Lets Talk Leverage

By Markets Fool.com

Joe Magyer, the chief investment officer of Lakehouse Capital, joins Gaby Lapera to talk about banking metrics. He reminds listeners not to miss the forest for the trees when evaluating banks. One of the metrics that people frequently gloss over is leverage. In this segment of Industry Focus: Financials,learn about leverage, why it's important, and how to interpret it.

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A full transcript follows the video.

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This podcast was recorded on Sept. 15, 2016.

Gaby Lapera: So,now that I revealed the purpose of the show --banking metrics -- I hear thatyou have a couple that you think investors should look at thatpotentially they don't really think about too much.

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Joe Magyer:Yeah.I'm a nerdin many facets. But around financials, I think people tend to gloss oversome of the more important metricswith banksin particular. People get caught up in some of thefiner points and metrics,like net interest margins. They get really excited about it,and they can sometimes miss big things,like the amount of leverage in a bank,the returns on equity and assets,and how those variables all move together. They're actually not complex. It's not rocket science. But most people just pass by it,and I think that's a missed opportunity on their part.

Lapera:Yeah,that's really sad. That's a little bit like missing the forest for the trees or missing the trees for the forest.

Magyer:Yeah, or the pine needles. A clean example is,people will look at returns on equity for a bank asbeing the best measure of how the bank is doing in terms ofcreating value for shareholders. That's basically rough cutting yournet profit over your equity that you have at a bank. Generally speaking, that's a really good proxyfor how much value a bank is creatingand how much they're earning againstequity. But,there's another variable there,which is leverage. I think a lot of people neglect thisto their detriment. They don't appreciatethe amplification and the importance.Basically, there are two levers here. There's return on assets, gross leverage,that leads to return on equity. Your gross leverageis the actual amount of assetsrelative to your equity. This is all in the balance sheet. You don't need to be a rockstar analyst or get anyfancy designations to find thisstuff. It's all right there. Total assets over equity. Doing that will allow you to find out how levered theoverall business is. Andwhen you multiply that by return on assets, that gives you return on equity,which is a very helpful way to understandthe overall economics. But when you just unpack those two numbers,it gives you more of a sense of what is creating value. Is it operational excellence? Returns on assets? Or is it just straight up leverage?

Lapera:Let'stake a quick break to talk aboutwhat leverage is,because I have discovered through angry emails, onoccasion, to the show, that some people really wantsome very basic terms defined.

Magyer:Gotcha. Sure. Overall leverage, the math istotal assets divided by total equity. Inpractical terms, talking about what the bank actually does, banks makevery small amounts of money,pound-for-pound,for how much is actually in the business. They'll make, maybe,1% on every dollar that they get in assets in the business. Theway that they make that workis the lever up a lot. So, they'll take your deposits, and they'll lend it out to people and make loans. And they do thatin a big way that will help them growand make up for the overall narrow marginsin the business. That's the leverage that's baked into the model.

Lapera:Right. Andthis can become a problem ifit's used irresponsibly.

Magyer:Yes. Flashingback in time, the major investment banks inAmerica had leverage above 30 times, back heading into what theAustralians call the GFC, theglobal financial crisis. Here, we just call itthe financial crisis, because we're Americans, and it's just our financial crisis. Ifyou're not familiar with these numbers, you might be like, that doesn't mean anything to me. But imagine if you had a house. You borrow moneyto buy the house. How much you borrowagainst how much you put down is,essentially, your leverage. So, if you buy a houseand you put down 10% equity, your levered 10:1.

The thing is, with a house,it's a pretty steady investment.(laughs) If I'd said that in 2006,that would have been pretty embarrassing. Over time, though,it's pretty steady. You are slowly putting more equity into it. That's a pretty low risk degree ofleverage. But if you'redoing the same thing with liquid assets and you're making loansthat are illiquid,but you have liquid deposits and people can take money out of your bank,you can have a bank run, and that can come in different forms. Basically, the more levered you are,the more important it is that you are rightand you don't make bad loans, and the more at risk you are that yourcapital goes out the doorone day, and you'll just have to wave a white-flag there,like what happened withMF Global orLehman Brothers. It happens. Not often, but it happens.

Lapera:Could you give an idea of how leveraged, on average, big banks inAmerica are today?

Magyer:They used to be high,but it's gotten a lot lower.Wells Fargo's(NYSE: WFC)total assets to equity now is below 10. It wassubstantially higher than that before. They've always been more conservative,except when they're creating a couple million accountsfor people who don't know about it,thousands of employees were doing that. In Australia, it's more like around 15, which is a good bit moreaggressive. That's a combination of more friendlylocal regulation, but also confidencein demand. Wells Fargo has said this for a while --there just isn't enough demand for loansfor them to go out and lever up more. They would be happy to do it,but there hasn't been that demand. Another thing,regulators have been pushing back on banks and saying, "You need to lower your overall leverage..."

Lapera:U.S. regulators have been pushing on U.S. banks.

Magyer:Yes. People are still pretty stungabout having to bail out the banks. With less leverage, you'remuch less likely to blow up. If you do, there will be much less of aneeding hand. Andoverall, it lowers a bank's returns on equity, but it also lowers the systemic risk to the overall common. Specifically, the bank lowers their risk as well. There are pros and cons to it.

Lapera:As with everything in life.

Magyer:Indeed.

Gaby Lapera has no position in any stocks mentioned. Joe Magyer has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short October 2016 $50 calls on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.