Wall Street Law Blog

Leverage, the Downside; An attempt to simplify (Our top 5 posts of 2011)

THIS WEEK, WALL STREET LAW BLOG REPOSTS OUR 5 MOST VIEWED POSTS OF 2011... 

Originally posted: May 2011.

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 Stearns 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

 

Diary of a 9-11 Survivor (Our Top 5 Posts of 2011)

THIS WEEK, WALL STREET LAW BLOG REPOSTS OUR 5 MOST VIEWED POSTS OF 2011... 

This morning, the 10th anniversary of the September 11 terror attacks, I coached my daughter in her team's first soccer game of the season.  She was born nearly two years after 9/11.  Last night I watched my son play football.  On 9/11, he was 15 months old. Two weeks ago, my beautiful wife and I celebrated celebrated our fifteenth wedding anniversary.

The past ten years have been the best of my life (so far).  How different things might have been.

 ***

Do you know know where you were and what you were doing on the morning of September 11, 2001? Do you have a clear memory of the moment you first heard about the attacks?

On the morning of September 11,  I was in New York City.   I worked for Morgan Stanley in 2001. My office was on the 65th floor of Two World Trade Center (forever known to the world as the South Tower).

***

September 11, 2001-

I stepped out of the elevator right around 8:30 on the morning of September 11, 2001.   A few minutes later, I crossed the maze of cubicles that filled the interior of our floor and walked into the office of a colleague.  His wife was very pregnant. I planned to ask how she was feeling.

My colleague was at his desk reading the New York Post.   I knocked as I entered. He looked up at me.  But before either of us said a single word, we heard a tremendous roar.  It was a sound that I will never forget, a sound I cannot adequately describe.

That roar -- we now know -- was the engine of a large commercial airliner.  The plane was filled with innocent people and full of highly flammable fuel

Seconds later came a thunderous explosion, the loudest sound I have ever heard. Then, almost immediately, a shockwave radiated out from the blast.  The windows on my floor rattled. The building shuddered.  Right away we knew.  A plane - a jet plane - had slammed into One WTC.

I rushed over to an office with windows that faced the North Tower.  The guy in that office was a lawyer I passed often in the hall, but  he was the type that rarely made eye contact and I doubt we ever spoke to each other.  I think his name was Dave. 

Dave was hysterical.  He stood in front of his desk screaming "My God, My God, My God" over and over again.  

***

I cannot possibly describe everything I saw through the windows of Dave's office.  But I will try to sketch the scene in the very broadest strokes.

There was, of course, a gaping hole.  From where I stood, high in the South Tower, the hole looked massive.  Black smoke, dense and oily, poured  into the sky.   Everywhere was fire.  The flames glowed like the mid-day sun.  And then there was all of that paper.

Juxtaposed against the intensity of the surreal inferno was an incredible mass of paper that floated almost peacefully on the currents of air that swirled between the two towers.   It was paper was from offices on floors in the impact zone.  It may sound odd, but that paper reminded me of a ticker tape parade.

I stood in Dave's office, mesmerized. He kept  screaming.   And then one thought entered my mind.  It was nothing profound.  Just simple common sense.  I thought about my wife and young son. I knew I needed to get the hell out of that building.  It was the best and most important thought I've ever had.

---

I was in one of the overcrowded stairwells, still high in the South Tower, when the second plane tore through the building somewhere on the floors above me.  You cannot tell on television, but the impact made the entire building lean in one direction.  

For what seemed an eternity (but could not have been more than a few seconds), I was certain that the Tower was about to tip over and fall.  It was the one time on September 11 that I believed I was experiencing the final moments of my life. But then the building stabilized.

Ultimately, I reached the lobby.  Then the lower concourse. A police officer told me to go out through the subway.  I did.  And then the building collapsed.

***

Due mainly to sheer luck, I escaped the twin towers on 9/11/2001.  So many others, through no fault of their own, did not.  I dedicate this post to those murdered on September 11, and to the friends and family members they left behind.  

***

A lot has changed for me and my family in the past ten years.  How different things might have been...

 

 

By Brett Sherman

Editor of Wall Street Law Blog

September 11, 2011