Leveraging and greed

Businesses are greedy. They like to earn a ROE (return on equity ) of 15% to 20% per year. This can only be achieved by taking excessive risk, through leveraging (i.e. borrowing several times of their equity).

In a competitive market, a business can earn a return of say 8% per annum. If all the capital is funded by equity, the ROE is 8% and the risk is low.

If they issue a bond at 5% of the same amount as equity (i.e. leverage of 1 time), they hope to earn the difference of 3% on the bond. This will give a return of 8% + 3% on the equity, i.e. 11%. This is risky as the interest on the bond has to be paid first from the profit.

If they are greedy and are leveraged 2 times, they hope to earn 8% + 2 X 3% or a total of 14% on the equity. This is more risky compared to a leverage of 1 time.

Some investment banks were leveraged 20 times. This is madness.

To make matters worse, the borrowings were made on 30 or 90 days credit, instead of long term bonds. During good times, the cost of short term credit is lower than the cost of bonds. The businesses were greedy to make higher profits on the spread. This is extreme madness.

During the financial crisis, they were not able to get new borrowings to repay back the old borrowings. This lead to the collapse of the global financial system.

In the new financial system, there has to be regulatory control over the amount of leveraging. especially for financial companies, including hedge funds.