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What is Financial Leverage?

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This is the idea of borrowing money in order to invest.

The idea: raise more money than was otherwise available and invest that money to produce profits — whether we’re talking about buying assets in financial markets or corporate investments in new projects. If the profits are strong enough, the debt can be repaid without issue.

Take these examples: A person borrows against a house that can hopefully rise in value. A business borrows against new equipment so it can produce new products and generate sales.

Sophisticated investors may borrow against equities or bonds they think are worth a lot.

But what happens if the ratio of debt to value produced expands too much? Basically, what happens if there’s a lot of debt compared to what people or businesses can actually produce?

There’s a risk that that’s happening right now, although many agree it’s a risk the U.S. must withstand.

Currently, the U.S. Treasury Department is borrowing gobs of money (by issuing new treasury bonds) to help fund its stimulus programs so that you can get your stimulus check and so the small business administration can allocate for the paycheck protection program.

Corporations are also borrowing a bit, especially the ones that need cash right now to remain liquid/ Fortunately, interest rates are way lower than they were pre-virus, but there’s still a lot of borrowing going on, which can be risky.

According data from the treasury and the Congressional Budget Office, debt-to-GDP is at roughly 123%. That means for every dollar of production in the U.S., there is $1.23 of debt outstanding. The ratio was 75% in 2016, the highest it had been since World War II at that time.

Let’s be clear before we continue. Without the monetary and fiscal stimulus we’ve seen, the virus-induced recession could easily have turned into a depression.

To see how this can impact the market when the virus-induced new normal fades, watch the quick video above. 

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