Comments on Saving to Inve$t: Leverage 101 – The Real Cause of the Financial Cri...

A Major Problem for Hedge FundsHedge funds do two ...

2008-10-29T13:09:00.000-04:00

A Major Problem for Hedge Funds

Hedge funds do two things to make outsized investment returns. They use a lot of leverage and they bet both directions (bet that securities will go up or down). But the first item – leverage – is dependent on one thing: borrowed money. As the investment banks disappear, who will be left to loan to these hedge funds. They will still have access to equity capital through pension funds, mutual funds, private investors, etc., but they leveraged up by borrowing money from investment banks. Without that leverage, the investment returns are more in line with the overall stock market (although, again, they do make money when securities fall – if they bet correctly). Some of the best hedge funds had returns of 40 to 90% per year for several years, but without leverage, the best funds may return around 15 to 25%

These lowered returns will still allow them to keep their clients, but will likely change the current fee structure that the hedge funds’ management collects – often called “2/20 fees” - a fee of 2% per year based on the value of the assets and 20% of all profits.

Many of the smaller hedge funds that do not have substantial equity capital will be forced to liquidate their holding, as their ability to continuously raise (and thereby “turn-over”) more debt will disappear. In the short-term, this will have a negative impact on the economy, as tons of securities – that nobody wants – will be sold at distressed prices.

OUR OWN CORRUPTED CONGRESS CAUSED THE 2008 FINANCI...

2008-10-05T04:22:00.000-04:00

OUR OWN CORRUPTED CONGRESS CAUSED THE 2008 FINANCIAL CRISIS
FINANCIAL CRISIS 2008:

Senator Chris Dodd D-Connecticut $165,000
Senator Charles E. Shumer D-New York
Senator Barack Obama D-IL
Senator Bob Bennett R-Utah
Rep Gregory Meeks D-New York
Rep Maxine Waters D-California
Rep Lacy Clay D-Missouri
Rep Artur Davis D-Alabama
Rep Barney Frank D-Massachusetts (Financial Services)
Frank Raines (EX CEO of Fannie Mae and Current Obama's Campaign Advisor as Chief Economic) Illegal Activities
Tim Howard (Current Obama's Campaign Advisor as Chief Economic)
Jim Johnson (Hired as a Senior Obama's Finance Advisor and was selected to run his Vice Presidential Search Committee)

@ Until Debt: Thanks. Yes leverage enhances greed ...

2008-10-02T15:02:00.000-04:00

@ Until Debt: Thanks. Yes leverage enhances greed and magnifies the falls. But it is just a concept like compound interest, that needs to be understood and can be very useful if used wisely. This time all of Wallstreet was caught with their pants down - so to speak.

@ Chloie:

1. Banks typically get about 80% of there money back after foreclosure. But that was before zero down mortgages, negative amorization mortgages, in which the principal may actually get LARGER, and before housing prices were dropping significantly. Therefore, for a lot of these subprime foreclosure, the banks are lucky to get 50% of the loan money back. In areas with numerous foreclosures, it may be closer to 30% recovery.

2. Although the Fed did raise the rates a few years ago, I don't believe it was the primary driver for the crisis. Why

- Many adjustable mortgages are linked to LIBOR (the London Interbank Offering Rate), not the Fed's prime rate.
- Many of the adjustment mortgages were opotion ARMs, that allowed you to "pick a payment". If you picked the lowest payment the extra interest got tacked onto your principal (negative amorization).
Therefore, raising the prime rate does not do nearly the damage as the negative amorization does to your home vs. mortgage ratio.
- The Fed has been lowering the rates over the last year and yet the crisis continues.
- Bottom line, individuals borrowed to much (leveraged up) for a house they couldn't afford and Wall Street leveraged up with the reserves to withstand a housing downturn.

But, the fact that many people took out 2 and 5 year ARMs, in the hopes of refinancing into a "better" mortgage once their house went up in value (which everyone in the industry expected would go on forever) , certainly added to the crisis, as this individuals that took 2 and 5 year ARM are stuck in bad mortgage.

Great article! One question: I thought that banks...

2008-09-30T16:53:00.000-04:00

Great article! One question: I thought that banks get their invested money back when a home is sold at a foreclosure sale.

Also, a few years back the fed raised the interest rate over and over at exactly the same time as the lending industry predicted that lots of 2year and 5year fixed mortgages were about to become variable. Did that help turn a financial correction into a financial crisis?

Great article - very informative. I know that you ...

2008-09-26T10:37:00.000-04:00

Great article - very informative. I know that you were explaining the technical aspects of leverage but one element that played a huge part in the whole show was simple greed.

The returns from leveraging up in the ggod times were simply too hard for a lot of people to resist. Now unfortunately they are paying the price.

Pinyo - Thanks. I think foreclosure would result f...

2008-09-25T12:42:00.000-04:00

Pinyo - Thanks. I think foreclosure would result from homeowners being unable to refinance their house (not enough equity). As their rates reset on their ARM loans, they can no longer afford the repayments and as they can't refinance, they have to go into foreclosure. Happening everyday all over the country.

Dead Cat - bounce.

Curt - I agree leverage is a good tool, but clearly works in both directions which some of our biggest financial institutions failed to understand as they kept growing their loan book. There are off course many factors, but over leverage is what finally bought them all down. Low interest rates fed the fire, but we have had low interest rates in the past without such a massive fallout requiring the government to step in (since the great depression).

Leverage is and will always be part of investing a...

2008-09-25T10:17:00.000-04:00

Leverage is and will always be part of investing and business. The financial crisis goes way beyond leverage. The high risks taken on with excessive leverage were a symptom of a much larger problem - easy money - provided by the fed.

This is a government failure in an attempt to plan the economy. When someone gets drunk and makes a risky decision, the underlying catalyst is the alcohol. Take away the alcohol and the risky decisions are reduced.

The real cause is spammers and hackers. Spammy em...

2008-09-24T20:06:00.000-04:00

The real cause is spammers and hackers. Spammy emails and such have clogged the whole global economy and have caused it to shutdown.

Very nice job of explaining leverage. It's very c...

2008-09-24T15:13:00.000-04:00

Very nice job of explaining leverage. It's very clear and concise. I always thought foreclosure as not being able to pay your mortgage payment. I didn't realize that bank could tap you for more money when you go upside down.