The Leverage of Subprime

Sherry posted an excerpt from an article she read in my "Real Estate Will Get Worse" post. The author of the article, Jackie Corr, points out an interesting leveraged strategy that is very plausible as to why hedge funds have been posting out-of-control losses recently.

If you buy a stock for $36 and sell it for $72 four months later, you've made 100% on your money. If you add $30 of borrowed money to $6 of your own to buy the stock at $36 and sell the shares at $72, your profit is $36, but you've made 600% on your $6 of which the hedge fund takes a percentage, roughly 2 percent or 72 cents, so your profit is now $35.24 on the $6 which is 587% and you can live with that

Multiply that transaction times billions and you are talking not billions but a trillion or more in profits which is why offshore tax havens like the Cayman Islands and the Bahamas are booming.

But the worm turned as we have been reading.

So now, let's say you put up $6 and borrow an additional $30 to buy a stock at $36. The stock falls to $18. You have lost $18 on the stock but still have a stock worth $12 after subtracting your $6. But all of a sudden, because of the panic that came with this crisis, you have to pay back $30 and quickly for that $2 stock. Your loss is now 300%.

Multiply that little transaction times billions and you understand why Wall Street is close to a nervous breakdown..

Makes sense to me and I agree 100% with Bernanke when he was quoted this past Friday at Jackson Hole as saying, "It is not the responsibility of the Federal Reserve -- nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions."

In other words, Mr. and Mrs. Hedge Fund, take your medicine like the rest of us.