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Concepts & Tutorials

Leveraging Our Trust

My Column at Yahoo last week was on Leveraging Our Trust.

Let us say there is a great business you would like to set up that involves a return of 20% every year after expenses and taxes. What if I gave you two choices:

1)      You put in Rs. 1,000 as your investment, in setting up a business that returns Rs. 200 per year.

2)      You put in Rs. 200 and borrow Rs. 800. The business still generates Rs. 200 per year. You pay Rs. 80 as interest on the loan, and the remaining, or Rs. 120 is yours.

In the first case the return you get is 20%. Your capital is at stake so if the business slows down to a return of 5%, you’ll only get Rs. 50 per year.

In the second case, you make a 60% return — Rs. 120, on Rs. 200 of your capital. Awesome?  But if the business drops to a 5% return, you will end up getting Rs. 50, and you now have to pay interest of Rs. 80 — for which you have to shell out more money from your pocket. Effectively that whittles down your capital to Rs. 170 (Rs. 200 minus the 30 as excess of interest over profit)

In the second case, the return was amplified by the loan you took, and the losses were amplified as well. This is the classic concept of leverage, where you increase returns by using money you didn’t have.

Leverage is a two sided beast. We all like the upside — amplified returns — but we don’t like the impact of huge losses. Leverage is unavoidable today, and if you have money in a bank, even if you don’t have a loan, you’re impacted.

Let’s take the case of an economy with a single bank.

I put in Rs. 100 into that bank. The bank takes that Rs. 100 and keeps Rs. 10 as a Reserve, because of a reserve requirement of 10%. It then lends Rs. 90 out to an Amit Varma, who expects to take that money and double it with his business. But until he does so, he puts the money in the bank (remember, there’s just one bank).

So my Rs. 100 has become Rs. 190 already. I have Rs. 100 and Amit has Rs. 90 in the bank. The bank owes me Rs. 100 and Amit owes the bank Rs. 90. So the amount of “money” that’s out there is Rs. 190.

The bank, on seeing Amit’s money, keeps Rs. 9 as reserve and lends Rs. 81 to that young Aadisht wants Rs. 81 to make his life more interesting in the rural Tamil Nadu setting he is in. The  total money increases to Rs. 271.

This can go all the way till the  total amount of money people have and owe will be Rs. 1000.

This kind of system is very good in that Aadisht, Amit and so many other people could get money, and more money than the Rs. 100 I had. The bank makes money from the interest that the borrowers pay, offset their cost of sending spam SMS selling me insurance, and the rest is their profit.

You might think the banks have it good – after all, they never put any money in? That’s not really true, as sound banking requires them to put SOME money down. How much? They use another ratio, called the “Capital Adequacy Ratio”: if this ratio is 10% and the bank has lent Rs. 1,000, then the bank needs to put up Rs. 100 of its own money as capital.

Suddenly this becomes more apparent  – for every Rs. 100 the bank has, it can lend out Rs. 1,000. The leverage it has is 10 times.

This is all fine, you think. How does it affect you and me? Because the leverage means there is risk in the system, and that risk is only apparent in a crisis.

The Default

Let’s just say that Amit’s business doesn’t do so well, and he can’t pay the money back. If the bank says goodbye to the Rs. 90 it lent Amit, and since it still owes the rest of us money, that Rs. 90 will have to be taken out of its capital. The bank now has just Rs. 10 left as capital.

Phew, you think. The bank didn’t go bust. Yet, the bank has to now keep to the capital adequacy ratio of 10, which means it can lend only Rs. 100 worth of money! This is the downside of deleveraging— that when you have a problem, the problem magnifies itself on the way down.

What the bank must do now is either to call in all the loans above Rs. 100 — which is usually not possible, because people might not be able to pay. The other option is to raise another Rs. 90 in capital. When a bank is in trouble, no one wants to give it any money. The only way ahead is togenerate confidence in the public, by having the regulator or the government say that it will back all the loans up, or to get the banks assets and deposits to be sold to another bank through a merger.

