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?
The problem with leverage has nothing to do with assets and liabilitys.
The problem is that leverage amplifys the penaltys and benefits of correct
So if the mortgages are toxic debt in the sense that they will see a lot of
arent assets and become liabilitys when you cant get rid of the mortgaged
I totally understand the principle of leverage and how it accelerates
bankruptcy. My question arised after reading about American and
European banks and their capital structure on http://valtenbergs.com/archives/601
They compared European banks, which had a very high leverage ratio
when compared to American banks. However, I would think that a bank
which has a lot of depositiors and very few borrowers is a more
prudent bank. Of course, they probably aren't making much money.
According to my calculations, the HIGHER the leverage ratio (i.e.
(liabilities + equities)/(equities) ), the more solvent is the bank.
All depositors are liabilities, remember. Moreover, assets is always
equal to liab. + equities.
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.
On Thu, 23 Oct 2008 11:25:12 -0700, 2.7182818284590... wrote:
i don't know what you're asking but if you can accept the question being
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...)
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
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
Now it seems like a lot of people got it wrong.
Thanks - kind of answers the question I posted a week ago re: Bank
Clearly, the more highly leveraged bank is in the more tenuous
position, and is the least 'liquid' - there is very little margin for
them to weather a downturn in their assets.(Would you consider
yourself more liquid if you owed 10x your net worth, or only 1x your
I would like to know how Wachovia went from a 10Q stating $812 billion
total assets to selling itself on the street corner for $17 billion. I
read over their 10Q and could not find indications of a $795 billion
write down. Finally it dawned on me that the place to look would be
the year to year increases in liability accounts such as long term
loans. If the bank borrowed $40 billion (not unseemly for an $812
billion dollar balance sheet) and used that to buy 20x leveraged
CDO's, well, there is $800 billion in mark-down-able CDO's. Trouble
is, I didn't see where they stated such holdings of CDO's. So the
mystery remains, and remains ... how do you hide an elephant in a
swimming pool? Cramer's Wall of Shame has Steele's picture on it.
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