How did it get so BIG?

On September 15 2008, Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy protection, marking the largest bankruptcy in U.S. history. This follows the collapse of many financial institutions around the world. So how did it get so big with billions and billions of dollars of debt?

Perhaps one of the reasons could be the effect of financial leveraging. In finance, leverage (or also known as gearing) is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity. Deleveraging is the action of reducing borrowings.

Financial leverage takes the form of a loan or other borrowings (debt), the proceeds of which are reinvested with the intent to earn a greater rate of return than the cost of interest. If the firm's rate of return on assets (ROA) [also called as return on investment (ROI)] is higher than the rate of interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow. On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential returns to the investor than otherwise would have been available. The potential for loss is also greater, because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.

Margin buying is a common way of utilizing the concept of leverage in investing. An unlevered firm can be seen as an all-equity firm, whereas a levered firm is made up of ownership equity and debt. A firm's debt to equity ratio (measured at market value or book value, depending on the purpose of the analysis) is therefore an indication of its leverage. This debt to equity ratio's influence on the value of a firm is described in the Modigliani-Miller theorem. As is true of operating leverage, the degree of financial leverage measures the effect of a change in one variable on another variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (Earnings per share) that occurs as a result of a percentage change in earnings before interest and taxes.

Source: Wikipedia