Leverage by the numbers
November 24, 2008 – 2:59 am
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 taking two components of the accounting equation and putting one over the other: Assets / Equity = Leverage
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 impacts 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. F*ck 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 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.
…
(Don’t forget to read Part 2 and Part 3 of this series Leverage by the Numbers. The leverage numbers actually get scarier when you factor in “other assets”…)
Posted in accounting, bailout, banking, bankruptcy, credit crunch |
38 Responses to “Leverage by the numbers”
Didn’t GE raise $3B of pref equity from Warren Buffett ~a month ago? Don’t see this in your table.
You need to provide sources for your numbers - which SEC filings, dates etc…
Completly agree with the overall thrust though … delevering has a long way to go yet.
By Mark on Nov 24, 2008
A great point Mark….see my next post.
By RolfeWinkler on Nov 24, 2008
“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.”
That was the whole point of the system of explicit and implicit guarantees. That’s what a guarantee is, i.e., a pledge to take care of a problem if someone else can’t.
By Don the libertarian Democrat on Nov 24, 2008
the sources for my numbers are the latest form 10-q, and 10-k for each company. You can access these on edgar.gov, the SEC’s website.
By RolfeWinkler on Nov 24, 2008
The $100,000 house value scenario does not take into account the cost to sell and the cost to refinance (which is the only way to convert “equity” into usable cash). With realtor commissions at 6%, cost to sell at a minimum of 1% (title transfer, etc), the first 7% of “equity” is eaten up in non-recoverable fees (except by an increase in value translated to sales price).
With a 5% downpayment, the homeowner is immediately “upside-down.” And that doesn’t count the finance costs to purchase. $2500 finance costs to purchase a $100,000 house eats up another 2.5% in equity. Of course, these figures can be tampered with according to the rate one pays for their mortgage. But, they must be factored.
By Noel Cookman on Nov 24, 2008
Thanks Noel! Great points! I was just trying to keep the math simple for people. But you make the point very clearly that when factoring in all costs, there’s a lot less equity than you would have thought.
By RolfeWinkler on Nov 24, 2008
Your theory fails when you consider that the asset the banks have is not the house, it is the loan. Mark to market on the asset should have no effect on those bank balance sheets since they have signed contracts from buyers. once the home forecloses and the loan is gone, then the true value of the home is determined and the balance sheet is adjusted.
Many bloggers go to your site and others to learn, this article makes that fact a scary proposition.
By DigDoug on Nov 24, 2008
not sure what you mean Doug. You’re right that the bank’s asset is the loan itself, which is what I say in the post. When a borrower defaults, the bank takes possession of the home and sells it. If the proceeds it receives are less than the value of the loan balance outstanding, then the loan (the asset) has to be marked down.
As assets are written down, tangible book value per share declines, decreasing equity.
By RolfeWinkler on Nov 24, 2008
Then maybe, in homage to the “Great Depression” what’s going on now should be referred to as the “Great Transfer”
Governments have an infinitely large fund to draw on - future tax income. Who is to say “too much!” when all are doing it? True, some countries hold lots of reserves while others don’t, but aren’t those reserves measured in greenbacks? Would the little boy have ever said the emperor had no clothes if he had a gun pointed to his head?
By CB on Nov 24, 2008
“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.”
I think a lot of people are having a disconnect with this concept. Is there anyone here who can articulate what exactly this all means to the US taxpayer? -As in how will all of this actually affect us?
By Kevin on Nov 24, 2008
DigDoug,
Not sure where you live but in the states like FL, CA, NV, AZ….the mark to market is now 40-60% of the loan value…and still going down. And with the high leverage that is WAY more than enough to put many banks into insolvency. I had been trying to figure out why the banks were not aggresively moving their REO, but realized awhile ago if they were to sell REO at current market (real) prices, the list of implodes would be huge. Same reason the Derivitives auction was a little too revealing for the players involved. I’m suspecting you live in a place where the assets backing the loan have not tanked like some of the markets mentioned. There are 30-70 properties PER day on the courthouse steps here in SW FL. (Lee and Collier co. )
By Jadventur on Nov 24, 2008
What kind of accountant are you?
