In finance, leverage (sometimes referred to as ‘gearing’ in the UK) is a general term for any technique to multiply gains and losses; common ways to attain leverage are borrowing money, buying fixed assets (non liquid assets such as real estate) and using derivatives (contracts to buy or sell something, such as call and put options respectively).
The most obvious risk of leverage is that it multiplies losses. A corporation that borrows too much money might face bankruptcy during a business downturn, while a less-levered corporation might survive. An investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%.
There is an important implicit assumption in that account, however, which is that the underlying levered asset is the same as the unlevered one. If a company borrows money to modernize, or add to its product line, or expand internationally, the additional diversification might more than offset the additional risk from leverage. Or if an investor uses a fraction of his or her portfolio to margin stock index futures and puts the rest in a money market fund, he or she might have the same volatility and expected return as an investor in an unlevered equity index fund, with a limited downside. So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly-levered hedge funds have less return volatility than unlevered bond funds, and public utilities with lots of debt are usually less risky stocks than unlevered technology companies.
There is a popular prejudice against leverage rooted in the observation that people who borrow a lot of money often end up badly. But the issue here is those people are not leveraging anything, they’re borrowing money for consumption. In finance, the general practice is to borrow money to buy an asset with a higher return than the interest on the debt. That at least might work out. People who consistently spend more than they make have a problem, but it’s overspending (or underearning), not leverage. The same point is more controversial for governments.
People sometimes borrow money out of desperation rather than calculation. That also is not leverage. But it is true that leverage sometimes increases involuntarily. When Long-Term Capital Management collapsed with over 100 to 1 leverage, it wasn’t that the principals tried to run the firm at 100 to 1 leverage, it was that as equity eroded and they were unable to liquidate positions, the leverage level was beyond their control. One hundred to one leverage was a symptom of their problems, not the cause (although, of course, part of the cause was the 27 to 1 leverage the firm was running before it got into trouble, and the 55 to 1 leverage it had been forced up to by mid-August 1998 before the real troubles started).
The financial crisis of 2007–2009, like many previous financial crises, was blamed in part on ‘excessive leverage.’ However, the word is used in several different senses. Consumers in the US and many other developed countries borrowed large amounts of money, $2.6 trillion in the United States alone. For most of this, ‘leverage’ is a euphemism as the borrowing was used to support consumption rather than to lever anything. Only people who borrowed for investment, such as speculative house purchases or buying stocks, were using leverage in the financial sense. Financial institutions were highly levered. Lehman Brothers, for example, in its last annual financial statements, showed accounting leverage of 30.7 times.
The Daily Omnivore 
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