Posts Tagged ‘asset’

Effect of write-down on bank balance sheet

Sunday, July 27th, 2008

On Friday, National Australia Bank reported a $830 million write-down on their assets. As this news article, More NAB bad debt revealed reported,

National Australia Bank’s senior management has been castigated by banking analysts after the bank released a fresh $830 million writedown of its investments in US housing mortgages.

The stock market reacted by plunging 3.5% at the time of writing. Will there be more? We will leave it to the mainstream media chatter to talk about it. Meanwhile, we will show you how a write down will affect the bank’s balance sheet. For this, we continue a simplified bank balance sheet from Introduction to banking corporate accounting:

Asset: $98.50 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

Let’s say 2% of a bank’s non-performing assets is being written down. That means $1.97 of the asset will be gone. In that case, the asset part will look like this:

Asset: $96.53 (Loans), $10.50 (Cash)

But what about the liabilities and equity side of the balance sheet? The liabilities side remains intact because they represent the saver’s deposit. Therefore, it will be the equity side that gets deducted:

Equity: $2.03

The balance sheet now looks like this:

Asset: $96.53 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $2.03

In one write-down the bank’s capital ratio gets reduced to 2.03/96.53 = 2.10%. It’s reserve ratio is still 10%. Will it get into trouble? As we explained before in Banking for dummies,

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank?s liability but your asset. In accounting technicalities, your money goes into the bank?s balance sheet as an asset with a corresponding liability.

Let’s say the bank pays 9.5% interest rates to its depositors (liabilities) and receives 10% interest rates from its loans (assets)- assuming interests-only payments. That means it will have to pay $105 * 9.5% = $9.975 to its depositors and receives $9.653 from its loans. In this case, the bank is in trouble.

Or let’s say banking regulations says that the capital ratio cannot go below 4%. Currently, it is at 2.10%, which means it is in trouble. It has to either sell its assets or raise cash (via equity raising) to bring the ratio up again.

No matter what, the bank’s profit will fall.

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Posted in Analysis - Business, Economics/Finance | 3 Comments »

Introduction to banking corporate accounting

Thursday, July 24th, 2008

Today, we will go deeper in depth on corporate accounting for banks. Without a proper understanding of this, it will impair our ability to appreciate a bank’s financial position. Back in Banking for dummies, we explained that

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank?s liability but your asset. In accounting technicalities, your money goes into the bank?s balance sheet as an asset with a corresponding liability.

Today, we will go deeper into that.

First, we will introduce the basics of accounting:

Assets = Liabilities + Equity

So, let’s say you deposit $100 into the bank. In this case, the highly simplified bank’s balance sheet will be:

Assets: $100 (Cash)
Liabilities: $100 (Deposits)
Equity: $0

In this example, the bank is losing money because it is borrowing $100 from you which it has to pay interests on. But its $100 of cash is sitting there idle. Therefore, the bank has to lend out, say $90 at a higher interest rate than it borrows the cash from you. The balance sheet will now look like this:

Asset: $90 (Loans), $10 (Cash)
Liabilities: $100 (Deposits)
Equity: $0

Let’s say it pays 5% p.a. interest rates on deposits and receives 10% p.a. interest rates on its loans. At the end of the first year, the bank balance sheet will be (assuming interest-only payments on loans):

Asset: $90 (Loans), $19 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

Now, there are 2 ratios that you need to understand. First, government regulations require that banks keep a certain ratio between equity and risky loans (in the assets) that it makes out to others. We shall call this the capital ratio. In this example, the capital ratio is 4 (Equity)/90 (Loans), which gives 4.44%. That is, its leverage is 22.5 times. There is another ratio called the reserve ratio, which is the ratio of cash and deposits. In this example, the reserve ratio is 19 (Cash)/105 (Deposits), which gives 18%.

