Thursday, January 04, 2007

The greatest depression ever!

Given Dave's post on investing with leverage, I'd like to point out that the Great Depression wasn't so much caused by the Stock Market Crash of 1929 as the fact that people had posted their homes as collateral for loans to invest in the stock market. When the market crashed and the lenders saw that they weren't going to be repaid, they started foreclosing on houses and farms set as collateral. With people losing their jobs and homes the Great Depression set in.

Cautionary tale aside, people invest with leverage all the time. In a short sell, one sells stock borrowed from others with the promise to return it by a certain date hoping the price will go down and they will pocket the difference. In a long sell, stock is purchased at the current price with money the investor has borrowed, often from the brokerage itself,
with the hope the price goes up and they will pocket the difference. In both of these cases, the non-leveraged portion of the investor's portfolio is used as collateral. Performing long and short sells requires a margin account with a brokerage of some kind.

Additionally, investors at the Prosper Loan Market Place are using their high credit ratings to secure sub-prime interest loans to invest in other loans on Prosper. Because the loans on Prosper are unsecured, the speculator could be burned if enough of their purchased loans default. They would still be on the line for making the monthly payments on the money they borrowed. I think investing in these characters is attractive for a lot of people because they view it as safer because their money has been lent to a person with a good credit rating to protect. However, one never knows the confluence of events that could occur. The speculator's loans could default and they lose their job leaving them to default on their own loan.

I think the real lesson here is that "investing" with leverage is entirely speculative and as a general rule no more than 5% of your portfolio should be held in speculative investments.

Disclaimer: The above does not construe actual financial advice. If you lose all of your money it's your own fault.

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