According to Investopedia: Leverage is the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
Leveraged Investing Exploded
The World of Finance has gotten increasingily complex in the last five years. The collapse of some famous Banks like Lehman Brothers was laid firmly at the door of the problems related to CDOs (Collateralized Debt Obligations) which used complex structures to combine insurance products with subprime debt and graded it well above where it should have been. In 2008, Lehman faced an unprecedented loss due to the continuing subprime mortgage crisis. Lehman’s loss was apparently a result of having held on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages.
In simple terms, a CDO is a promise to pay cash flows to investors in a prescribed sequence, based on how much cash flow the CDO collects from the pool of bonds, mortgages or other assets it owns. If the cash collected by the CDO is insufficient to pay all of its investors, those in the lower layers (tranches) suffer losses first. These products were extremely leveraged resulting in massive profits on the way up and tremendous losses on the way down. But these paper monstrosities were so complex that not even the experts understood how to properly determine the risk or the value. Theoretically they were insured, thus increasing their value but that just shifted the risk to an insurance company. But when the dominoes began to fall the leverage was so great that the insurers couldn’t cover the losses.
When the market realized the imbalance, the resulting crash resulted in a more cautious approach to credit whether it is personal loans or mortgage applications.
Leveraged Investing After the Crash
After the 2008 Crash, a number of financial institutions have taken a more cautious approach to personal loans thus drying up the availability of leverage for a variety of purposes including home purchases, consumer loans and investing. The ability to repay is the primary issue a lender is concerned with while the investor is concerned with achieving a better return than the costs of borrowing.
Leveraged Investing = Buying on Margin
Another name for leveraged investing is buying on margin. Often investment leverage can be obtained directly through your investment broker by allowing you to borrow against your stock portfolio. All that is required for you to begin trading is that you open a “margin account”.
This precludes the necessity to find a seperate lender willing to loan you money on potentially risky investments. Using leverage can multiply your investment gains but is not so popular when the overall market is flat or declining. If the value of the underlying stocks are falling this can result in the lender (the brokerage company) forcing a sale and closing the position if they feel the collateral’s value has declined too far to provide them adequate protection. This is called a “Margin Call”. Often by the time the margin call is exercized the remaining money goes to the brokerage and the investor is left with nothing.
On the other hand, if the money to be invested comes from personal loans, the prospective investor needs to be sure that the loans can be successfully repaid if the investments do not perform as expected. In that case, the individual investor could lose more than the value of his investment. For instance if the investment went to zero he would still be personally liable for the loan. Most advisors do not recommend using borrowed money to fund an investment account.
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