Leverage, the Downside; An attempt to simplify

Leverage, which is usually expressed as a ratio, is a comparison between a company's debt and its equity.  Put more simply, a company's leverage ratio expresses how much it borrows (debt) versus how much it owns (equity). 

 

Thus, if-

(a) Investment Bank X has $100 million in cash and securities on its balance sheet; and

(b) $10 million of X's balance sheet is equity capital; and

(c) the remaining $90 million is funded by debt (bond issues, bank loans, commercial paper, repurchase agreements, etc.), then

(d) Company X has $90 milion in debt and only $10 million in shareholder equity, so it is leveraged 9:1 (If the company was separated into little $10 segments, shareholders owned only about $1 dillar for each of those segments. segment  company x borrowed the other $90)creditors paid for owned $90 of each $100 dollar segment of the company it borrows $90 out of every $100).  Reduced to its least common denominator (remember algebra?), Company X has a leverage ratio of 9:1.  So far, so good, right?

NOW, by the end of 2007, some of Wall Street's old school investment banks -- Bear Stearns, Morgan Stanley, Lehman Brothers -- were leveraged at ratios above 30:1.  Bear Stearns, as an example, was leveraged somewhere around of about 33:1.   By any measure, this is excessive leverage, and it is very risky.

Leveraged 33:1 meant that the former investment bank owned only about 3% of a balance sheet worth nearly $400 billion. The other 97% percent of Bear's assets were encumbered (subject to claims by Bear's creditors because Bear borrowed so much).

Here is the kicker - the reason why it is incredibly risky for a company to to have equity represent only 3% of its balance sheet...  Creditors have superior claims to equity-holders (typically shareholders).  IN OTHER WORDS, LOSSES ARE, AS A RULE, ALLOCATED TO SHAREHOLDERS ONLY UNTIL ALL EQUITY IS GONE. 

Therefore, if Investment Bank Z is leveraged at 33:1, and declining market conditions cause the value of Z's balance sheet assets to drop by just 3%, Bank Z's equity is wiped out.  It is insolvent. 

Still confused?  Fear not, we can illustrate with a hypothetical.

(a) In May, Z's entire balance sheet consists of collateralized debt obligations (CDOs) valued at par (they are valued at 100 cents on the dollar); but

(b) Market conditions deteriorate in June, causing CDOs values to fall from par to 97 cents on the the dollar. 

A security trading at 97 cents on the dollar doesn't sound too bad.  But for Investment Bank Z, leveraged at 33:1, 97 cents on the dollar is a complete disaster.  This 3% decline in the value of its balance sheet assets means the bell is tolling.  Z's entire equity stake is wiped out.  The company is insolvent. 

THIS IS THE DOWNSIDE OF EXCESSIVE LEVERAGE.

By Brett Sherman, Wall Street Law Blog

Comments

[Nicholas Banner, Esq.]

Now this I understand. Thank you for the informative post.