Understanding “Tier 1" capital ratios

[Today on OA, a guest column by Dash Riprock. Dash previously worked as a CDO underwriter at a U.S. brokerage house in New York. He currently helps evaluate fixed income derivatives for banks and insurers.]

With all the talk of bank failures and government involvement here on OptionARMageddon and throughout the media, I thought it made sense to explain a basic concept that investors and regulators use to measure solvency: how assets are “risk-weighted” in order to measure banks’ so-called “Tier 1 capital ratios.”

Rolfe (rightly) has been estimating the amount of leverage (and, by extension, a rough relative default probability) by looking at companies’ tangible assets relative to tangible equity. Again, Leverage = Assets/Equity.

Reiterating the basic definition of “tangible equity,” imagine that a company’s owner decided today that he was going out of business. He holds a going-out-of-business sale and sells everything—buildings, office equipment, any securities the company held, and so on. Once he has sold all his assets, he uses the proceeds to pay back all his lenders (bonds and loans), his senior equity holders (preferred shares) and, if he’s a financial, anyone who has given him money to hold or invest (depositors). Tangible equity is what’s left after the business has been liquidated and all its debtors paid off.

Unfortunately, it is not easy for the casual investor to find tangible equity figures. For starters, when it comes to banks, it’s nearly impossible to set the value of illiquid financial assets like CDOs. But another reason investors may have trouble finding tangible equity stats is that they are rarely reported.

There are a couple of reasons for this. The most cynical perhaps: If companies reported their true tangible equity, even more investors would run for the hills. The 280x tangible leverage that Rolfe calculated earlier for Citigroup is a pretty terrifying number. For an individual with $100,000 in assets to run that leverage ratio (let’s call her Cindy), she would need to borrow $27.9 million. Even the worst mortgage banker wasn’t handing that type of money out to borrowers, which is why you could imagine Citi investors weren’t totally comfortable with their position.

http://optionarmageddon.ml-implode.com/2008/11/30/understanding-tier-1-capital-ratios/

Have fun reading !

 

Thanks!

lol 280 citi.