I now want to introduce you to
the concept of leverage. And then in future videos, we’ll
talk about this more in terms of what leverage does
and when it’s good and when it’s bad. We’ll talk about it in a lot
of different contexts. Right now, I’ll talk about
a little bit more in the context of a bank. So let’s say I start off my bank
again and I have 300 gold pieces of equity and let’s say
I use that for my building. That was 100 gold pieces. And then I have 200 gold pieces
that I just put into my building just to start it off. Let’s say I take a 100 gold
piece deposit, and of course I have an offsetting checking
account that those people can at any point use– either to
write checks or at some point they can come back and demand
their money back. Let’s say I make out some loans
for different projects. 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 a 300 gold
piece checking account. Let me just do one more loan. Let’s say I make another
loan for 300. Loan B– and I can give that. I could have also issued notes
and all of that, but let’s say I just give them a
checking account. And we have explored reserve
requirements and all that. Let’s think a little
bit about leverage. And leverage is essentially, how
much assets do you control with a certain amount
of equity? So in our example right now,
what is our equity? Our equity is equal to
300 gold pieces. Let me do it in a different
color just so the equity stands out from the
liabilities. And how many assets are we
controlling with that 300 gold pieces of equity? So I have 300, 400,
700, 1,000. So, assets are equal to
1,000 gold pieces. So a lot of times people– when
they talk about leverage, you might hear someone
say, 2:1 leverage. Well, that means the ratio
of the assets to the equity is 2:1. In this case, the ratio of our
assets to equity– so we have assets to equity leverage, is
what people say– in this case, it’s 1,000 to 300–
or what is it? 10:3. You seldom hear 10:3 leverage. You’ll hear people talking in
terms of 10:1 or 2:1, or something to one, but 10:3
is a fair leverage ratio. It tells you just how many
assets we’re controlling with a certain amount of equity. I guess a very good reason why
a bank wants to do this, because if it’s making more
money on its assets than it’s paying on its liabilities, in
theory, a bank will want to take on as much leverage
as possible, right? Because with this original 300
investment, every time it adds some assets and some
liabilities, it’s going to make a difference. It’s going to make the spread on
that money and so it wants to keep doing that. But there’s a downside to
leverage because what if the bank– what if some of these
loans aren’t so good? your What if some of these loans
just don’t turn out to be so good? So leverage, when things are
good, when they go on the upside, it kind of multiplies
how much money you’re going to make. But as you’re going to see in
about a second, on the down side, 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 have all this leverage, if I just had the
same amount of assets and equity– so in an example like
this where my assets are equal to my equity– if my assets go
down by 50%– notice here I have no liability. So this is all equity and
this is all assets. In this example, if my assets–
for whatever reason, I take a loss. If they go down by 50%, my new
balance sheet looks like this. Let me scroll down
a little bit. My new balance you will look
like this– 150 and 150. So my equity 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
by– at some point, I determine that Loan B– they’re
probably not going to pay up and Loan A maybe
won’t pay up. So the value of my assets
go down by 50%. So I have 1,000 of assets– so
essentially I’m writing down my assets by 500. So let’s say that I think Loan B
is only worth 50 and I think that this is only worth 50–
because for whatever reason, maybe I give these loans out to
build real estate or these were loans to sub-prime
individuals. Who knows? Whatever loans these were, they
just weren’t good loans and I realize I’m not going to
get 300 gold pieces back. I’m only going to get
50 gold pieces back. But in this situation,
what does my balance sheet now look like? Now that I had leverage, my
balance sheet looks like this. I have 100 in terms of
the building itself. Then I have 300 of
gold deposits. And then that first loan shrinks
to 50 only and then that second loan
shrinks to 50. So now, what are my
total assets? This is 50 and this is 50. So I have 100 plus 300 plus
250– so it’s 100. So I have 500 of assets,
which is consistent with what I said. Our assets go down by
50% because I had 1,000 of assets before. And then what are
my liabilities? Well, I owe this 300 checking
account, this 300 checking account– because he might have
written checks to other people so it’s not necessarily
the same person that I lent it to initially. But I have– let’s see–
700 of liabilities. So notice, I now have negative
equity, right? Because assets are equal to
liabilities plus equity. Well, if my assets are 500 and
my liabilities are 700, then what is my equity? Well, my equity’s going
to be minus 200. So essentially I’m broke. This bank is out of business. And in this situation, there’s
a very good reason for people to want to get their
money back. There’s a very good reason to
have a run on this bank because frankly, even if you
gave this bank all the time in the world, this bank is not
going to be able to pay back its money. Even if it were able to offload
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. Let me do that in
another color. And that just means you
don’t have the money. You’re not good for it. Remember, when we talked about
the reserve ratio, that dealt with illiquidity. You wanted to make sure you
had enough gold left aside that when people came and said,
I want my gold back, that you had gold to
give it to them. But if by chance, people ask for
more gold than you had, it doesn’t mean you’re
out of business. You just essentially have to
tell them, oh well, can you wait a little while while I deal
with my assets and wait for those loans to
get paid back? You’re still solvent. Insolvency is when you actually,
because of bad investments, you actually end
up with less assets then do have liabilities and then
there’s nothing left over in the equity column. And that’s what leverage is a
measure of, because if you have really high leverage, then
you– notice, when we had no leverage, you could take a
50% loss really easy, but now that we had even 10:3 leverage,
even a 50% loss wiped 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 do you have to take losses
in the future. Anyway, before I run out of
time– and in the next video, I’ll actually talk about how
leverage is regulated within banks, but just to give you
another measure of leverage– because this measure I gave
you– if someone says 10:3 leverage, it’s assets to
equity– another one that people often use, often
in the investing world, is debt to equity. But it’s 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 ratio before I took
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 it’s 7:3 is my debt
to equity ratio. Anyway, see you in
the next video.