Posts Tagged ‘equity’

Is it better for potential first home-owner to save first or jump first?

Tuesday, August 26th, 2008

Among the different class of property buyers, first home-owners are the most vulnerable. This is because they have the least outstanding equity, which means there is a greater chance of negative equity should they have to sell their home in a hurry. The equity portion of your property is its market price less the outstanding debt you owe on it. Let’s say the market price of a property is $500,000 and you have an outstanding debt of $450,000 remaining on the mortgage debt, your equity is $50,000. Negative equity occurs when the market price of the property falls so much that it is below your outstanding debt. This means that if you liquidate the property, you will still owe the bank money.

Worse still, for first home-owner, at the initial stage of the debt repayment, most of the payments goes to servicing the interest, leaving very little for reducing the principal of the debt. For example, for a 30-year $450,000 at 8.5% interest p.a., the first monthly repayment of $3460.11 consists of $3187.50 of interest payment. At the end of 3 years, the interest payment is $3111.11. In other words, in the first 3 years, the first home-owner gets to reduce the outstanding debt by only $11,000 while paying a total of around $124,000!

So, given the amount of bad news regarding the economy lately, many potential first home-owners are becoming more cautious about jumping into the property ladder. Some may opt to delay their purchase in order to save more to ensure that they have a greater equity when the time comes to buy the property. But what if the property prices climb too fast while they save, resulting in them being priced out of the market by the time they are ready to buy? Or, should they jump in now or should they delay?

Well, the answer to this question will depend on these factors:

  1. How much they save
  2. Savings interest rate
  3. Mortgage rate
  4. How fast property price rise
  5. How much deposit they already have

To answer this question, we constructed an Excel model to simulate the financial outcome between jumping in now or delaying to save. Our Excel model contains the following parameters:

  1. Wage inflation rate- this determines the growth of monthly savings due to wage rise
  2. Property price inflation rate- this is the rate at which property price rise per year
  3. Savings rate- this is the interest paid on the savings
  4. Mortgage rate
  5. Initial deposit for the property
  6. Extra repayment- the extra amount above the mortgage repayment that you can pay/save
  7. Amount of to borrow
  8. Loan period in number of years

So, we punch in the following numbers for our simulator:

  1. Loan period- 30 years
  2. Amount to borrow- $450,000
  3. Initial deposit- $50,000 (i.e. 10% deposit for a $500,000 home)
  4. Mortgage rate- 7% (this is far below the current mortgage rate)
  5. Savings rate- 5% (this is far below the current term deposit rate)
  6. Property price inflation- 6% (this assumes that property prices will increase 6% p.a. forever and ever)
  7. Wage inflation rate- 0% (this assumes that your wage rate get frozen for 30 years and thus, cannot increase your monthly savings amount or make extra monthly repayment for the next 30 years).
  8. Extra repayment-0

These numbers are intentionally unrealistic to illustrate a point. Guess what is the outcome? By the 359th month, the property price will be $2,709,193.95. If you choose to save, your savings will be $2,711,133.30. This means, if you buy with cash on that month, you will have $1935.35 left over. But if you choose the borrowing route, you will still have $2,976.50 in outstanding debt.

Let’s tweak the figures a little. Let’s say your wage inflation rate is 3%. This means you can make extra loan repayments or increase your monthly savings as your wage grows. You will then find that your debt balance is always higher if you jump into the market now. Now, let’s make the property price inflation rate be 7%. You will find that it is more advantageous to save than to jump in for the first 6 years.

Playing around with the simulator, we find that if you are a high-powered saver, you can still be better off delaying your purchase for several years even if property prices appreciate (up to a certain point) in those years.

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.

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 appreciateĀ 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).