Monday, 28 July 2008 01:00

Reposting: Capital, Leverage and Loss in the Banking system

Back by popular demand (and broken links) - Capital, Leverage and Loss in the Banking System.

Excerpt: As you can see, there are quite a few banks, some with well known brand names. I have defined leverage as tier 1 capital divided by average quarterly assets. Tier 1 capital ratios that drop below 6% invite regulatory intervention, which is why banks are in such a hissy fit to raise capital against the backdrop of all of all of those losses. Don't be fooled by the snake oil salesman line of "these asset values will return to a profitable position when the market gets back to normal". This is Reggie on earth beaming a message to all of those on Planet Overly Optimistic, the market is back to normal. If you lever up and buy a bunch of assets at the top of a bubble with borrowed money, you will be losing a lot on the way down. The market will not return to those bubble levels, on a real basis, for DECADES! Simple look back and let history speak for itself. Look at the charts below, and think of the morgtage and CDO assets as Yahoo stock Q1 200o. You, as a super smart banker, buy a million shares of Yahoo Stock on margin for $122 per share, using only $50 per share of your money since you are so smart, of course. Your plan is to take these shares, turn around and flip them to your clients for a profit, but all of a sudden the market drops and you are stuck with the product on your balance sheets.

yhoo.chart.gif

Well, you tell your clients that the market is acting irrational and will return, we just have to wait it out. So, you have $61,000,000 of your capital tied up in $122,000,000 of this tech stock waiting for the market to return. In the mean time, the market drops the price to $15 by the end of the year, effectively wiping clean all of your equity and forcing you to recieve the margin call from hell. But wait, you told your clients, accountants, lawyers, investors and regulators that this was temporary blip and values will return back to pre-bubble times. You see, that was Freudian slip. The asset values did return back to pre-bubble levels, but you bought your assets at the peak of a bubble, and leveraged up on top of it. When that return to the mean comes, it will devastate those who used leverage. This scenario is only using 50% leverage, or 2:1. The banks on my Doo-Doo list are using leverage above 6:1 to 11:1. Reference the first chart to see a sampling.

Last modified on Monday, 28 July 2008 01:00

10 comments

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  • Comment Link Johnny Lay Wednesday, 30 July 2008 00:10 posted by Johnny Lay

    Thanks for the advice. I have had a problem for the last few days and worse than costing money its going to cost time as i had foolishly built my watch lists on my brokerage acct. I knew this was going to be a problem but 'there was never enough time' to do it correctly. Now there will be 'time to do it over' Dammit.

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  • Comment Link James Morales Tuesday, 29 July 2008 23:45 posted by James Morales

    that Merrill deal is hysterical... they have to finance 75% of the deal just to get it off their books and their only recourse is to take the junk back!!! and the market likes it because now 'we know what the bottom is'...

    by the way TOS is excellent, i only use it to paper trade but will be moving money over there soon.. im not an active trader but I think it's great if you're sophisticated enough...

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  • Comment Link Robert Maxi Tuesday, 29 July 2008 17:58 posted by Robert Maxi

    I will second Thinkorswim here. I've got accounts with them as well as with Scottrade. I've tried placing the same order on both, with Thinkorswim filling nearly instantly and Scottrade filing only 1 out of 10 of the total order quite late. This is not an isolated occurance, so I only use my Scottrade account for my long term positions where execution time and price isn't so important. Scottrade's handling of options also it terrible compared to Thinkorswim.

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  • Comment Link Kip Coon Tuesday, 29 July 2008 13:38 posted by Kip Coon

    Thinkorswim is an excellent platform. Tons of free tutorials, outstanding charting and order execution, DIRECT ACCESS and they are NOT a broker who sells your orders. Many brokers will at times - trade against you and may or may not always get you the best price. Thinkorswim does not do this to their clients. During the major market volumes, Thinkorswim did NOT fail me on quotes and continued running. TD Ameritrade freezes often and has cost me thousands when their prices freeze on their trading platform, yet give the appearance everything is working. Stay away from TD Ameritrade. You can try Thinkorswim for free and even paper trade to get used to their platform. Great tools. They also have mobile capability to tie into your account.

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  • Comment Link charlie WILSON Tuesday, 29 July 2008 10:52 posted by charlie WILSON

    Muddlin,
    But did discharge E Trade some time back for their averace and fee greed

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  • Comment Link charlie WILSON Tuesday, 29 July 2008 10:50 posted by charlie WILSON

    Muddlin,

    Have had excellent excellent experience with Fidelity and Scottrade for some years

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  • Comment Link Johnny Lay Tuesday, 29 July 2008 07:35 posted by Johnny Lay

    Having online broker trouble. I know that is a touchy subject here. Would some of u folks send a PM with some brokers u have a GOOD experience with?

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  • Comment Link Reggie Middleton Tuesday, 29 July 2008 01:08 posted by Reggie Middleton

    I, unfortunately, do not have an existing position in Mer, so I follow the news from a cursory perspective. It is unfolding as I anticipated though. GS and MS have signiicant exposures to the two major monolines that I am sure will have to pay the piper soon. I have included a pdf detailing the exposures with each of the recent analyses.

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  • Comment Link Stephen Marshall Tuesday, 29 July 2008 01:05 posted by Stephen Marshall

    What do you think of the recent ML transaction? I remember reading your thoughts on MS and how they were particularly exposed to the monolines. From the release

    "Merrill Lynch executed an agreement to terminate all of its CDO-related hedges with XL. The transaction is expected to close in early August 2008. When the transaction closes, all of Merrill Lynch’s CDO-related hedges with XL will be terminated in exchange for an upfront cash payment to Merrill Lynch of $500 million. These hedges had a carrying value of approximately $1.0 billion at June 27, 2008. As a result of this transaction, Merrill Lynch will record a pre-tax loss of $528 million during the third quarter of 2008."

    Implies a 50% loss on closing out the hedges with XL from where they were marked at the end of Q2 (6/27/08).

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