Balance Sheet

Management
Implications for the current
Financial Crisis

-Dan Edelstein
 Liquidity
“When the music stops, in terms of
liquidity, things will be complicated. But
as long as the music is playing, you've got
to get up and dance. We're still dancing." –
Charles Prince, CEO, Citigroup, in an interview
in London’s Financial Times, July 9th, 2007
 Subprime Fallout
Beginning in the Summer of 2007, analysts and policy
makers were assured the fallout could be contained for
two reasons:

1. Financial Institutions appeared large enough to absorb

any losses.

2. Securitization of the loans via Collaterized Debt

Obligations (CDO’s) diluted risk by spreading it out
amongst various investment pools.
 Bank Losses through 10/2008
Bank Country US$ Billions
Citigroup USA 60.8
Wachovia USA 52.7
Merrill Lynch USA 52.2
Washington Mutual USA 45.6
UBS CHE 44.2
HSBC GBR 27.4 US losses: $290 billion
Bank of America USA 21.2
JPMorgan Chase USA 18.8 Foreign losses: $295.4 billion
Morgan Stanley USA 15.7
IKB Deutsche Indus DEU 14.3
Royal Bank of Scotl GBR 13.8
Lehman Brothers USA 13.8
Deutsche Bank DEU 10.1
Crédit Suisse CHE 10.1
Wells Fargo USA 10
Crécdit Agricole FRA 8.6
Barclays GBR 7.5
Canadian Imperial (CIBC) CAN 7.1
Fortis BEL/NLD 6.9
Bayerische Landes DEU 6.7
HBOS GBR 6.6
ING Groep NLD 6.5
Société Générale FRA 6.4
Mizuho Financial Group JPN 6.1
Subtotal 473.1
Source: Bloomberg and Financial Times (October 1, 2008)
Worldwide 586.2 http://www.ft.com/indepth/creditsqueeze
 Mark to Market
Asset value is immediately reflected on the balance sheet

Healthy Market Sick Market

Improves insight into a Asset prices reflect
firm’s risk profile immediate amount of
liquidity, rather than
expected future returns

Volatility can cause assets

to fall below liabilities =

INSOLVENCY
 Mark to Market Contagion
Changes in balance sheets may not be justified by
fundamentals.

Deficient liquidity creates a downward spiral

transforming an apparent liquidity crisis into a crisis of
solvency.

Permanent Devastation:
Bear Stearns, Merrill Lynch, Lehman Brothers, IndyMac,
Washington Mutual
 Important Terms
Leverage: Ratio of Assets to Equity

Leverage = Assets
Equity

Liquidity: Ability to convert asset to cash

Value at Risk (VaR): Estimation of firms worst case

loss scenario.
Value At Risk (VaR)
Banks Adjust Assets and Liabilities to ensure
their total equity is proportional to VaR:
E=VxA
V = Value at Risk per dollar
A = Assets
E = Capital held by bank to offset risk

Leverage (L) = Assets (A)

Equity (E)

Finally: L = 1/V
 Targeting Leverage
Bank Targets a Leverage of 10

Assets Liabilities
Securities, 100 Equity, 10
Debt, 90

L = Assets/Equity, L = 100/10 = 10
 Issuing Debt
Assets Increase by 1% to 101:
L = Assets/Equity, L = 100/11 = 9.18
To Maintain Target Leverage of 10, debt (D) is
issued to purchase D worth of securities:
Leverage = Assets = 101 + D = 10, D = 9
Equity 11

Assets Liabilities
Securities, 101 Equity, 11
Debt, 90
 Issuing Debt
The firm uses the capital raised by issuing debt of 9, to
purchase securities worth 9.
The small price change of 1% forced the bank to
increase debt by 10% and increase assets by ≈ 9% in
order to realign leverage back to 10.
Assets = Debt & Leverage

Assets Liabilities
Securities, 110 Equity, 11
Debt, 99
 Declining Assets
Assets decrease by 1 from 110 to 109
Leverage is now too high: 109/10 = 10.9
Bank Sells 9 worth of securities, paying off 9
worth of debt to return leverage back to 10.

Assets Liabilities Assets Liabilities

Securities, 109 Equity, 10 Securities, 100 Equity, 10
Debt, 99 Debt, 90
 Aggregate Spiral
As the price of the asset falls, the firm responds by
selling the asset to maintain target leverage.
Reducing liabilities more sharply than their assets
declined.

Simultaneous balance sheet adjustments by several

firms can lead to sharp price declines in assets as
the market becomes saturated with securities.
Assets Liabilities
Securities, 110 Equity, 10
Debt, 90
 The Leverage Amplification
Cycle
Target Leverage Target Leverage

Stronger Balance Increase Balance Weaker Balance Decrease Balance

Sheets Sheet Size Sheets Sheet Size

Guided by
VaR
Asset Price Asset Price Decline
Boom
The Conundrum of a Strong
Balance Sheet
When banks hold excess capital, their balance sheets
are strong and their leverage is too low. They must
expand their balance sheets.
To utilize excess capital, banks take on debt on the
liabilities side, searching for borrowers on the asset
side.
When balance sheets are rapidly expanding the intense
urge to employ surplus capital causes banks to grant
credit to borrowers with no means to repay (subprime
mortgage market).
A Solution?