What The Hell Is Leveraging?
Leverage leverage leverage. Everyone's talking about it, but what does it mean?
Basically it's a fancy word for debt, and companies can use that money to go buy more stuff. But if the stuff you bought is a bunch of risky messed-up investments like crap mortgaged-backed securities then you've got a problem. Or, as Paddy Hirsch learns us in his latest whiteboard explainer, a big balloon straining to burst. Video inside...
Leveraging and deleveraging [Marketplace]
Lorem ipsum dolor sit amet, consectetur adipiscing elit. Nam malesuada commodo erat et molestie. Duis pellentesque aliquam bibendum. Suspendisse venenatis lobortis eleifend. Mauris id est sed lectus convallis aliquam.
Post a comment
Comments:
I love these whiteboard videos!
I like how he splains things cause I not that smart.
I want to become a multiple hedge fund running, $trillion losing, economy-threatening i-banker, simply so I would be interesting enough for Paddy Hirsch to want to interview.
Simply so I can shake his hand for a job well-done.
Sure, millions of families will be made homeless and countless children will go to bed hungry. But aren't MY needs important, too?
This guy has the best analogies.
The stick people before were hilarious...
I (heart) Marketplace. It's what's making me strongly consider switching my NPR membership to the other nearby affiliate. My nerd crush on Kai Ryssdal is luring me away from the local one.
In all seriousness, Marketplace (and that one This American Life episode about the big pile of money) have made this whole mess make sense to me when no other news outlet has been able to do it. I'm not dumb, but I'm no economist. That video was great.
Our economy is flaccid and useless.
Actually I've just learned about this young trader in his early 20's who in the 90's made so many bad trades and kept doubling-down with a lax oversight, that by the time he was found out, the bank, which was one of the oldest banks of the world....(Barkley's Bank or something like that), was unable to get a loan from the Bank of England because they were determined insolvent due to his risky trading. He lost billions though, good luck with your trillions!
Leveraging is what happens when you buy a house. You put down 20% and get a 100% investment in a house. Or like the video says, you are leveraged 5:1.
This is great when the house price goes up 5% because you make 25% on your money! But it is very very bad when the house goes DOWN by 5% because you LOSE 25% of your money. There is no way to separate the upside reward from the downside risk (unless the government gives you the money when you lose).
So leveraging is just betting. And just like people who bought houses with 10% down (10:1) or 5% down (20:1), investment "banks" where doing 20:1 or more.
So I can make it simpler than the video. If a bank is leveraged 25:1 and their investments loses a meager 4%, they are down 100% and the game is over.
Why would a bank do something so stupid? Because they expected gains/losses on their investment to move by a fraction of 1% and they needed a lot of leverage to make investors happy with returns of 8% or more. But then everything dropped (a relatively small) 2 or 3% (think subprime loans as one) and they lost 50%. This happened several quarters ago.
They just didn't want to admit it. So first you saw them admitting to only $5 Billion per quarter for a few quarters. And when they couldn't fake it any longer, they ran to the government to cover their mistakes.
@doodaddy: Wow, that was clear, precise, and easily understandable. We are on teh Internets, right? I didn't think a blog post could make it onto the 'Nets without the obligatory "lulz" in there...
Thank you for that explanation. I'm sure there's a little more that happened behind the scenes, but this is a great, short example of what brought us to this clusterf%^k.
@doodaddy: So it wasn't really that serious to begin with, only 2-3%... its just the banks over extended themselves?
Wow.
So why are we bailing them out again? So they can repeat this in another year or so?
@doodaddy: Which is why sensible regulation is needed to prevent everyone from riverboat gambling with what turn out to be public moneys. If no one can make 20% returns (in good years, only) using overly leveraged coin-flips, then the only AAA vehicles available are correctly priced, regards risk/reward.
Of course, there's always the junk market for the high fliers/low crashers, but they're labeled accordingly. Everyone's happy, with little gov't intervention needed. Adam Smith rejoices!
That's one of the huge failures of this fiasco: that junk became an artificial norm, thus a race to the top (bottom) ensued.
What The Hell is Matt Leveraging Now?