Now, let us assume that the reserve ratio has to be, by law, a minimum of 10%. In that case, this bank has an excess reserve of 8% (see 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?). It can lend out an additional $8.50 to give a balance sheet of:

Asset: $98.50 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

In this case, its reserve ratio is $10.50/$105, which gives 10%. Its capital ratio is 4/98.5, which gives 4.06% (leverage of 24.6 times).

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Posted in Analysis - Business, Economics/Finance | 22 Comments »

Should you liquidate your asset?

Monday, July 7th, 2008

Back in How do we prepare for a possible economic crisis?, one of our readers asked,

A lot of us, simply do not have free floating (saved) money to worry about. What we have, instead, are huge debts that are closely tied to the so-called, and as yet unrealised, ?equity? we are supposed to have in the assets that we borrowed against.

…

But for the rest, all I see is a sea of debt with an island in the hazy distance that is supposed to be my ?equity? in assets held hostage by banks as security. So, to simplify it to the bare bones, the first question for many is, not whether one should buy gold or silver, but whether one should liquidate assets in which one supposedly has some equity.

Now, armed with a new understanding of value-investing and what assets truly are (see Value investing for dummies), you may see this problem in a different light. Let’s suppose you bought a property with a market price of $900,000 and an outstanding debt of $600,000 to go with it, leaving you with an ‘equity’ of $300,000.

Your mortgage debt is an asset to the bank because you are ‘selling’ yourself to it by committing part of your future earnings as money to be put into the bank’s pocket. Let’s suppose your mortgage rate is 10%. At that rate, you will be paying $63,185.16 per year to the bank for the next 30 years. Now, let’s calculate the value of you as an asset. Using a discount rate of 10%, the value of $63,185.16 of cash flow per year for 30 years is $595,641.10. This figure is the present value of your debt to the bank.

Now, look at your property as an income-producing asset. Let’s suppose you can rent it out forever and ever at $600 per week ($31,200 per year) initially. Let’s assume thatt income from that asset can grow at an annual rate of 5% forever and ever (i.e. property income more than keep up with the RBA’s upper band of inflation targeting). Again, we apply the same discount rate of 9% (i.e. your employment income is higher risk than the income derived from your asset). Guess what the intrinsic value of your asset is? In this case, given such generous assumption, it works out to only $780,000!

Now, let’s suppose that instead of borrowing to buy a property, you borrow $600,000, plus your $300,000 equity, buy $900,000 worth of risk-free government bond at a rate of return of 6.50%. For this risk-free investment, you will receive $58,500 of yearly income which you re-invest into the government bond immediately. By definition, the value of that $58,500 of yearly re-invested income is $900,000.

In other words, it is simply not rational to invest in property because you are better off putting that money in risk-free government bonds (or better still, term deposits that currently pays as high as 8%). Some ‘investors’ may use the prospect of capital appreciations as a reason for ‘investing’ in property. But this will only work if there is the next fool willing to pay over-inflated and irrational price for your property. As we said before in Difference between ?assets? and real assets,

That is why there are property speculators ?investing? in houses that are far overvalued and getting caught out in a property price bubble when the business cycle turns. In essence, the property price bubble is a Ponzi scheme that collapses when the economy runs out of money through a credit contraction brought about by the credit crisis or rising interest rates.

Once credit deflation sets in the economy, the economy starts to run out of fools. Many ‘investors’ turn out to be the last fool. In times of deflation, many people will find that the ‘value’ (market price) of their property turns out to be illusionary. You may want to read our other article, Aussie household debt not as bad as it seems? for more details on that.

The lesson here is this: if you purchase the property below its intrinsic present value, you need not worry about its market price.

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Posted in Investor Education, Property, Value Investing | 8 Comments »

Is the value of an asset its price?

Wednesday, July 2nd, 2008

Continuing from our previous article, Difference between ?assets? and real assets, we will discuss two concepts that are often confused with each other- price and value.

