Bear Stearns: RIP, Part II

In my last post I talked about the collapse of Bear Stearns in terms of liquidity. What happened was an old fashioned run on the bank. But the other half of the story was leverage.

Leverage is a measure of the ratio of debt to equity, equity being the cash money that investors put in to a company. The use of debt allows you to "lever up" the rate of return on equity. Let's work through an example to illustrate how this works.

Suppose you buy a slightly run down house in a decent neighborhood for $110,000. You put another $10,000 into fixing the house up over six months, then list the house for sale. Six months after that you sell the house for $135,000. So your profit is $15,000 (you put in $120,000 total, and got out $135,000). The rate of return on equity is profit/equity, or in this example, .125 or 12 1/2%. Which is okay, but not spectacular. Don't quit your day job.

Now let's see what leverage can do for you.

Work the same example, but assume we buy the house with $10,000 down and an interest only loan of $100,000 at 7%. Same $10,000 to fix the house, same $135,000 sale at the end of the year. The first thing you do is pay off your loan, so reduce the sales price by $107,000. Your profit is lower, because you got $28,000 less the $20,000 you put into the house. So your total profit is only $8000, versus $15,000 in our first example. But look at rate of return on equity. In this case, return is 8/20, or 40%. Houchee mama! By using 5 to 1 leverage, we've increased our rate of return by a factor of three. Why wouldn't you want to use leverage? Let's play this game again!

Well, the problem is that leverage can work against you as well as for you. Remember, the guy who holds the debt always gets paid back first. Let's run our second example again, only this time we'll assume that the real estate market is tanking, so instead of selling the house for 12.5% more than we put in, we sell for $107,000, or about 11% less than what we put in. We pay back our loan for $107,000, leaving us with...zip, nada, bubkus. Your equity of $20,000 got wiped out. Game over.

That's with 5 to 1 leverage. Bear Stearns had $11.5 billion worth of stockholder's equity. They had leveraged that to control $395 billion worth of assets on their balance sheet. When you are leveraged at 34 to 1, it only takes a three percent drop in value to wipe out your equity. Game over.