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Current time:0:00Total duration:9:21

Video transcript

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 and we'll talk about in a lot of different context 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 300 gold pieces of equity and I use that let's say I use that for my building so building and that was 100 gold pieces and then I have 200 gold pieces that I just put into my building just to start off 200 gold pieces let's say I take 100 gold piece deposit 100 gold piece and of course I have an offsetting checking account 100 checking account that those people can at any point use either the right check so at some point they can come back and demand their money back let's say I make out some loans for different projects so 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 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 all of 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 our equity is equal to 300 gold pieces so that's equity right there 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 see you have three hundred four hundred seven hundred thousand so assets are equal to one thousand gold pieces so a lot of times people when they talk about leverage you might hear someone say two to one leverage well that means the ratio of the assets to the equity is two to one in this case the ratio of our assets to equity so we have you know its assets to equity leverage is what people say leverage in this case it's one thousand to three hundred or what is that 10 to 3 ten to three leverage you seldom hear 10 to three leverage you'll hear people talk in terms of ten to one or two to one or something to one but ten to three is a is a fair leverage ratio and it tells you just how many assets these are our assets right here we're controlling with a certain amount of equity and there's a bunch of there's a I guess a very good reason why Bank wants to do this because if it's making money if it's making more money on its assets than its 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 and let me erase what I just drew 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 downside leverage also multiplies the loss you would take so in this situation what happens if I have a if I had a 30% loss let's say well let's 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 have the same amount of assets and equity so in an example like this where my assets are equal to my equity so 300 I just have 300 of assets if my assets go down by 50% or notice so 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 sheet will look like this 150 and 150 so my equity will also went down by 50% I took a 50% loss because maybe I made some bad investments but now that I have leveraged what happens if the value of my assets get written down by Lena at some point I determined 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 a thousand of assets so essentially I'm writing down my assets by 500 so let's say that I think loan B is only worth so if I'm going to write down by 500 let's say I think this is only worth 50 and I think that this is only worth 50 because for whatever reason maybe I gave these loans out to buy to build a real estate or these were loans to subprime individuals who knows whatever loans these were they just weren't good loans and I realized 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 leveraged my balance sheet it looks like this I have a hundred in terms of the building itself then I have 300 of gold deposits 300 of gold that's this part right here 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 that our assets go down by 50% because I had a thousand of assets before and then one of my liabilities y/o this this 300 checking account this 300 checking account because you know you might have written checks to other people so it's not necessarily the person the same person that I lend it to initially but I have let's see seven of liabilities 700 of liabilities so notice I now have negative equity right because assets are equal to liabilities plus equity both my assets are 500 and my liabilities are 700 then what is my equity well my equity is 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 around 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 insolvency let me do that in another color in solvency 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 in liquidity you wanted to make sure you had enough gold left aside that when people came and said oh I want my gold back and you had gold to give it to them but if by chance people asked 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 than you 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 you know notice when we had no leverage you could take a 50% loss really easy but now that we had even ten to three leverage even a 50% loss wiped us out if you had 10 to 1 leverage then even a 10% loss would wipe you out so leverage it really is a measure of how much cushion do you have to take losses in the future anyway before a lot 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 you know if someone says ten to three leverage its 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 is you can view that as debt alright because I owe these people that money is 700 and my equity is 300 so seven-to-three is my debt to equity ratio anyway see you in the next video