Everyone knows about price. So, we will not talk more about it. But the trick question is: is the value of an asset based on its price? In accounting, the value of an accounting asset (as opposed to the definition of an asset that we mentioned in Difference between ?assets? and real assets) is based on price, whether historical price of some kind of derivative of market price. In today’s speculative mindset, the quality of our investing endeavours is often judged according to the price it can fetch on the market. For example, the 2007-2008 financial year was marked by abysmal ‘performance’ of the stock market, which implies abysmal performance of our superannuation funds. Basically, this means that the price of stocks have fallen. In this kind of herd mentality, it is often easy to associate price with value.

But as investors, we have to understand that there is a difference between price and value. The former is just an easily understood nominal number. Value, on the other hand, is a relative concept. The value of something implies its worth relative to something else. So, what is the value of an asset? As we explained before in Difference between ?assets? and real assets, an asset is something that

… puts money into your pocket periodically.

Therefore, the value of an asset is a measure of the worth of its cash flow relative to the cash flow of something else. What is the “something else” that an asset’s value is compared against? Well, it is the cash flow fetched by a long-term government bond. In other words, the cash flow of the long-term government bond is used as a yardstick for which we measure the value of an asset’s cash flow.

Government bonds are theoretically zero risk in nominal terms (not in real terms though) because it cannot default on its loan (well, not if the government happens to the Russian government in 1998) as it has the power of the monetary printing press.

The cash flow of an asset, on the other hand is full of risks compared to the long-term government bond. Behind an asset is always a business enterprise, which can fail in its ability to earn cash to its owners’ satisfaction- the business may even fail completely. Therefore, to compensate its owners of that higher risk, it has to earn a return higher than the risk-free government bond. The riskier the business enterprise is, the higher the rate of return should be demanded.

In the next article, we will explain what the return on an investment is. That will involve more mathematics.

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Posted in Investor Education, Value Investing | No Comments »

Difference between ‘assets’ and real assets

Monday, June 30th, 2008

From our previous article, How do we prepare for a possible economic crisis?, one of our readers asked:

A lot of us, simply do not have free floating (saved) money to worry about. What we have, instead, are huge debts that are closely tied to the so-called, and as yet unrealised, ?equity? we are supposed to have in the assets that we borrowed against.

…

But for the rest, all I see is a sea of debt with an island in the hazy distance that is supposed to be my ?equity? in assets held hostage by banks as security. So, to simplify it to the bare bones, the first question for many is, not whether one should buy gold or silver, but whether one should liquidate assets in which one supposedly has some equity.

Before we continue, we must stress again that we are not providing financial advice of any sorts in this web publication. All views expressed are merely our own personal opinions. With this disclaimer, we can now proceed to what we think…

This question from our reader requires a long and thoughtful answer. Therefore, we will answer it over the course of a few articles.

First, we must be sure of the meaning of “asset.” This word is often misused and misunderstood, leading people to make the wrong investment decisions. We will use Rich Dad, Poor Dad‘s definition- an asset is something that puts money into your pocket regularly.

That definition may sound too simple, but many people do not really understand this concept, thinking that an ‘asset’ is something that can go up in price. That is why there are property speculators ‘investing’ in houses that are far overvalued and getting caught out in a property price bubble when the business cycle turns. In essence, the property price bubble is a Ponzi scheme that collapses when the economy runs out of money through a credit contraction brought about by the credit crisis or rising interest rates. If you read the newspapers today, you will find ‘investors’ bemoaning the horrible superannuation returns of the past financial year because the stock prices were ‘performing’ very badly. Fund managers are judged according to how prices of ‘assets’ under management ‘performs.’ As we said before in Harmful effects of inflation,

The surging asset prices (e.g. stocks, bonds, properties, commodities and yes, even artwork!) of the past several years are not signs of a strong economy. Rather, they are symptoms of inflation, brought about by speculation.

Without a proper understanding of what an asset is, many people mistook rising prices for wealth and could not see them for what they truly are- inflation. If an asset is something that can go up in price, then in this time of commodity price inflation, a sack of rice (or a bottle of vegetable oil, or a can of petrol, etc) is also an asset! In fact, there are plenty of ‘assets’ in Zimbabwe today, with the prices of stuffs going up exponentially.

