Leverage is the amount of loans compared to equity. If the leverage is 1 time, the amount of loan is the same as the amount of equity.
Some hedge funds are leveraged by 10 times. The borrowing is 10 times of the equity of the investors. This is risky.
I recalled that at the time of its collapse, Bear Stearns was leveraged 30 times. This is far, too high. To make matters worse, the borrowings are short term and their investments are long term. When the lenders refused to refinance the borrowings, Bear Stearns become insolvent. If they had to sell their investments, the markets would collapse. Bear Strearns had to be rescued by J P Morgan.
Lesson: It is very bad for hedge funds and investment banks to be highly leveraged. Leverage of 10 times is too high. Leverage of 30 times is madness.
Thank you for providing your insights. Good stuff!
ReplyDeleteJust to add another perspective on the rescue of Bear Stearns - it was done through the "blessings" of Fed. Reserve - meaning public money was used to "insure" the toxic overpriced junk bonds, that caused the subprime mess. JP Morgan got a good deal, because they got the assets that carried good value (such as the 1 billion building) while the Fed Reserve is holding to rotting flesh.
If you think leveraging is madness, then what about using good assets to exchange for toxic, zero-value, items. That's why JP Morgan can put a value of $2/share to Bear Stearns. It is that bad.
R.