on "the market." The proprietor's bet is on the market for his or her product and usually the interest expense of loans weighs heavily against the profits from expansion. Still, the leverage allows profits to be magnified, but only by adding to the risk of magnified losses. If the demand for the product is insufficient, the result could be bankruptcy. The proprietor might lose his or her business.
Further, since the debt is being used to build real productive capacity, there is a natural identification of the increased leverage with increased capacity. If the capacity turns out to be excess in retrospect, with losses and even bankruptcy as a result, then "clearly," the leverage was excessive.
Switching away from the personal finance or business management perspective of the individual investor or businessman "leveraging" his or her own"capital" and instead thinking about the economics of the firm, profit opportunities require finance. Equity investment comes from owners, and debt finance comes from lenders, but both are alternative methods of funding profitable activity. The owners serve as residual claimant, and so reap extra gain and are the first to suffer loss. However, if the losses are so great that the equity investors lose everything, then the debt holders no longer receive all of their promised share of the gain, and also take a loss.
Rather than the owner leveraging his or her capital, investors are funding productive activity, and the division between equity and debt finance is a way of sharing the risk that is inherent in productive activity.
Taking a macroeconomic perspective, there are a variety of firms that must fund their activities through either debt or equity. They must either borrow, or bring in new partners, such as shareholders. From the point of view of the investors, they must either lend to the firms, say, by purchasing the bonds they issue, or else make equity investments, by purchasing shares of ownership. The leverage of firms--the division of finance between equity and debt--isn't about the proper allocation of productive capacity among firms or in aggregate, but rather about the sharing of risk among investors.
As for the expansion of capacity, the key question is whether or not it is value enhancing. Are the extra goods and services that can be produced worth more than the opportunity cost-- the goods and services that cannot be produced because the resources were used to expand capacity.
For a single firm, an expansion of its productive capacity is, for the most part, a shift of resources away from other firms. "Excess" capacity is a situation where the resources could have been used by other firms to produce other, more valuable goods or services.
However, from a macroeconomic perspective, aggregate net investment is an expansion in the productive capacity of all firms, and it comes at the expense of the current production of consumer goods. The relevant issue is whether the consumer goods that can be produced in the future are worth more than the consumer goods that must be sacrificed now--taking into account marginal time preference--when do people prefer to consume goods and services.
A single firm could have no leverage, and still have overcapacity. It could be financed entirely by equity, but be utilizing resources that dould be more profitably utilized to by other firms to produce other goods and services. The owners would lose money and would be motivated to curtail operations and eventually will run out of money and be forced to curtail operations. If the firm truly has no debt, it cannot go bankrupt, but it can still fail.
Similarly, it would be possible for no firm to have any leverage, and still, in aggregate, for the firms to devote too many resources to produce capital goods, and not enough to produce consumer goods in the present. It is even possible for net investment to turn negative, so that existing capital goods are not replaced, and resources are used to produce consumer goods and services at levels that cannot be sustained in the long run.
Given how much productive capacity is appropriate both in aggregate and for various indistries and firms, there is the separate question of how it should be financed. Returning to the individual firm, it isn't simply a possible expansion that must be considered. How much of the firm's total activity should be funded by equity and how much by debt? Perhaps the existing owner should sell out and put his "capital" in a bond mutual fund. Perhaps the existing level of equity investment is too high, and the new owners will fund more of the firm's existing operations with debt.
If the firm is over-leveraged, then it needs to finance more or of its activity by equity and less by debt. New partners--say, shareholders--need to be brought in, and the proceeds used to pay off debt.
If the firm needs to expand because there are profitable opportunities, and it is already over-leveraged, then it should expand by bringing in new owners--sell new shares. It should still expand, but by using equity finance.
From a macroeconomic perspective, to say that all firms are over-leveraged is not to say that have expanded too much or have excess capacity. It is rather to say that they should be funding their activities with equity rather than debt. They should be selling stock and paying off debts.
Equally important, if firms are "over-leveraged" that means that investors should be buying stock rather than bonds. As firms pay down their debts, those investors receiving the repayments should be buying stock to fund the profitable activities of the firms.
And so, the solution to over-leveraged firms is debt-to-equity conversions. Some debt-holders should become stockholders.
But suppose the bond-holders don't want to hold more equity? If investors want to hold bonds rather than stock, then the firms aren't over-leveraged. What can over-leverage mean other than the existing debt to equity ratio fails to reflect the preferences of investors?
But what if investors don't want to hold stock or bonds? It is, of course, possible that people would prefer to spend their incomes on consumer goods and services rather than save and accumulate assets. If that is true, then firms should not be expanding capacity because the resources are needed to produce consumer goods and services now.
But suppose people want to save, but not by purchasing risky assets like stocks or bonds issued by leveraged firms. Suppose they want to save by accumulating riskless assets? And suppose the market clearing interest rate on such assets would be zero, or even negative? Can't households still save by just accumulating money? Yes, that is possible. And an imbalance between the quantity of money and the amount of money people choose to hold is the problem. Worry about over-leveraged firms is a diversion.