A = L + E cannot be replaced with L = A/E
That is not mathematically correct.
L = A/E is only divisible with the equation A = L x E ( which isn’t applicable in this case)
So please rework your spreadsheet to make assertions.
By RonW on Nov 24, 2008
Ron: In the equation A = L + E, L stands for “liabilities.”
The ratio A/E does not equal liabilities, it equals leverage. They are two different concepts entirely.
As you can see from the post above, I never say L = A/E. I said “Leverage” = A/E.
By RolfeWinkler on Nov 24, 2008
Rolfe I really like your explanation. It is very simple to a guy like me that does not know about accounting. I just want to ask you two things:
1) In the spreadsheet, does assets include level 3 assets?.
2 ) If the government is guarantying around 360 bi in Citi and Rubin is the one that designed this plan to save his skin. Does this mean that the losses in Citi up to know should be around this number?. Could it be higher? .
In case it is higher what will happen to citi and the government?
By cuervomejicano on Nov 24, 2008
I’m not convinced with your calculation. Can you explain why you have removed the intangibles from equity?
By Moose on Nov 25, 2008
How will the respective bank stocks will play out? Wells Fargo is the most prudent but they have not been rewarded with a $306B free pass. Will their stock price will languish while Citi explodes?
By Richie Cunningham on Nov 25, 2008
Thank you Rolfe for a well crafted simple and lucid explaination in your post, and for your wonderful generous patience responding questions, and teaching us all. I hear so much about “mark to market” rule how it needs to be suspended and how it causes accounting problems, inaccuracies, deceipts etc. Can you explain the controversy and opine on MTM.
By billhopen on Nov 25, 2008
First time visitor. Read a lot of explanations of leverage, and I think you did an exemplenary job of explaining it.
Maybe I can find an explanation here of something I can never understand - how can a business, expecially a heavily regulated business, have things “off balance sheet?”
I wish I could do that with my taxes (yeah, those lottery winnings are “off balnace sheet”)
By fresno dan on Nov 25, 2008
The gist of this post is good information. However, you state “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.”
But E is the book value which is almost always different from the market value (share price * number of shares outstanding).
By Brent on Nov 25, 2008
cuervo: the numbers for on-book assets include level 3 assets. Mr. Mortgage has a GREAT TABLE listing the assets of the big banks by Levels 1,2 and 3. As far as Citi’s losses, and all the banks’, it’s tough to know how big they are because they publish so little info about the assets they’re carrying. I expect the losses to be stupendously large, yes. But the point of the post is that they don’t have to be to bring down the banks. With only a sliver of tangible common equity to absorb losses, the banks would implode even if losses were modest. Hence the government bailouts.
Moose: I’ve removed intangibles because these assets can’t be converted to cash. In a bankruptcy situation, which is what all the banks are threatened with, intangibles can’t be sold for cash to pay off debts. See my post “Fannie: $100 billion ain’t enough” for a more thorough explanation of why intangibles shouldn’t be counted. Also “Citi’s Leverage”. (Just type the titles into the search bar at the top).
