Loss spiral & margin spiral

[Imad]

Hi David,

Hope you are well.
I need a clarification on above subject. To my understanding, leverage ratio is debt to equity, however, in your notes (page 45 "current issues"), there was the following example:

***For example, consider an investor who buys $100 million worth of assets on 10% margin. This investor finances only $10 million with its own capital and borrows $90 million. The leverage ratio is 10. ***

If we consider debt as $90 and equity as $10, the leverage ratio should be 9. Am I right?

Thanks for your help.

 

[David Harper CFA FRM]

Hi Imad,

I am doing well, thank you, I hope you are too (and i hope studies are going well?).

You make a good point, leverage ratio is, and can be, defined as debt/equity. In a two-class (simple) capital structure, as assets (A) = debt (D) + equity (E):
leverage A/E = (D+E)/E = D/E + 1 = leverage D/E + 1; in this case,
your definition 9 + 1 = Brunnermeier's definition 10 (i.e., my notes are sourcing the assigne "Deciphering the Liquidity and Credit Crunch of 2007-08" where he defines leverage as assets/equity).

So, both are correct. Further, please note, leverage can also be E/A or E/D; e.g., leverage of A/E can also be expressed as 10% E/A

However, I find assets/equity more convenient:
1. It is Basel's definition; the new B3 net leverage ratio is 3.0%, which while not precisely defined yet (to my knowledge) refers to equity/asset (not equity/debt);
2. If you have more than 2 classes, including hybrid instruments, assets/equity does not risk omitting liability tranches (as opposed to building up the numerator);
3. fwiw, assets/equity is the CFA's definition (so more likely to be consistent with credentialed practitioners, a minor point)

I hope that's helpful, thanks, David