In the 2008 crisis, US banks went through a similar problem, where a large number of (sub-prime) loans weren’t getting paid back, and the resulting deleveraging required bank capital — the US Treasury had to feed in capital into some banks (so much that they nearly took over Citigroup) and other sovereign funds chipped in with capital once they had confidence. In India, when Global Trust Bank ended up losing all its capital through bad loans, RBI forced it to merge with OBC, another bank, in order to contain the contagion.

In both the above cases, depositors weren’t hit, but in over 100 banks in the US last year, a failure meant that the depositors lost some of their money. To cover such problems, there is deposit insurance — upto $250,000 in a bank account in the US is paid back by the FDIC if the bank “fails”. (In India, deposit insurance covers you up to Rs. 100,000)

The Run

Let’s say I decide to take back my Rs. 100. That reduces the available deposits by Rs. 100 — so the bank now has just Rs. 900 in deposits but it has Rs. 1,000 in loans. It can pay me because it kept that 10% in “reserve”. But after me, if everyone tried to take their money back at the same time, the bank wouldn’t have the money to pay!

When a large number of depositors try to take money from a bank, it will have a problem — and this is when regulators need to step in and generate confidence. This involves regulators saying everything is fine, which we know, after Enron, Lehman, Bear Stearns and Greece, means that the poo has hit the fan. But without such confidence, bank runs can quickly shut a bank down.

Collateral Damage

In the US, many sub-prime borrowers took loans for 100% of a house’s value, placing the home as collateral. Banks were fine because now if borrowers defaulted the banks could recover the money by selling the house. Except house prices fell, and when borrowers defaulted, banks took the houses and tried to sell — resulting in even lower prices. The spiral of selling then brought down the value of other banks’ loans and gave us a crisis of gargantuan proportions.

It is these risks (and there are many more) that call for diligent regulation. For banking, regulators monitor a number of such ratios — the Cash Reserve ratio (CRR) is one, the Capital Adequacy Ratio (CAR) is another, and yet others include non-performing loans (potential defaults), exposure to different sectors (too much to one sector is a problem) and so on. Banks are required to invest nearly a fourth of their deposits in government bonds, so that there is some element of security in the loans they provide.

Still, there continues to be leverage; India is levered about 4x — 5x(depending on which ratio you consider) and the US, nearly 10x. Some European banks have more than 30x leverage, where even a 3% drop in their assets can wipe out their entire capital.

For a highly leveraged system, a crisis is always a crisis of confidence. Just a word that a bank may be in trouble can cause a run on the bank, or for a selling spiral to mark its assets down. Even if the bank is sound, it will fail. That crisis compounds when you realize that no one has any idea of how many other parties will be hurt if one party fails. With banks taking on complex financial instruments and then hiding away from regulation, we’ve got a system that can go out of control very fast. As an astute saver and responsible unleveraged investor, you may be wiped out just because you choose the wrong bank, or indeed, the wrong geography.

Which is why the whole world waits anxiously as a tiny country votes on whether to pay back its loans. The problem isn’t what will happen; it’s that the rest of the world will get scared and lose faith. In a world addicted to leverage, we can’t have a recession of trust.

  • Ramesh says:

    A very well-written article. Kudos to you for explaining in a very simple terms, such a complex thing. Thanks.

  • phani says:

    If 200rs capital generates 50rs profit and you have to pay 80rs interest… doesnt it mean your effective capital is now 200 + 30 rs extra that is been paid for interest.. you made it 170(200-30)??

    • You’ve brought up an interesting point. Consider the investment was a separate entity – what you put in initially was the investment, which is the capital the entity has. If the capital “erodes” due to such losses, you have to top it up with more capital.
      The idea is to look at the investment independently, what kind of return do I get for my Rs. 1 – the leveraged idea, when loss making, is hugely negative.

  • Murty says:

    Excellent Piece of info.I am zealous of Mr.Ramesh who read it ahead of me

  • Siva says:

    Hi Deepak,
    Nice article.

