The Death of Leverage

During my presentation at the Morningstar Stocks Forum in April, I touched on the implications of an economy with a structurally lower amount of leverage. I think this process of deleveraging is important for investors to understand, so I want to explain this big-picture theme.

For most of this decade, credit has been much too easy to obtain and leverage rippled throughout the economy. When the first wave of mortgage defaults crashed ashore in early 2007, our financial system began to realize it probably wasn't a great idea to lend to anyone who could fog a mirror or to entities leveraged more than 30:1 (looking at you Carlyle Capital Corporation).

The return to prudent credit standards has had and will continue to have broad implications. Consumer spending will be curtailed because individuals can no longer tap into home equity at will. Corporations and private equity firms can no longer rely on easy debt terms like we saw with "covenant-lite" and "toggle PIK" notes. Financial institutions are forced to raise capital to plug the black holes on their balance sheets. This list is hardly exhaustive, but it's important to note the key underlying theme in all these instances: the curtailment of leverage.

The upshot is that we must figure out which business models will be viable in an economy with structurally lower leverage. I've been picking on the investment banks for a while now, but that's no reason to stop flogging them. Plus, they are a good example of the effects of deleveraging on earnings power. Back in March, in the aftermath of the Bear Stearns bailout, I cast a skeptical eye toward the quality of earnings reported by  Lehman Brothers  and  Goldman Sachs (GS). The market ignored the big flashing red lights when Lehman filed its quarterly 10-Q report a few weeks later, but concerns about the firm's assets are at the forefront once again. Lehman just announced it will be raising capital yet again, which in turn will lower its leverage ratio--and there are few things more important to an investment bank's earnings power than leverage.

This chart shows the historical leverage ratios (return on equity divided by return on assets) of four large investment banks (Goldman, Lehman,  Morgan Stanley (MS), and  Merrill Lynch ) and three large commercial banks ( Bank of America (BAC),  Wells Fargo (WFC), and  Wachovia ). As you can see, the amount of leverage at the investment banks has exploded since 2003. On the other hand, the leverage at commercial banks has stayed steady at about 10 times because commercial banks are regulated entities with capital requirements.

The earnings power of a financial entity is its return on equity multiplied by its equity base, and return on equity is the product of return on assets multiplied by leverage. If the amount of leverage goes down, it's axiomatic that earnings will go down absent an offsetting increase in the return on assets. In a lower-leverage world, the earnings power of the investment banks is impaired. The implosion of Bear Stearns and the continuing troubles at Lehman show the market no longer considers a 30:1 leveraged entity stuffed with illiquid assets to be particularly safe. Market discipline is forcing leverage ratios to come down.

Moreover, I think the investment banks have a giant regulatory bull's-eye on their backs. In exchange for access to the Federal Reserve discount window, commercial banks and other depository institutions are subject to regulation. This is simply sound public policy. Investment banks are free from regulatory capital requirements because they are not backstopped by the Federal Reserve and, by extension, U.S. taxpayers. This regime, however, changed when the Federal Reserve bailed out Bear Stearns and opened the discount window to investment banks with the Primary Dealer Credit Facility.

By endangering the stability of our financial system, the investment banks unwittingly drove themselves into a Faustian bargain with the Federal Reserve. It goes beyond the pale to have public money backing the speculative schemes and private profits of the investment banks, and even in my most cynical moments, I have to believe our elected and nonelected leaders would not abdicate their responsibilities to such a degree. I do not know what leverage ratio the regulators will eventually settle upon--commercial banks are essentially limited to 10:1 leverage. However, I do know it likely won't be 30:1.

To give a counterexample, I'll bring up  Capital One Financial (COF). Although bad-debt charge-offs will be a head wind for a long, long time, Capital One has chugged along for many years earning respectable returns on equity with essentially 10:1 leverage. That's a reasonable and acceptable amount of leverage, and Capital One's earnings power is unlikely to be permanently impaired in a world with structurally lower leverage.

The deleveraging theme is an important one for you to understand as you choose your investments. The key question to ask is whether the earnings power of the businesses you own will be impaired in a lower-leverage world. To quote a popular Capital One advertisement: "What's in your wallet?"--a Lehman Brothers or a Capital One?

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