Questions on a bank's operations

I have a question: Since deposits are liabilities and mortgages/loans are assets, then isn't a highly leveraged bank a *GOOD* tihng? Here are two examples: Bank A: It has $1M in total assets, of which $100K is equity, and $900K is in depositor's accounts which is a liability. The leveraged position here is 10x.

Bank B: It has $1M in total assets, of which $500K is in equity, and $500K is in depositor's accounts which is a liability. The leveraged position here is 2x. However, this sounds like a stronger balance sheet, but keep in mind, they have far more in outstanding mortgages/ loans that they've financed. This is a bad thing.

On the other hand, Bank A has far less in outstanding mortgages/loans, and therefore, they are less "margined" or leveraged.

I'm confused. Which bank is in a better predicament, and what ratio would show that it's in a better predicament?

Reply to
2.7182818284590...
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The problem with leverage has nothing to do with assets and liabilitys.

The problem is that leverage amplifys the penaltys and benefits of correct financial decisions.

So if the mortgages are toxic debt in the sense that they will see a lot of defaults, they arent assets and become liabilitys when you cant get rid of the mortgaged propertys.

Reply to
Rod Speed

"2.7182818284590..." wrote

If, and only if the assets (loans) are valid and presented on the financial statements at the lower of cost or market. So that $100,000,000 loan you made on an asset that is now worth $500,000..........people want to know.

Otherwise, if the loans are all good - being paid or if the loan collateral is good - greater than the loan amount.

What has happened is the loans are not being repaid and the banks are finding the colateral is not worth the loan amount.

Reply to
Paul Thomas, CPA

i don't know what you're asking but if you can accept the question being restated as:

bank A: $1M in deposits with $900K loaned out & $100K in reserves bank B: $1M in deposits with $500K loaned out & $500K in reserves

if they both have similar loan default rates, then i'd say normally bank B would be safer. however, i think what you're getting at is that if bank A had it's reserves stored in treasuries and bank B had it's reserves stored in CDOs which had a book value of $500k but were actually only worth $50k due to the CDO market collapsing, then bank A is safer.

with mark-to-market rules bank B should have already marked down the value of it's reserves but, imo, a big part of the current credit crises is that there's not a lot of confidence that banks have properly marked down their CDOs (and how could they with no buyers at all, they'd have to write them down to zero and while that's probably what the lowest tranche CDOs are worth that's not true of the higher tranches so what value should they be written down to? that's the trillion dollar question...)

Reply to
Mike
Reply to
2.7182818284590...
2.7182818284590... wrote

defaults, they

capital structure on

Its not the number of each that matters, its the amount of money deposited and lent.

Indeed.

It much more complicated than that, particularly when runs on banks happen because the depositors have decided that you have a lot of toxic debt that you arent admitting to.

Its much more complicated than that too, particularly when you have to mark to market.

Reply to
Rod Speed

I've been thinking about the fair value question in illiquid markets, and so far my answer is value = ? .

Could there be historical precedents?

David

Reply to
David Bernier

If things are going well, and the income from the assets is more than the cost of the deposits, then Bank A will be more profitable.

But it's different when things go wrong.Say some of the loans default, so the assets are now only worth $800k.

Bank B now has assets of $800k and liabilities of $500k.So they're still solvent.The shareholders lose because their $500k equity has gone down to $300k. But anyone who buys shares knows (or should know) that they're taking a risk.

However, Bank A now has $800k in assets and $900k liabilities.So now they're bankrupt, and the government will have to bail them out.

This is the problem with fractional reserve banking.When people deposit money in a bank they expect it to be 100% safe.Loans, on the other hand, are never 100% safe.Assets can lose their value, people can lose their jobs, businesses can fail.

What the banks are trying or pretending to do is to take a bunch of risky assets and somehow make them into a risk-free asset.For a while, it looked like the banks had solved the problem. lots of people thought that by diversifying investments, hedging bets, etc.,etc., the risk could be eliminated.

Now it seems like a lot of people got it wrong.

Reply to
Andy F.

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