[Today on OA, a guest column by Dash Riprock. Dash previously worked as a CDO underwriter at a U.S. brokerage house in New York. He currently helps evaluate fixed income derivatives for banks and insurers.]
With all the talk of bank failures and government involvement here on OptionARMageddon and throughout the media, I thought it made sense to explain a basic concept that investors and regulators use to measure solvency: how assets are “risk-weighted” in order to measure banks’ so-called “Tier 1 capital ratios.”
Rolfe (rightly) has been estimating the amount of leverage (and, by extension, a rough relative default probability) by looking at companies’ tangible assets relative to tangible equity. Again, Leverage = Assets/Equity.
Reiterating the basic definition of “tangible equity,” imagine that a company’s owner decided today that he was going out of business. He holds a going-out-of-business sale and sells everything—buildings, office equipment, any securities the company held, and so on. Once he has sold all his assets, he uses the proceeds to pay back all his lenders (bonds and loans), his senior equity holders (preferred shares) and, if he’s a financial, anyone who has given him money to hold or invest (depositors). Tangible equity is what’s left after the business has been liquidated and all its debtors paid off.
Unfortunately, it is not easy for the casual investor to find tangible equity figures. For starters, when it comes to banks, it’s nearly impossible to set the value of illiquid financial assets like CDOs. But another reason investors may have trouble finding tangible equity stats is that they are rarely reported.
There are a couple of reasons for this. The most cynical perhaps: If companies reported their true tangible equity, even more investors would run for the hills. The 280x tangible leverage that Rolfe calculated earlier for Citigroup is a pretty terrifying number. For an individual with $100,000 in assets to run that leverage ratio (let’s call her Cindy), she would need to borrow $27.9 million. Even the worst mortgage banker wasn’t handing that type of money out to borrowers, which is why you could imagine Citi investors weren’t totally comfortable with their position.
But the more accurate reason that banks don’t report leverage numbers like ‘tangible equity’ is because the balance sheet is only half the story. Let’s look at Cindy again: she has $100,000 of assets to start and is borrowing $27.9 million for a total of $28 million, and she is planning on investing that money in good faith, because she wants to pay her lenders back. So she is considering two business plans:
- Investing all $28 million into BBB-debt (rated Baa2/BBB by Moody’s/S&P)
- Investing $20 million into short term (less than 1-year) treasuries and $8 million in AAA-debt (rated Aaa/AAA by Moody’s/S&P)
Now in both cases Cindy has an assets-to-tangible-equity leverage ratio on her investments of 280x. But in case 1, the risk of loss on her investment is much, much higher than in the second. In fact, if Cindy can borrow at a rate around treasuries (maybe she locked in some great rates when the market was lending money to anyone and everyone) then case 2 might be an ok deal for everyone involved.
So how do you compare the relative risks of the two situations? You adjust the leverage for the relative risk of the portfolios. This is known as risk-weighting and became a key part of bank analysis after Basel I in 1992.