Richie: how will the respective bank stocks play out? I haven’t a clue. I think at this point, you might see short sellers play chicken with the government, selling the other stocks down until the Fed/Treasury step in with deals for each bank that are like Citigroup’s.
billhopen: mark-to-market means writing the value of your assets down (or up) to whatever their current fair value is. If you trade stocks, your portfolio is marked-to-market every day to reflect fluctuation share prices. This is possible because stocks trade a lot and their prices are easily determined. Not so with esoteric mortgage securities. Banks carry them on their balance sheet at one value, but currently many are worth far less. If you have to mark down assets, it wipes out equity on the other side of the equation (A = L + E). Banks would love to ignore the fact that their assets are worth less, thereby avoiding the write downs. But investors know the marks are coming, they aren’t fooled. So they beat the stocks down to reflect their true value, which I would argue is $0 for all the big banks. The only reason they continue to have positive value is the government intervention/bailouts.
fresno dan: off B/S? I may be getting too far afield with what I know here, but the principles of GAAP accounting mean that you only “consolidate” assets that you control. Consolidate just means put them on your balance sheet. But companies often have investments in other companies or special-purpose vehicles that they don’t control because they have only a minority interest for instance. Trouble arises in the case of banks (and Enron) when they only control a small portion of the equity of the off-balance sheet entities, but remain responsible for providing guarantees that the entities have liquidity, for instance. The bank stands ready to lend whatever amount is necessary to fund the losses of the off-balance sheet entities. Why there aren’t much tighter accounting rules and regulations regarding such investments boggles my mind. Did we learn nothing from Enron?
Brent: you’re right. But my point is that the market cap reflects the value of equity in the market, not the value of equity on the books. This is why stocks will typically trade at a multiple of book value, because the assets on the books are worth more than their value on the balance sheet. The problem with the banks is that the book value of assets is far lower than what’s listed on the balance sheet…
By RolfeWinkler on Nov 25, 2008
This is a great an important post! For the first time that I’m aware, we have a public look the leverage of critical individual financial institutions (inc. GE). I recall that a working group put together an industry-wide look by category (investment banks, comml. banks, credit unions, GSEs) in mid-summer, but I don’t recall ever seeing a systematic look at individual banks. Thank you!
Now that you’ve done such great work, may I make one suggestion for further work: Put together the same data for, say, end of 2007. That way we can see how the individual institutions have improved or deteriorated since, including the roll of USG injections. My guess is that the banks are continuing to deteriorate despite the taxpayer money thrown at them.
By Terry on Nov 25, 2008
I have one point on the mortgage example.
If you live in a “no recourse” state then yes the bank will have to eat the loss if the borrower walks away. But in a state like Texas which is where I live, you take out a loan and that’s what you owe. And with the new bankruptcy laws that the republican Congress rammed through recently, you’re stuck. So in these states the borrowers are gonna hurt along WITH the banks.
By Kelly on Nov 25, 2008
DB’s leverage is 86 according to your formula
By Phil on Nov 25, 2008
Interesting article. One question though. Can the big banks invest their cash assets in the stock market? And if so, what are those asset figures? It is a moving target and almost impossible to calculate if they are invested.
Could they be buying put options on competitor stocks or shorting the comex heavily? (ie JP Morgan illegally)
Basically what you are saying is that every single bank will fail because Asset values will certainly drop in this defaltionary spiral we are in.
Therefore, If I invest every dollar I have in $5 put options on each bank stock you’ve listed I will be a multi millionaire in the coming months?
Good Article. Thanks.
By Gary on Nov 26, 2008
Thanks for the simple explanation of how great the
problem is. I’m not a professional in this field whatsoever, but I was scared years ago when I saw banking and brokerage firms being allowed to merge. This created a competition of greed that allowed prudent solid banks to join the casino world of Wall Street. Nothing that has transpired since has been a surprise. The nuts and bolts of how leveraged the banks are now exceeds anything I could have imagined.
Do you agree that this is not a crisis, but a collapse of such proportion that the breadlines of the 30’s will be replaced by marauding hordes of angry former Middle class folks who will want to hang every financial pro from the
Statue of Liberty after your important and simplified message hits the mainstream?
Or is there a long-term solution?
By c j flynn on Nov 26, 2008
Rolfe,
A very interesting analysis..however for analysis, should we not compare tangible equity against risk weighted assets instead of total assets?e.g if a bank had a substantial amount of cash or other liquid assets that require lower capital, the ratio could look different..do you have any information on how TCE/RWMA ratio looks for the banks and GE?
