Tuesday, November 04, 2008

Understanding the financial crisis - Leverage

The financial crisis currently sweeping the United States and much of the world for more than a year now has claimed many innocent victims. Many people unconnected with the crisis have suffered losses of 40-50 % on their investments. The magnitude of the crisis can be judged from the fact that governments around the world have had to intervene with massive infusions of money, with the $700 billion intervention by the US leading the pack. Many financial institutions and agencies from around the world are tangled up in this mess. Among these are banks in the UK, continental Europe and Asia, sovereign wealth funds from the middle east, Singapore and Korea and governments with large foreign exchange reserves, such as China.

I have been frustrated by the reporting on this crisis, especially by the implication that the whole crisis is too complicated for anyone except the experts to understand. This I hold to be untrue. There is complexity, but most of it lies in the myriad linkages between participants in the world financial system. Part of it also arises from some unusually involved financial instruments. I believe however, that it is possible to get a pretty good grasp of the situation by abstracting those details. Thus, while you may not be able to predict which institution will fail next or which country will be jolted by the still evolving crisis, you should be able to understand why this crisis is taking place at all. Secondly, when you hear competing assertions about this one thing or that other thing being responsible for the problems, you can make your own judgements. Finally, you should be able to see the pros and cons of the proposed intervention schemes.

Leverage and its effects.
Let us first make up a model of how a financial firm works. Our firm starts with initial capital C. It then borrows money. Let us call the amount borrowed D, for debt. It then buys assets, worth A. Initially, C = A – D, or, owners' capital is the difference between assets and debt. After the initial stage, as the assets rise and fall in value, the difference between the assets and debt is referred to as owners' equity, E. So, in general, E = A – D. If the value of assets goes down enough, E can become zero or negative. If this happens, we say that the firm is insolvent. If, as in good times, the value of assets goes up, E can be greater than C, which means that the owners' equity has increased through profits.

All of this is simple enough. In fact, it applies to any entity, including households. What then is specific to financial firms ? Financial firms borrow a lot of money relative to their capital. This is known as leverage (or gearing). Leverage can be measured using A/E, or the assets-to-equity ratio. Leverage has the property of magnifying returns. For our model firm, the initial leverage is A/C. After some time passes, the assets appreciate or depreciate, yielding a percentage return (profit or loss) R. From the firm's point of view, its initial investment was C = A/L. The firm's return, therefore is

Leveraged return = (Amount of return)/(Initial investment)

= (R x A) / (A/L) = L x R

So, if the leverage ratio is 5, an asset value appreciation of 10% becomes a spectacular return of 50% on the firm's investment. The unfortunate part of this is that any losses are also magnified. Continuing with our example, a leverage ratio of 5 means that the initial capital is only a fifth (or 20%) of the initial value of the assets. If the assets fall in value by 20%, the firm becomes insolvent (the return is 5 x -20% or -100%). The creditors then take over the firm in order to try and recoup their money.

[My example of a leverage ratio of 5 is somewhat deliberate. This leverage is common in homebuying, where the buyer makes a 20% down payment. It is interesting to note that historically, real estate returns have been similar to stock returns. It is the leverage effect that makes homebuying such an enticing investment].

This simple principle of magnifying returns through leverage is employed by many financial entities, from banks to hedge funds. The difference lies in the kinds of assets they purchase and in how they borrow money. Commercial banks “borrow” by inviting deposits. Their assets (predominantly) consist of the loans they make to businesses, companies and individuals. The source of funds for insurance companies are policyholder premiums. Securities firms such as Bear Stearns or Lehman Brothers borrow from the capital markets by issuing securities of their own. Many hedge funds borrow from banks or from the established securities firms.

The creditors of a firm see equity capital as a cushion against losses and thus a buffer before their money is at risk. When the assets fall significantly in value, creditors demand that the firm raise additional capital or turn over its assets. If a firm is unable to raise capital, it files for bankruptcy in a court, seeking protection from creditors. Bankruptcy resolution takes a long time, and creditors inevitably lose a significant chunk of their money.

Banks and other financial institutions in the US have usually kept their leverage ratios at about 10. International standards usually specify a maximum leverage ratio for financial institutions of about 12. During the boom years, large securities firms in the US had much higher leverage ratios. In 2004, the US Securities and Exchange Commission, which supervises these firms, approved a waiver for five large securities firms – Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns. They promptly took advantage of the waiver. Leverage ratios of 30 and more were not uncommon. At these levels of leverage, a fall in asset values of about 3 – 4 % makes a firm insolvent. It was a disaster waiting to happen.

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