Monday, November 2, 2009

Subprime-Lending Crisis -The problem with leverage and the tricks it can play on you -

Leverage is the use of debt to increase the earnings of the company. The company borrows 100million at 7% and puts that money to work, where it earns 12%. This means that it is earning 5% in excess of its capital costs. The result is that $5million is brought to the bottom line, which increases earnings and return on equity.

The problem with leverage is that it can make the company appear to have some kind of competitive advantage, when it in fact is just using large amounts of debt. Wall Street investment banks are notorious for the use of very large amounts of leverage to generate earnings. In their case, they borrow $100Billion at, let us say, 6%, and then loan it out for 7%,which means that they're earning 1% on the $100Billion,which equales to $1 billion. If that $1 billion shos up year after year, it create the apperance of some kind of durable competitve advantage,even if there isn't one.

The problem is that while it appears that the investment bank has consistency in its income stream, the actual source that is sending it the interest payments, may not able to maintain the payments. This happened in subprime lending crisis that cost the banks hundreds of billions of dollards. They borrowed bilions at, say , 6%, and loaned it out at 8%. to subprime home buyers, which made them a ton of money. But when the economy started to slip, the subprime homebuyers started to default on their mortgages, which meant they stopped making interest payments. These subprime borrowers did not have a durable source of income, which ultimately meant that the investment bank didn't either.

In short run, they appear to be the goost that lays the golden eggs, but at the end of the day, they're not.

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