A Lesson In Leverage

My prediction on the market turned out to be prophetic.  The Dow took a 500 point plunge today.  Considering the heavy selling at the end of the day, this pattern looks to continue in the morning.  How did we get into this mess?  We have just seen Lehman Brothers, a company over 150 years old, a company that survived the Great Depression, just declare Bankruptcy.  How does something like this even happen?

Leverage can be great.  In financial terms, leverage allows you to greatly magnify the effect of a given asset.  Leverage is what allows you to buy a home with a 20% down payment (not that anyone does that anymore).  You put down $2, the bank loans you $8, and you are able to buy a $10 house.   You just levered your $2 into $10.  Now imagine the house appreciates 40%.  The house is worth $14.  You still owe the bank just $8.  But you just got a $4 gain off of a $2 investment, a 200% gain on your initial investment!

Now lets work the story in reverse.  Imagine your house depreciates in value.  Something we have seen recently in the housing market.  Your house depreciates 40%.   The house is now worth $6.  However, you still owe the bank $8.  You don't even have your initial $2 investment as you put it in the house.  You have an asset that is worth $6, but owe $8 on it.  If you are able to sell the house for $6, you would net lose $4.  You just turned $2 into -$4, a 200% loss on your investment!  However, unlike a house, the people who are loaning Lehman and other financial institutions money have a right to call in the loan at any point.  So now you are scrambling to find capital to pay off the loan.  You are selling assets to come up with the money.  But when you are a big player, your selling moves the market!  So you are causing the very thing you are selling to lose value!

Now multiply the above example by about $100 billion, and you have the problems we are facing now.   When things were going great, all these financial institutions attempted to turn their $2 billion into $14 billion.  They just didn't see didn't know what to do when the music stopped playing, and the chairs were all pulled.  The scary thing?  We are only in the 5th inning of a 9 inning game.