If we return to the fundamental definition of an asset being something that puts money into your pocket periodically, then we put ourselves in the right frame of mind in evaluating the value of assets. Next article, we will talk about the value of assets.

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Posted in Investor Education, Value Investing | 4 Comments »

Banking for dummies

Wednesday, April 23rd, 2008

One of the most lucrative business in the world is banking. This is especially true in a world of fiat money and fractional reserve banking system, where money that is backed by nothing can be created from thin air. As we have seen previously in Reserve Bank of Australia entering the landlord business, the central bank can always prevent or prempt a shorter term financial meltdown by pumping liquidity into the system (that is,’printing’ money and then followed by lending them or buying up bad debts or some other tricks- see Recipe for hyperinflation) and introducing moral hazard. But in the longer term, the people have to pay for these moral hazards via inflation.

Today, we will take an introductory look at the business of banking.

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank’s liability but your asset. In accounting technicalities, your money goes into the bank’s balance sheet as an asset with a corresponding liability.

Currently, today’s banking system is a fractional reserve banking system. That means banks do not have to keep all your deposit money in its ‘vault.’ Since it is unlikely that you will recall most of your deposit money at any one time, it can lend out the vast majority of your deposit money while simultaneously maintaining the full balance in your bank statements. Legally, banks have to keep a minimum ratio of deposit money in its ‘vault’ to deposit money. This ratio is the reserve ratio, which is 10% in the US. Countries like Australia do not have formal reserve ratio requirement. The implication is that if every bank customer decides to recall all their deposit money simultaneously, the bank is insolvent instantaneously. That is, there is a run on the bank.

As we said earlier, a bank profits by taking a cut between its borrowing and lending interest rates. If it keeps too much deposit money in the ‘vault,’ it is money that is not put in productive use and thus, have a negative impact on its profits. On the other hand, lending money out entails risks of debt default. Side note: With the rise of securitisation (see Collateral Debt Obligation?turning rotten meat into delicious beef steak), banks (and non-banks as well) are able to lend and re-lend money many times over, spewing out massive amount of credit into the financial system.

As you can see by now, the banking business is a balancing act of managing a portfolio of assets and liabilities. Since the banking industry is a highly regulated one, there are rules for them to follow in this balancing act. For example, there are government regulations that require banks to keep a certain ratio between risky assets (loans and bonds) and equity capital (excess of assets over its liabilities). The upcoming Basel II accord is another such example.

The global credit crisis has thrown many spanners in the works of many banks’ portfolio and by extension, the global financial system. As you can see, bad debts is causing the mayhem in banks’ portfolio (see Is this sub-prime or solvency crisis?). When the financial system realised that the price of money was too low for too long (see Prepare for asset repricing, warns Trichet, which is written back in January last year), banks (as well as non-bank) become very much risk averse and hoarded money as a result. In other words, money suddenly becomes scarce (which implies its price, the interest rates has risen).

So, as we asked before in Reserve Bank of Australia entering the landlord business, what might be the “possible repercussions if the RBA had not [got into the landord business]?” When money becomes scarce and banks (as well as non-banks) become more scared, lending seizes up and credit standards become tighter (see Rising price of money through the demise of ?shadow? banking system). For economies that are drugged up by credit (e.g. Australia, UK and the US), this can cause the economic activity to seize up. The fact that the RBA is temporarily swapping risky assets (mortgage bonds) for thin air money at a bargain price is a very telling sign. And it is not only the RBA that is doing this- it looks that other central bankers are coordinating their efforts in pumping liquidity into the financial system. At least this is the official reason. Since the RBA did not reveal who they get their mortgage bonds from, other conspiracy theorists believe that the RBA are bailing out some financial institutions (which include banks and the non-bank lenders).

For bankers, there is such a thing as free lunch.

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Posted in Economics/Finance, Market Observations | No Comments »