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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

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closed as off-topic by Alex C, skoestlmeier, amdopt, Daneel Olivaw, Attack68 Apr 20 at 20:23

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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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  • $\begingroup$ Shouldn't the liability be 400K? Because the asset is worth 500K, but the loan from the bank covers only 400K $\endgroup$ – Lukas Apr 9 at 8:08
  • $\begingroup$ Are you familiar with how a lever works ? en.wikipedia.org/wiki/Lever You put a weight at one end and it balances another weight at the other end. In this case the "weights" are the 500K house and the 100K payment that you used to "lift up" the house. $\endgroup$ – Alex C Apr 9 at 12:17

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