Saturday, 15 May 2010

Understanding Leverage

Leverage is easily expressed as a ratio:  assets/equity

Most banks equity:asset ratio is around 8% to 9%.  Thus, the average bank has a leverage ratio in the range of 12 to 1 or so, compared to 2 to 1 or 3 to 1 for the average company.

Given the size of the average bank's asset base relative to equity, it's not difficult to imagine a doomsday scenario.

  • Earnings serve as the first layer of protection against credit losses.  
  • If losses in a given period exceed earnings, a reserve account on the balance sheet serves as a second layer of protection.  Banks must have a pool of reserves to protect shareholders, who hold only a small stake in the company because of the leverage employed.
  • If losses in a period exceed reserves, the difference comes directly from shareholders' equity.  When losses at a bank start destroying equity, turn out the lights.

Leverage isn't evil.  It can enhance returns, but there are inherent dangers.

For example, if you buy a $100,000 home with $8,000 down, your equity is 8%.  In other words, you're leveraged 12.5 to 1, which is pretty typical for a bank.  Now, if something atypical happens and the value of your home suddenly drops to $90,000 (just 10%), your equity is gone.  You still owe the lender $92,000 but the house isn't worth that much.  You could walk away from the house $8,000 poorer and still owe $2,000.  Highly leveraged businesses put themselves in a similar situation.

This doesn't mean all leverage is bad.  As a rule, the more liquid a company's balance sheet, the more the company can be leveraged because its assets can be quickly converted to cash at a fair price.

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