By sridhar on Nov 26, 2008
Thank you RolfeWinkler for the explanation - I probably don’t really understand due to a lack of knowledge of accounting and maybe a lack of brains. I can understand an asset going down in value, but “The bank stands ready to lend whatever amount is necessary to fund the losses of the off-balance sheet entities” - does that mean more than 100%? I thought banks were suppose to be well divirsified and their reserves were suppose to be SOLID. Anyway, thanks for the help.
By fresno dan on Nov 26, 2008
First of a, Mark to market means banks have to write their mtg backed paper down to today’s bid. since there is no market for such paper today, the bid is 0, hence the m to m value on the bank balance sheet is 0. The paper is worth much more than 0 since all of the borrowers will not default, only a small %age of them (10 to 20 %).
Secondly, in your example every time you write down assets on the balance sheet the leverage multiple is affected. As far as off balance sheet assets, a reduction in there value would not affect the multiple because they are not a part of the numerator in the first place.
By joe on Nov 26, 2008
Gary….banks don’t typically have investments in stocks. These would qualify as Level 1 assets, for instance, which means their prices are easily determined daily. The bulk of bank assets are loans and securitized assets, not easily valued.
Sridhar—risk-weighting assets? This strikes me as missing the point. Look at Fannie and Freddie. The argument always was they never did subprime, that their assets would only fall in value a little and that their small capital position wouldn’t be an issue. First of all, they did do subprime. Anyone who says they weren’t involved in toxic mortgage paper hasn’t read the footnotes in the K. More to the point, it wouldn’t matter if they’d only been involved with prime paper, their tangible capital was so slight, even a couple % points of writedowns on their assets was enough to wipe out common equity. Same is true for our big banks after you back out intangibles and other assets. See the post right after this one to see how this impacts Citi’s leverage.
joe–off B/S assets don’t directly impact leverage, you’re right. The risk is that those off balance sheet vehicles will have to be brought back ON balance sheet. For instance, Citi’s SIVs. Investors anticipate this and measure the leverage ratio with that in mind.
By RolfeWinkler on Nov 26, 2008
sridhar–check out today’s post (11/30) explaining Tier 1 capital. The key paragraph comes at the end. Those risk-weightings are dependent on credit ratings, which we’ve learned are often a joke.
By RolfeWinkler on Nov 30, 2008
Rolfe - Interesting article, but I think that you are looking at a snapshot, not the full economic lifecycle. By that, I mean that, while the house may be worth $100,000 as real estate, it is worth $100,000 + $600 a month for 30 years to the bank. Part of the problem in all of this meltdown is that the banks and bettors are playing fast and loose with their calendars, and taking money today (in the form of fees and commissions) for earnings that haven’t happened yet. There is a massive amount of future earning that has been stripped out of much of today’s real estate market. I’m not sure how to reflect that in your chart (I am neither an accountant nor have I recently stayed in a Holiday Inn Express ;> ), but I think that it bears looking at.
By cherter on Dec 9, 2008
Cherter, that is exactly what I am saying! Banks traditionally exchanged lump sums of capital for streams of capital + interest. Same with bonds and sort of the same with CDOs. The value of these financial instruments have become based solely on their speculative value and not the fact that the poor working stiff is still paying on his upside down mortgage and the stream is preserved. A self fulfilling prophecy has been achieved where fear of what possibly could happen (risk increase) has soured the speculative value of the CDO held by the bank which results (through mark to market) in a decrease in ability to loan which results in disruption of the productive economy dependent on loans, which results in the poor working stiff losing his job and fulfilling the prophecy. The government should have used direct means to stop this compounding of risk, not thrown more fuel on the fire.
By rwatt on Apr 21, 2009
sounds like all we need is one winner to put us back on top!
By haggs on Apr 21, 2009