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High Leverage = Increased Delinquencies

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With high leveraged lending comes inevitable increases in delinquencies.

High leverage has had a hand in all the financial crises that have plagued the U.S. over the decades. In fact, high leverage has long been associated with an increased level of delinquencies.

Leveraged lending involves extending loans to consumers or businesses that are already under a significant amount of debt. As such, leveraging comes with a higher risk of delinquency and winds up being more costly for both the borrower and the lender.

While high leverage has greatly improved since the financial crisis in 2008, it's steadily been on the increase. According to The Wall Street Journal, investors are increasingly seeking a sizeable income, and are taking out higher-risk loans that offer higher yields in order to realize that goal. This can result in high leveraged loans running rampant. The inflow of money into the leverage loan sector is reaching rates that haven't been seen since the Great Recession.

U.S. Household Debt Spikes

From a consumer standpoint, Americans are borrowing more than ever, especially when it comes to auto loans and student loans. Outstanding auto loans have passed the $1 trillion mark, reaching a total balance of $1.07 trillion. With a rise in debt comes an inevitable rise in delinquencies, as both 30- and 60-day delinquency rates increased in the Q2 2017 to 2.3 percent.

Student loans are even more concerning, with approximately $1.3 trillion owed in student loans. By Q4 2016, 11.2 percent of all student loan borrowers were 90 days delinquent on their loans, with many already in default.

Delinquency Rates Expected to Increase

Almost one-quarter of American banks are anticipating consumer loan delinquencies to continue increasing throughout 2017. In fact, the personal loan delinquency rate is expected to increase year-over-year for the first time since the second quarter in 2014, reaching 3.72 percent by the end of the year. And with household debt totaling $12.73 trillion, it's not hard to see why.

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Household debt and subsequent delinquencies are on the rise in the U.S., with auto loans and student loans the biggest gainers.

While big banks in the U.S. are much less leveraged today compared to what they were back in 2006 to 2008, they're still highly leveraged nonetheless. Leveraged loan issuance spiked to $345 billion in Q1 2017. And as household debt continues to rise, high leveraged loans will continue to contribute to heightened rates of delinquency.

The Great Recession - A Prime Example of High Leveraged Lending Leading to Increased Delinquencies

High leverage was a key driver in the financial debacle of 2008 when the housing market crashed following years of inflated prices well over their value based on fundamentals. In the years leading up to the economic crisis, lenders heavily practiced risky lending, extending loans to consumers who were already greatly in debt.

This risky behavior was intensified by highly-leveraged instruments, including credit default swaps and mortgage-backed securities. Inevitably, the asset bubble that continued to grow burst, leaving over 11 million households underwater by 2011.

Homeowners who were heavily-indebted began falling behind on payments and inching closer to foreclosure as the price bubble in the real estate market started to deflate. As delinquencies and eventual defaults increased, and losses in the financial sector soared, the entire financial system began to completely unravel.

While the situation may not be exactly the same as it was nearly a decade ago, the high level of household debt and increase in delinquencies we are seeing today reinforces the fact that high leverage lending is a prime driver of delinquencies.

Selling Loans to Optimize Loan Portfolios

The faster financial institutions can get risky and delinquent loan assets off the books, the better. By selling loans that are nearing delinquency and acquiring assets that are poised for profit, banks and lenders can successfully optimize their loan portfolios and subsequently reduce risk and increase profit.