Question

4. Consider an investment bank called Stear Bearns. It has loans = 600, investments = 500, and cash = 400 on the asset side, and it has short-run debt = 700 and long-run debt = 500 on the liability side (all the figures are in billions of dollars). (a) Calculate the equity capital of Stear Bearns. (b) Draw their balance sheet. (c) Calculate their leverage ratio. (d) By how much must the value of their investments fall for Stear Bearns to become bankrupt? (e) Draw their balance sheet once it has become bankrupt. (f) What would your advice to Stear Bearns be if the goal was to decrease the prob- ability of defaulting? Why might Stear Bearns not have followed this path? g) Suppose the government imposes a capital requirement, i.e., a maximum value for the leverage ratio. Take the Stear Bearns example above (with the initial balance sheet) and suppose the government imposes a maximum leverage ratio of 4. Suppose Stear Bearns is not able to adjust its long-run debt adjust short-run debt to meet this requirement. Suppose moreover that it wishes to have 10% cash as a fraction of total assets but otherwise is happy to use cash to pay back debt and that it prefers to reduce investments rather than loans for any further asset deductions. What will its new balance sheet look like? Suppose that, in the new situation with a 4 maximum leverage ratio, asset prices fall so that the value of its investments goes down by 10% (so that they are worth 0.9 times what they were worth before). Short- and long-run debt are not affected directly by the fall in asset prices, so equity falls. However, the balance sheet of Stear Bearns now must somehow adjust in order to not violate the 4 leverage rule. Supposing that Stear Bearns can only adjust on the asset side by adjusting their investments (and on the liability side only by adjusting their short-term debt), what would have to happen to their balance sheet? What final contraction of total assets (in percent) was induced by the fall in asset values of 10%?

Answer 1

a) Loans =600billion Dollars

Investments =500billion Dollars

Cash =400billion Dollars

Total Assests =Loans + Investments+Cash

=1500billion Dollars

Short run debt =700billion dollars

Long run debt =500billion dollars

  

Total Liabilities   =short run debt + Long run debt

=1200billion Dollars

Equity Capital = Total Assets - Total Liabilities

=1500-1200

=300 Billion Dollars

c)

The leverage ratio is the proportion of debts that a bank has compared to its equity/capital.

• Equity to Debt = Shareholders Equity/Debt = 300/1200=.25=25%