Leverage by the numbers

[mawilson 2,133]

So what is the capital cushion underneath our largest financial institutions? I spent today

compiling this spreadsheet:

Those are some ugly numbers and I’ll explain why. Citigroup’s leverage ratio of 56 means

that the bank has $56 of assets for every $1 of common equity. If the value of those assets

falls 2%, then common stockholders are wiped out. Here’s why: Assets = Liabilities + Equity.

If you understand this formula, you will understand the credit crisis. So read on…

That formula is known as “the accounting equation.” Fundamentally, it shows how an asset

(like a house) or collection of assets (like a company) is financed—either with borrowed money

or your own, with debt or with equity.

One side of the equation has to equal the other. If the assets fall in value, and not because

cash was used to pay off a liability, then equity has to fall by an equal amount. If assets fall

far enough, then equity falls below zero.

Take a house for example. A house is an asset, typically paid for with both a mortgage

(liability) and a down payment (equity). If you pay $100,000 for the house and put 20% down,

you have an $80,000 mortgage and $20,000 of equity. The leverage ratio is 5.

($100,000 asset / $20,000 equity = 5x assets/equity). Notice that we’re still using the same

formula above (A = L + E), but taking two components of it and putting one over the other

(Leverage = A / E).

A higher leverage ratio means greater potential for profit AND loss on your initial investment.

Let’s apply the accounting equation to a few scenarios. For the first two, let’s take the above

example where your leverage ratio is 5x:

• House value INCREASES $10k to $110k. Remember: Assets = Liabilities + Equity.

  $110k house = $80k mortgage + $30k equity. $10k increase on original equity investment

  of $20k = 50% return!

• House value DECREASES $10k to $90k. $90k house = $80k mortgage + $10k equity.

  $10k decrease on $20k investment = -50% return. Boo!

What if, just like so many home-borrowers did during the days of the housing bubble, you put

5% down instead of 20%? First of all, your leverage ratio jumps to 20. ($100k house / $5k

equity investment = 20x assets/equity). Let’s see how this affects returns…

• House value INCREASES $10k to $110k. $110k house = $95k mortgage + $15k equity.

  $10k increase on original equity investment of $5k = 200% return. Yippee!

• House value DECREASES $10k to $90k. $90k house = $95k mortgage - $5k equity.

  $10k decrease on $5k investment means not only have I lost my original investment, but

  now I owe $5k more than I started with. I’m upside-down on the mortgage. #### me!

In this last scenario, I keep the house as long as I keep paying the mortgage. If I default,

however, the bank forecloses and sells the house. If it can only get $90k for it, it has to take

a $5k loss on ITS asset, which was the mortgage loan.

Here’s where the rubber meets the road, where a housing crisis becomes a banking crisis.

You see, that same equation (A = L + E) applies to banks. Just like you save for a down payment

and borrow money to buy a house, a bank will take deposits, sell debt and raise equity capital

to make loans. But if the value of its loans fall, then it has to write down them down by that amount.

To keep the equation in balance, if it writes down assets, it must simultaneously write-down equity

by the same amount. Look at the last of the four scenarios above. If the borrower stops making

his payments, the bank has to foreclose and sell the house. If it recovers less in the sale than the

home-borrower owed on the mortgage, that’s the amount by which the bank has to write down its

assets.

Since the equation (A = L + E) applies to the bank, it’s important to know the bank’s leverage ratio.

As it does with our imaginary home-borrower, the leverage ratio tells us how much cushion the bank

has to lose money on the asset side of the balance sheet before equity goes negative. The higher

the leverage ratio, the less cushion. Now go back to the top and look at the table.

All of those leverage ratios are high. And they actually understate the truth. For instance, besides

the $2.1 trillion of assets Citi has ON its balance sheet, it has another $1.2 trillion OFF its balance

sheet. The only reason I didn’t include these in my calculation is I wasn’t sure how much off-balance

sheet exposures the other banks have and I wanted the leverage calculations to be consistent.

(I tried to look it up in their SEC filings, but disclosure varies by company. Citi is the only one of

the bunch that spells it out clearly.)

With such stupendously high leverage ratios, is it any wonder that bank stocks are dropping like

rocks? Common stock is just another word for common “E”quity. Market capitalization

(share price * shares outstanding) is the Equity value of a company after Liabilities are deducted

from the value of its Assets. A = L + E. If A/E is huge, then it takes only a small decline in A to

wipe out all of E.

As more Americans fall behind on their mortgages, credit card bills, auto loans, student loans, etc.,

the financial companies that own these assets and have to write them down see the value of their

equity get hammered, especially if they’ve employed excessive leverage.

