Leverage Ratio

What is the leverage ratio?

The leverage ratio is the ratio of debt to equity in a company, bank, house, etc. A high leverage ratio indicates a company, bank, home or other institution is largely financed by debt. A high leverage ratio also increases the risk of insolvency. In other words, it becomes more difficult to meet financial obligations when a highly-levered company’s assets suddenly drop in value.

Let’s take a look at a familiar, real-world example: the down payment on a house.

When you purchase a home with a mortgage from a bank, the money you put down on the property is known as “owner’s equity” -- the difference between the value of the house and the unpaid amount of your mortgage. As you make mortgage payments, your owner’s equity in the house increases.

Now, imagine that you need to sell your house, and the value of your home is now worth less than when you bought it. If you sell, you won’t make enough money from the proceeds to pay off your mortgage. This is not a good situation for you. It’s also bad for the bank.

In the video, we also cover the example of how a high leverage ratio led to the demise of Lehman Brothers leading up to the 2008 financial crisis.

Want to learn more about financial intermediaries and the Great Recession? Check out our Macro section on Savings, Investment, and the Financial System.