Leading up to the Financial Crisis of 2009, major investment banks were highly leveraged institutions. When asset values are increasing, financial leverage is a powerful tool to gain incremental returns. However, when assets decline, an institution, if overly levered, can go bankrupt on even small losses.
Financial leverage is defined as the total assets of a firm over the amount of equity that the firm has in those assets. The difference between the level of assets held, and the amount of equity a firm has, is leverage (or borrowed money). For example, a firm that owns $10 million in assets, but only has $1 million in equity is 10x levered ($10 Mn in assets/$1 Mn in equity). This means the firm has borrowed $9 million to pay for 90% of its assets and has only used 10% of its own money, or $1 million, to take a stake in whatever it has purchased. If its $10 million asset level appreciates to $10.2 million, it has just made 20% on its equity as its $1 million equity is now worth $1.2 million. Conversely, if its assets fall to $9 million, the firm has just lost all of its original equity and now needs to sell its remaining assets to pay back its lenders or raise new equity to ensure it has some ownership of its asset base.
Most firms on Wall Street have gone bankrupt by simply being over levered or not having the timing (called duration) of their assets and liabilities matched up. Drexel Burnham, a successful high yield bond firm in the 80’s, funded most of its securities inventory with short term loans from other banks (even though some of its assets held were longer term). When the short term lending market dried up, Drexel was forced to liquidate its holdings and the firm because it could no longer get financing from other lenders.
The leading investment banks of Goldman Sachs (GS) and Morgan Stanley (MS) have greatly reduced their total leverage over the past 16 quarters to ensure that they avoid being over levered, and so that they can satisfy their new status as bank holding companies. Goldman has reduced its total asset base from 19.6x its equity in 4Q 2009 to 13.5x in the most recent quarter with Morgan Stanley having had a similar trajectory. As both companies applied for bank charters in 2009, federal banking laws prohibit an institution from being more than 18x levered, which both firms are well below.
Financial leverage is a necessity of high finance to hold asset levels that can satisfy investor demand for all types of financial products. However, too much of anything can be a bad thing, and both leading investment banks have now right sized their holdings to ensure their vitality. Both GS and MS stocks are held in the Financial Sector SPDR exchange traded fund (XLF).
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