  • amol says:

    thats a excellent article Deepak

  • Bhupesh says:

    Leveraging is not the story of only banks, a big story of Indian Middle class living in urban areas.
    Let us say `A` bought a good apartment in a nice growing community. You paid 20% down payment and rest was funded by the bank @ rate 10% per annum.
    1) If property prices increased by 12% per annum and he saved on rental @2% of capital value every year. A total of 2.2 Lakh net appreciation (Rs 7 lakh appreciation in first year – 4.8 Lakh interest ), 22% return.
    Vs
    2) `A` bought a house from his own money. With 6 Lakh Rs appreciation in property value @12% and @2% Rs rental income. His return on money comes to 14%.
    Woh! 8 % additional return on capital . ( That’ why Indian loves investing in Real state, Pride of owning a apartment + doubling his money in 3.5 years (72/22) also their psychic allows them to invest a big chunk in real state compared to stock market, makes it a golden goose)
    But some loose it ..
    In a year of slow down in business few home owner lost their job thus making it difficult to service their loan. These apartment do come up in market for sell in addition because of down sentiment there are not many new buyers.
    (3) `A` bought property in 2006 in 50Lakh @ 8% floating interest rate with 20% down payment. Even after 5 years same property cost 75 Lakh appreciation of 8.5% per annum. + saving on rent @2% (while interest he paid in this period varies from 8% – 11% ). Taking average of 10% interest rate, he lost 24 lakh in interest
    (taken compounding interest as he is loosing opportunity to earn on interest paid).
    Making return on his 10 Lakh almost
    nil. ( Vs 22%)
    (4) `A` bought property in 2006 in 50Lakh with his own money. After 5 years same property cost 75 Lakh Which is appreciation of 8.5% per annum. + saving of rent @2%
    A return of 10.5%. ( Vs 14%)
    ————————————————————————————————
    Leveraging is not the story of only banks, a big story of Indian Middle class living in urban areas. When property price got multi-X from 200Rs sqft in 2003 to 2000sqft in 2008 it made over night Crore-patis.
    4000 Sqft plot @ 200/- = 8 Lakh Rs ( 2 lakh Rs own money + 6 lakh Rs from bank)
    4000 Sqft plot @ 2000/- = 80 Lakh Rs( 6 lakh return back to bank with interest , net gain 70 Lakh on 2 lakh Rs investment. 3500% appreciation) .

    • Murty says:

      It seems the calculations are not coherent with the facts.
      1.You assumed a house worth 50 to be bought by 20% advance payment.
      2.The advance would be 10Lakhs and the rest 40Lakhs would be from the bank
      3.The Twelve Plus Two percent appreciation(As you claim) of the house is 7Lakhs.
      4.At 12.05% home loan interst, on 40 Lakhs, for a 20 year loan, the interest is Rs.4.8 Lakhs
      5.Hence the net return is 2.2Lakhs
      6.Your investment is 10lakhs and the returns would be 22% as per your claim.
      Am I right?

      • Bhupesh says:

        7 Lakh = 50Lakh * ( 12+2)%
        There are certain simplification in calculation though!

        • Murty says:

          Simplification?
          How come the Returns on YOUR investment was doubled in 3.5Years?
          You put 10 Lakhs,
          The appreciation is 7 Lakhs on 50 Lakhs,means it is 1.8Lakhs on your own 10Lakhs,
          The principal portion is not considerd, which is 0.5Lakhs, which is the equity part of your investment.Shall we keep it aside or subtract it from the above figure?
          The tax outgo is 4.8Lakhs.Hence the net returns would be -3Lakhs , which is negative on your investment.Your 10Lakhs became 7 Lakhs, which you thought otherwise.
          By the way, do you have any idea of your total disbursement figure of your 20 year Loan, assuming that you pay over 20 years and the interest rate remains same?Guess what! It would be a whopping 1.06 Cr.Plus your own 10Lakhs which can easily be converted into another 44 Lakhs in 20 years.Your ownership cost is Rs.1.5Cr.Does it make a GLODEN SENSE TO YOU?On the other hand, is it a depreciating asset or appreciating one?

  • shankar says:

    Excellent work as usual, Deepak.