Mortgage Leverage: Debt-to-Equity Versus Loan-to-Value

Summary

The document clarifies a leverage example involving a home purchase financed partly with a mortgage. The question contrasts a four-to-one ratio based on the loan amount relative to the buyer’s cash contribution with a five-to-one ratio based on the total asset value relative to equity. The answer identifies the latter as a total-liabilities-to-equity calculation: the property’s full value is compared with the owner’s equity stake.

It also distinguishes this debt-to-equity measure from loan-to-value, a more customary mortgage ratio. The answer cautions that calling the measure “net leverage” in this example may be an unfortunate choice, since leverage definitions vary by context and the calculation depends on whether exposure means borrowed funds or total assets. The discussion is a brief definitional clarification rather than a broader treatment of mortgage or institutional leverage.

Key ideas

• Debt-to-equity compares total liabilities with equity.
• Using the full property value as liabilities produces a different ratio than using only the mortgage amount.
• Loan-to-value is a more common mortgage measure than the ratio discussed.
• Leverage terminology depends on the numerator and denominator specified.

Tags

# How to compute the Net Leverage Ratio for a mortgage


# How to compute the Net Leverage Ratio for a mortgage












In the introduction to the 4th video of lectures series Finance I on MIT Opencurseware (https://www.youtube.com/watch?time_continue=166&v=hyc8h5T76BE), Andrews Lo talks about the net leverage ratio of Lehman&Brothers, showing that it was around 16% on 2007. To explain the meaning of this number he makes the example of a mortgage.

Let's suppose I want to by a house for \$500K. I pay \$100K (i.e. 20%) upfront and I borrow $400K from a bank. He then says that the net leverage ratio is how much I am exposed compared to how much capital I manage. In this case it is 5:1.

My question is: shouldn't it be 4:1? I am exposed by \$400K, not by $500K. I tried to Google and I saw different definitions for the leverage ratio, but none of them seems to give 5:1

## Answer by MonteCarloSims (score 0)

https://quant.stackexchange.com/a/44996

The Leverage is calculated with the Debt-to-equity ratio:

$\frac{Total Liabilities}{Total Equity}$

In your example this would be:

$\frac{500,000}{100,000}$

This ratio is not a common one when dealing with mortgages (like loan-to-value), so it might be a case of an unfortunate example.

The reason it is not 4:1 is because the ratio doesn't call for 'exposure' but 'total'.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.