Financial leverage and where to find it

Financial leverage is a bit like caffeine. You can get by without it, but using it sparely can help you get through a rough batch. Constant usage, however, can result in overdependence—and the resulting crash is not pretty.

On their blog today, Stephen G. Cecchetti of the Brandeis International Business School and Kremit L. Schoenholtz of New York University’s Stern School of Business detail the role of debt in financial crises. The two academics note that the equity-driven recession of the early 2000s—the so called “dot-com recession”—did not drag the U.S. economy into a prolonged downturn because companies had not loaded up on piles of debt. This lack of leverage among companies rendered the 2000 recession mild compared to the Great Recession of 2007-2009, when imploding mortgage debt among individual homeowners, financial institutions, institutional investors, and other financial intermediaries that purchased these mortgages sank the global economy.

In their piece, Cecchetti and Schoenholtz note that they have yet to find any source that reports the risks that some financial intermediaries are taking in today’s real estate market. That means researchers and regulators are most likely unaware of many of the leveraged risks being taken in the real estate sector. Our understanding is further hindered because we also lack a real-time source of information of the distribution of household leverage.

How is it that such information about leverage and its role of as a financial accelerant is largely missing? After all, researchers and regulators spend a large amount of time figuring out how to measure bank balance sheets. The issue, though, is the amount of debt and assets that are off-balance sheet. Cecchetti and Schoenholtz mention the development of special investment vehicles in the years before the housing and financial crises in the previous decade. These off-balance sheet investments allowed banks to take on even more debt, but their leverage appeared unaffected. In short, the banks could make investments that could reap great returns but hide the risk.

Cecchetti and Schoenholtz focus their piece on the role of leverage in companies, but the story of increasing household debt can be even more important. As Atif Mian of Princeton University and Amir Sufi of the University of Chicago document, prior to the Great Recession household leverage increased dramatically as households took on more and more mortgage debt. The areas that saw housing prices drop the most then saw significant reductions in consumer spending. And the increase in household leverage was evident across the rich economies in the run up to the Great Recession.

Considering how intertwined the housing market has become with the financial system, the twin increases in leverage can be a toxic mix. We would all be better served if these dangerous gaps in our knowledge were filled.