Monday, April 19, 2010

Passion Party #198 - Leverage, Part 1

As we move farther from the Real Estate Bubble of 2007
and the Credit Crisis of 2008 and early 2009,
one culprit in both situations is becoming clearer:
Leverage compounds the winnings
but also magnifies the losses.
If you have a brokerage account at Schwab or Merrill or another investment bank, odds are they let you borrow "on margin" to increase your investments.
Simply put, you can "double your bet" with borrowed money from the bank. Your leverage is 2 to 1.
If your bet is wrong, the bank can make a "margin call", asking you to repay the money you borrowed, causing you to have to sell at a loss, and worse, compounding the loss if you don't have savings set aside to cover your bet.
At the peak of our current credit crisis in 2008, many of the major banks and Hedge Funds were leveraged 30 to 1, or often much higher. The bets were being made with borrowed money, and when "the call" came from the creditor, they had no choice but to sell, starting the great de-leveraging that brought us the collapse of Bear Sterns, and the bankruptcy of Lehman Brothers, Washington Mutual, General Motors, and a 40% drop in the stock market.
---to be continued...

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