Note today’s announcement by Citigroup and the government that the latter will “guarantee” (i.e.

absorb losses) for some $306 billion of Citigroup’s toxic assets. If Citigroup had to take those

losses, it would wipe them out. The same will be true for the other big banks. The Fed is already

on the hook for $29 billion of debts owed by JPM’s new subsidiary Bear Stearns. And a few weeks

ago the government agreed to guarantee $139 billion of GE’s debt. And then there’s the $100 billion

promised each to Fannie and Freddie, $150 billion for AIG.

This is the story of the housing crisis, the banking crisis and the global financial meltdown. Everyone,

everywhere was levered to the hilt, using piles of borrowed money to make leveraged bets on

everything from real estate, to stocks, to currencies, to bonds, to companies themselves (LBOs), etc.

With so many people maxing out leverage to drive returns, all it takes is a small decline in asset

prices for all of them to go bust. Unfortunately, the decline in asset prices isn’t going to be small.

Consequently, the value of equity capital will continue to get hammered.

All of these government bailouts, er, “guarantees” are simply a transfer of risk from the balance

sheets of various financial companies to governments’. To prevent “A” from falling too far, and

thereby wiping out the “E” of the financial companies, the government absorbs the assets itself,

immunizing the financial companies from loss.

The trouble is, the losses don’t just go away. Someone will lose. First it’s common shareholders.

Next it will be the U.S. taxpayer.

link

[Amby 490]

too much thinking...must rest mind

[Ban Hammer 13,346]

too much thinking...must rest mind

[mawilson 2,133]

too much thinking...must rest mind

Target audience: AJ, dalegg, britty, Lori, maybe Steven...

[Peikko 1,575]

Don't try to blame this on the white bankers. It's all the fault of black people wanting to buy houses.

[mawilson 2,133]

Don't try to blame this on the white bankers. It's all the fault of black people wanting to buy houses.

It's the fault of white and black wankers alike.

[Amby 490]

too much thinking...must rest mind

Target audience: AJ, dalegg, britty, Lori, maybe Steven...

I don't like numbers. They are not my friend. You guys can keep them.

[Peikko 1,575]

Oh please, don't try to bring reality into this!

[rocks 494]

well, i'm glad to see ge are doing badly. they are the anti christ, just like tesco.

this doesn't look good for me trying to sell my house here in blighty though.

[mawilson 2,133]

So.... who's going to collapse next, Bank of America or JP Morgan Chase?

My bets are on BoA.

[w¡n9Nµ7 §£@¥€r 123]

Very interesting post, mark. Thanks. Any idea why the Feds have been facilitating acquisitions of failing banks by Bank of America (countrywide, merrill) if they're also in so much trouble? Or are they in so much trouble because of those acquisitions?

So.... who's going to collapse next, Bank of America or JP Morgan Chase?

My bets are on BoA.

I have heard rumblings about GMAC.

[w¡n9Nµ7 §£@¥€r 123]

So I've been thinking about this.

The government has taken (or is taking) depreciating assets off the hands of the banks.

But the losses continue to come and will continue to come.

So what does the government do? If I'm reading this correctly, they have to increase the value of the asset side of the equation.

But the assets continue to depreciate. That's not going to change any time soon.

So what does a government do? Where does a government acquire new assets? And more importantly, what can a government do that a bank can not? After all, if the path to acquiring new assets was one a bank could embark on, a bank would. But they didn't. So what does a government have that banks don't?

Banks don't have the military. We have a huge military presence in the ME, how does one use that to acquire new assets to counteract the effect of depreciation in existing assets?

Is it possible the Bush-Cheney people knew this was coming and that the US military is deployed in the ME for precisely this reason?

[mRx 16]

So then these bailout loans (liabilities) are doing nothing more than increasing the leverage ratio, right?

And the government will be the one doing the write-downs, and taking the losses.

[w¡n9Nµ7 §£@¥€r 123]

So then these bailout loans (liabilities) are doing nothing more than increasing the leverage ratio, right?

And the government will be the one doing the write-downs, and taking the losses.

The federal government can increase their assets using tools at their disposal, tools banks don't have.

Only Nixon could have gone to China, isn't that what they say?

[mRx 16]

So then these bailout loans (liabilities) are doing nothing more than increasing the leverage ratio, right?

And the government will be the one doing the write-downs, and taking the losses.

The federal government can increase their assets using tools at their disposal, tools banks don't have.

By borrowing money from the Fed? That only creates more liability. My understanding is that the equity is what needs to be increased. As that would lower the leverage ratio.