Nov 9, 2007


Every time I look at the balance sheet of a financial company I'm constantly amazed these companies can stay in business. If you look at a balance sheet you of course have an asset, liability, and equity section. Assets - liabilities = equity. For financial companies this is very important because the equity section truly represents their capital standing. It's a good measure of what these company's earnings power is. If the equity of a financial company is $1 billion then regardless of their assets and liabilities, this is what they are essentially earning money on. This is why a return on equity is a common metric to look at financial companies.

If you look at other company's balance sheets you see a situation where the assets and liabilities are the same order of magnitude as the equity. For every $1 of equity that Microsoft or Conoco Phillips have, they have something on the order of $2 of assets and $1 of liabilities. For someone like Merrill Lynch this is not true. They have $26 of assets and $25 of liabilities.

That is just astounding to me. If $1 of that $26 in assets gets written down with no change in their liabilities, then their equity is wiped out. This literally means they would need to go find a source of more capital to keep operating. This is why these stocks are getting so hammered right now in the market. A lot of their assets are effectively junk. Typically a company like Merrill will try and hedge their positions so that they aren't as exposed as it seems. But hedges have a way of breaking down at the worst times. Right now it seems they are all walking on egg shells.

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