I now want to introduce to the concept of leverage and then in future videos. We will talk about this more in terms of what leverage does and when it’s good and when it’s bad. And we will talk about in a lot of contexts, right now we will talk about a little bit more of the contexts of a bank. So let’s say I start off my bank again and I have 300 gold pieces of equity. And I use that for my building and that was a 100 gold pieces and then I have 200 gold pieces that I just put in into my building. Just to start off 200 gold pieces, let’s say I take a 100 gold pieces deposit.
And of course I have an off-setting checking account - 100 checking accounts that those people can add any point use, either write checks or at some point they can come back and demand their money back. Or let’s say I make out some loans for different projects, so let’s say 300 gold pieces loan A. And I do that just by giving person A or entrepreneur A or whoever took this loan out of 300 gold pieces checking account. Let me just do one more loan, let’s say I make a another loan for 300 loan B. And I can give that, I can also issued notes and all of that but let’s say I just give him a checking account. And we have explored reserve requirements and all of that.
Let’s think a little about leverage, and leverage is essentially how much assets do you control with a certain amount equity. So in our example right now, what is our equity? Our equity = 300 gold pieces, so that is equity right there. And how many assets are we controlling with those 300 gold pieces of equity? So I see I have 300, 400, 700 thousand, so assets = 1,000 gold pieces. So a lot of times people when they talk about leverage you might hear someone say two to one leverage. What that means that the ratio of the assets to the equity is 2:1.
In this case, the ratio of our assets to equity, so we have is Assets to Equity leverage is what people say. In this case, it’s 1,000 to 300 or was that 10:3? 10:3 leverage, you sell them here 10:3 leverage, you will hear people talking terms of 10:1 or 2:1 or something one. But 10:3 is a fair leverage ratio and tells you just how many assets - these are our assets right here. We are controlling with a certain amount of equity and there is a bunch of - I guess a very good reason why bank wants to do this. Because if it is making money, if it is making more money or in its assets then it’s paying on its liabilities. In theory a bank will want to take on as much leverage as possible right? Because what this original 300 investment, everytime it adds some assets and some liabilities - its going to make a difference. It’s going to make a spread on that money and so it wants to keep doing that.
But there is a downside to leverage because what if the bank, what some of these loans aren’t so good? What if some of these loans just don’t turn out to be so good, so leverage when things are good, when they go to on the upside. It kind of multiplies how much money you are going to make but as you are going to see in a matter of second. On the downside, leverage also multiplies the loss you would take. So in this situation, what happens if I had a 30% loss, let’s say I have a 50% loss on these loans that I made?
In a world without leverage, so if I didn’t all of this leverage, if I just have the same amount of assets and equity. So that in an example like this, where are my assets are equal to my equity, so 300 of assets, if my assets go down by 50%. Notice that here I have no liabilities so this all equity and these are all assets. In this example if my assets for whatever reason I take a loss, if they go down by 50%, my ne w balance sheet looks like this. 150 and 150 so my equity will also went down by 50% - I took a 50% loss because maybe I made some bad investments.
But now that I have leverage, what happens if the Value of my Assets get written down, at some point I determine that loan B - they’re probably not going to payout. And loan A maybe will payout so the value of my assets go down by 50%, so I have a 1,000 of assets. So essentially I am writing down my assets by 500, so let’s say that I think loan B is only worth 50. And I think that this only worth 50, because for whatever reason maybe I give these loans to buy, to build Real Estate or these were loans to sub-prime individuals - who knows whatever loans this were. Well they are good loans and I realize that I am going to get 300 gold pieces back; I am only going to get 50 gold pieces back. But in this situation what is my balance sheet now look like? Now that I have leverage, my balance sheet looks like this.
I have a 100 in terms of the building itself then I have 300 of gold deposits. That this product right here and then that first loan shrinks to 50 only. And that second loan shrinks to 50, so what are my total assets? This is 50 and this is 50, so I have a 100+300+250 so it’s a hundred. So I have 500 of assets which are consistent of what I said that our assets go down by 50% because I have a thousand of assets before. And then what are my liabilities? This 300 checking account, because you might have written checks to other people so it is necessarily the person, same person that I lend it to initially. But I have 700 of liabilities, so notice I now have negative equity.
Because assets = liabilities + equity, well if my assets are 500 and my liability are 700, then what is my equity? Well my equity is going to be -200, so essentially I am broke - this bank is out of business. And in this situation, there is a very good reason for people to want to get their money back. There is a very good reason to have a run on this bank because frankly - even if you give this bank all the time in the world. This bank is not going to be able to payback its money. Even if they were able to off-load these loans, it still does not have enough money to satisfy all of the demand deposits or all of the liabilities. And this situation is called insolvency, and that just means you don’t have the money - you are not good for it.
Remember, when we talk about the reserve ratio, which dealt with illiquidity. You wanted to make sure you had enough to gold left aside that when people came and said I want my gold back. And you have gold to give it to them, but if by chance people ask for more gold than you had. It doesn’t mean you are out of business; you just essentially have to tell them “can you wait a little while, while I deal with my assets and wait for those loans to get paid back.” You are still Solvent; Insolvency is when actually because of bad investments. You actually end up with less - assets than you do have liabilities and then there is nothing left over in the equity column.
And that is what is leverage is measure of, because if you have really high leverage. Then you notice when we have no leverage, you could take a 50% loss really easy. But now that we had 10:3 leverage, even a 50% loss will wipe us out, and if you had 10:1 leverage then even a 10% loss would wipe you out. So leverage really is a measure of how much cushion. So you have to take losses in the future, anyway before I run out of time.
In the next video I will actually talk about how leverages regulated within banks. But just to give you another measure of leverage because this measure I give you. If someone says 10:3 leverage it’s assets to equity, another one that some people often use in the investing world is Debt to Equity. But it’s a really a measure of the same thing, because if someone tells you Debt to Equity, you can figure out the Assets to Equity. But in this case the Debt to Equity ration before I take any losses it was what? My liabilities are - this you can view that as debt, because I owe these people that money is 700 and my equity is 300. So its 7:3 is my Debt to Equity ratio.
Anyway, see you in the next video.
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