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