Monday, February 02, 2009

Disappearing Assets

The balance sheet of an investment bank or hedge funds looks this.

- Loans
- Owners Equity
Total Liabilities

- Assets
Total Assets

The two sides of the balance sheet must balance. If the value of the assets increases in value, the value of loans is unchanged, so the Owner’s Eequity must increase. This has been happening over last few years as the prices of financial assets and property have increased in rapidly. The property boom has led to huge increases in the value of assets.

These increases show up first on the profit and loss statement in an increase in profit. A substantial part of this profit was paid out to employees in huge bonuses. What was left of the profit came through to the balance sheet as an increase in Owner’s Equity. Increased equity was often paid out to the shareholders in large dividends or share buy back schemes, but to keep the balance sheet in balance, some assets would be sold or loans would be increased.

In the past year, asset prices have fallen dramatically. The value of the assets must be written down, so a change must be made on the liabilities column to keep the balance sheet balanced. The value of loans does not change, so the owner’s equity takes the hit. If the business is fully leveraged, a small decline in assets can wipe out all the owners equity. This is especially true of the previous increase in equity have been paid out to the shareholders.

If the decline in the value of assets is greater than the owners equity, then the business is insolvent and in danger of defaulting on its loans. If the business is a bank and the loans are actually deposits make by clients of the bank, those deposits are at risk. In the current crisis, many financial companies and banks are now in a position where the owners equity has been wiped out and their loans are greater than the value of their assets.

The interesting thing is that previous increase in assets is gone. It has been paid out in bonuses and dividends. The recipients have used their bonuses and dividends to buy new BMWs and holiday homes in Spain. They have no liability to the business that paid them. Once bonuses are paid, the employer cannot ask for them back. The increase in the value of assets has gone, so it not available to compensate for the decline in value that often follows.

Governments are wading in to rescue struggling banks and other financial institutions. By providing capital, they are taking equity that is not there. They are hoping that at some time in the future the assets will increase in value against, restoring their equity in the business. If this does not happen, taxpayers will carry the cost.

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