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.

Debt and Leverage: Financial weapon of mass destruction

When Genius Failed
By Roger Lowenstein

When Genius Failed, by Roger Lowenstein, is the detailed history of the rise and tragic fall of Long-Term Capital Management (LTCM).LTCM was a hedge fund that brought the financial world to its knees when it lost $4 billion trading exotic derivatives.

In its heyday, LTCM was run almost entirely by PhD’s and other extremely high level academics-the best and brightest on Wall Street. Several of its members were Nobel economists- Myron Scholes and Robert Merton. These academics relied heavily upon statistical modeling to discover how markets behave. At first, these models performed beautifully and the fund was up over 30% each year for several years.

Many Wall Street banks became investors as they considered Long-Term to be making riskless profits! Of course this is foolhardy, but blind faith was bestowed upon LTCM because of the pedigree of its creators.

Roger Lowenstein explains how Long-Term became arrogant due to its success and eventually leveraged $4 billion into $100 billion in assets. This $100 billion became collateral for $1.2 trillion in derivatives exposure! With this kind of financial leverage even the most minute market move against you can wipe you out several times over. Talk about financial weapons of mass destruction! This risk did not deter Long-Term, though.

Finally in 1998, Russia defaulted on its bonds- many of which Long-Term owned. This default stirred up the world’s financial markets in a way that caused many additional losing trades for Long-Term.

By the spring of 1998, LTCM was losing several hundred million dollars per day. What did LTCM’s brilliant financial models say about all of this? The models recommended waiting out the storm.

By August 1998, LTCM had burned through almost all of its $4 billion in capital. At this point LTCM tried to exit its trades, but found it impossible, as traders all over the world were trying to exit as well.

With $1.2 trillion dollars at risk, the economy could have been devastated if LTCM’s losses continued to run its course. After much discussion, the Federal Reserve and Wall Street’s largest investment banks decided to rescue Long-Term. The banks ended up losing several hundred million dollars each.

What became of Long-Terms founders? Were they jailed or banned from the financial world? No. They went on to start another hedge fund!

http://www.stock-market-crash.net/book/genius.htm

Also read:
http://practical-ta.blogspot.com/?expref=next-blog
http://findarticles.com/p/articles/mi_m1316/is_9_32/ai_65160621/

Two important things in the capital structure of the business

Capital Structure

When looking at capital structure, try to determine two things:

1. Is the business a consumer or producer of capital? Does it constantly require capital infusions to build growth or replace assets? Warren Buffett - and many other value investors - shun businesses that cannot generate sufficient capital on their own. In fact, one of the guiding principles behind Berkshire Hathaway is the generation of excess capital by subsidiary businesses that can be deployed elsewhere.

2. Is the business properly leveraged? Overleveraged businesses are at risk and additionally burden earnings with interest payments. Under-leveraged businesses, while better than overleveraged, may not be maximizing potential returns to shareholders.