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Let’s Talk Leverage

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.

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 that you have a couple that you think investors should look at that potentially they don't really think about too much.

Joe Magyer: Yeah. I'm a nerd in many facets. But around financials, I think people tend to gloss over some of the more important metrics with banks in particular. People get caught up in some of the finer 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 as being the best measure of how the bank is doing in terms of creating value for shareholders. That's basically rough cutting your net profit over your equity that you have at a bank. Generally speaking, that's a really good proxy for how much value a bank is creating and how much they're earning against equity. But, there's another variable there, which is leverage. I think a lot of people neglect this to their detriment. They don't appreciate the 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 leverage is the actual amount of assets relative to your equity. This is all in the balance sheet. You don't need to be a rockstar analyst or get any fancy designations to find this stuff. It's all right there. Total assets over equity. Doing that will allow you to find out how levered the overall business is. And when you multiply that by return on assets, that gives you return on equity, which is a very helpful way to understand the 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's take a quick break to talk about what leverage is, because I have discovered through angry emails, on occasion, to the show, that some people really want some very basic terms defined.

Magyer: Gotcha. Sure. Overall leverage, the math is total assets divided by total equity. In practical terms, talking about what the bank actually does, banks make very 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. The way that they make that work is 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 that in a big way that will help them grow and make up for the overall narrow margins in the business. That's the leverage that's baked into the model.

Lapera: Right. And this can become a problem if it's used irresponsibly.

Magyer: Yes. Flashing back in time, the major investment banks in America had leverage above 30 times, back heading into what the Australians call the GFC, the global financial crisis. Here, we just call it the financial crisis, because we're Americans, and it's just our financial crisis. If you'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 money to buy the house. How much you borrow against how much you put down is, essentially, your leverage. So, if you buy a house and 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 of leverage. But if you're doing the same thing with liquid assets and you're making loans that 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 right and you don't make bad loans, and the more at risk you are that your capital goes out the door one day, and you'll just have to wave a white-flag there, like what happened with MF Global or Lehman Brothers. It happens. Not often, but it happens.

Lapera: Could you give an idea of how leveraged, on average, big banks in America 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 was substantially higher than that before. They've always been more conservative, except when they're creating a couple million accounts for 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 more aggressive. That's a combination of more friendly local regulation, but also confidence in demand. Wells Fargo has said this for a while -- there just isn't enough demand for loans for 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 stung about having to bail out the banks. With less leverage, you're much less likely to blow up. If you do, there will be much less of a needing hand. And overall, 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.