Leverage - What is it good for?

We all know by now that the process of deleveraging is causing a sizeable deflationary pressure. And that the process - when it occurs systematically - creates a devastating feedback loop. Banks, predominantly, see the market price of their assets fall, their debt-to-equity ratio swings up into the red/danger sector of the gauge, they are forced to sell assets to pay off debts, depressing asset prices further, leading to even more deleveraging. It is painful medicine.

What about leveraging though? How did we get so leveraged in the first place?

If we look at the economic and financial theory - which of course is based on a number of unrealistic assumptions about the efficiency of the market - then there is no reason for investors to prefer debt to equity. An efficient market should ensure that the risk and likely return are in line. Of course, debt carries a preferential claim on the assets of the business. Debt is lower risk than equity, but that gets priced in. So in an efficient market the market value of debt and equity is the same.

In practice, there are often strong tax incentives to finance through debt rather than equity. A common inefficiency is the taxation of dividends but not interest paid on debt. Companies have already paid corporation tax by the time they get around to servicing their debt. But so they have when they get around to paying dividends to shareholders. The market is then skewed in favour of debt financing.

The main textbook purpose of leverage is to improve shareholder returns. If a company needs to raise finance for a new venture they have two options: they can issue new shares or borrow money, either directly from the bank or by issuing bonds. If you are a shareholder which would you prefer? You shouldn't mind issuing new shares. Your equity will be diluted but the capital of the company is increased by a like amount. But it means that you have to share future returns with the new shareholders. Conversely, debt usually involves fixed payments. If the company outperforms the market then rather than having to share that with the new investors you only pay them a fixed coupon and you keep more for yourself. If it goes pear-shaped, of course, you only get what's left over after the creditors have taken their dues.

But here's the thing. You hold shares in a company because you think it's a good investment. Shareholders are already of the opinion that the company will outperform, otherwise they'd sell up and invest elsewhere. They have inbuilt bias towards leveraging the company to get new long-term financing.

In the short term, leveraging up usually looks like a good idea. Businesses tend to finance new ventures when the economy is on the up. Profits go up because of generally increasing prosperity (so-called 'beta') rather than any special magic ('alpha'). Leverage makes mediocre companies look good in good times. This pushes up share prices, thus massaging leverage ratios downward, encouraging the company to take on even more leverage. In other words, it's the reverse of the deleveraging feedback loop described earlier.

Let's take a step back at this point. From the macroeconomic point of view, what is the effect of leverage. In the first instance, it doesn't really generate greater return on capital. It apportions the profits in different amounts to different investors. There may be a marginal effect of getting cheaper finance by catering to different risk appetites but leverage is one of the reasons that equity values are so volatile in the first place. The two most significant effects of leverage though are negative.

In the first place, leverage makes business less agile, less able to change direction with the economy. They go full steam ahead in good times, and when the downturn comes and the brakes come on, you end up with a train wreck. Arguably, this would not happen if investors discounted future contingencies properly but recent events have shown quite conclusively that the market is often quite short-sighted.

The second problem with leverage is that it obfuscates the real performance of business ventures. In good times, leveraged equity performs better and is valued higher. Again with entirely efficient markets this would not happen. But we must deal with the system as it is, rather than how we would wish it to be. This obfuscation interferes with the purpose of the financial system, which is to allocate capital to where it provides the best return. Leverage creates (or at least exacerbates) market inefficiency.

The conclusion is this, leverage - long-term debt financing of business - carries hidden costs for the economy that real world markets do not adequately price in. On top of that, tax regimes often skew the market in favour of leveraged finance. Policy-makers should do the opposite. There should be disincentives to leverage.