Leveraged financing is debt financing above the norm. Mezzanine debt and covered debt obligations (CDOs) are two forms of leverage. CDOs can reduce interest rates by using collateral, such as real estate, to reduce lender risk. Mortgage-backed securities (MBS) have been sold to investors in tranches based on perceived risks and expected returns, but leverage can be risky.
Leveraged financing refers to debt financing, usually of a business, that is above the norm. Businesses have two ways to finance their operations: debt and equity. Equity financing is done for a small business by the owner using his personal funds to keep the business going. A larger company will issue shares.
A business of any size may require additional funds for operation or expansion. Banks lend to businesses, usually in the form of a revolving credit line. This means that the company will draw money from the bank when it needs it, then repay it when sales create profits. For example, retail chains see most of their profits close to Christmas and will likely use a line of credit in the fall to finance an inventory boost for next season. Long-term corporate debt is financed by bond issuance.
Debt beyond these sources is leverage. One well understood approach is called mezzanine debt. The company issues bonds with warrants attached. A warrant provides the lender with a “stock kicker,” the option to buy a specified amount of stock at a specified price for a specified period of time. Equity kicker financing appeals because the lender agrees to a lower interest rate, making it easier for the business to succeed, but gets the opportunity for an above-market return by exercising the option to buy stock. An option is usually exercised only if the price of the stock exceeds the price specified in the option.
Leveraged financing can take another form called covered debt obligations (CDOs). Any form of collateral may be used, including machinery, equipment, real estate and gold. The reason for using a CDO rather than pure debt is to reduce the interest rate the company pays by reducing lender risk. In the early 21st century, many large banks used real estate to create CDOs called mortgage-backed securities (MBS).
The MBS have been sold to hedge funds, other banks and corporate investors in amounts estimated in excess of $10 trillion US dollars (USD). The MBS have been divided into groups or tranches based on perceived risks and expected returns. Individual tranches were rated by credit rating agencies, then sold to the buyer who wanted the features offered by MBS in that tranche. As subsequent events have shown, leverage can be quite risky and even world-sized banks can be destroyed by its use.
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