The current economic crisis was not caused by houses or barrels of oil. It was caused by the trade in pieces of paper. Mostly virtual pieces of paper, at that. These pages will give you a simple explanation - with simple examples - of a relatively complex situation.
We will start with a lot of definitions and short explanations. Why? Without them, you are less likely to understand the bottom line, when you read it. And it is important to understand the not quite standard way we use some terms for the sake of simplicity.
What are these pieces of paper?
The pieces of paper in question are often called "instruments", such as "financial instruments". They are things like stocks, bonds, Treasury Notes, Certificates of Deposit, commodities, and the like. They are (in theory) documents which represent something of value.
What are virtual pieces of paper?
In most cases these days, the pieces of paper described above never become physical pieces of paper. Instead, they exist as information on a bunch of computers. They have serial numbers and the like to give them their own identities, but they never make it to paper. For instance, few of the people who own stocks bother to get physical "stock certificates" for the stocks any more.
Some pieces of paper are more likely to "get physical" than others. Things like "Bearer Bonds", checks, Savings Bonds, mortgage agreements, and the like are in that category. Others, like stocks, bonds, etc., sometimes become physical pieces of paper.
What can you do with these pieces of paper?
Basically, you can buy them, hold them, and sell them. Usually, you can also create them, create other pieces of paper based on them, or convert them into something else. Some of them have limits (usually laws, regulations, and/or contract terms) which restrict what you can do with them.
What do you mean, you can buy them?
Depending on the kind of paper it is, you can either buy it directly from the current owner, buy it through an exchange, or buy it from the issuer (most often a financial institution or the government). You might be able to pay full price for it or even barter for it. Depending on the limits described above, you might be able to buy them using leverage, buy long, or even buy an option to buy them later.
What is an exchange?
An organization that exists to handle the buying and selling of specific kinds of pieces of paper. A couple of the best known examples are the New York Stock Exchange (NYSE), which handles stocks, and the New York Merchantile Exchange (NYMEX), which handles commodity contracts.
What is leverage?
This is one of the most important - and dangerous - concepts we will address. Basically, leverage involves borrowing most of the money used to acquire an asset, with the loan payable at the time you sell the asset.
Think of being someone who buys a new car every year or so. You see offers for "Small down payment, no interest or payments until 2010!" and take the seller up on that. You put down your 5%, and get the car. If the value of the car goes up (unlikely, I know) within the next few months, you can sell it for a profit. When you sell it, you have to pay off the 95% you still owe, but all the profit is yours to keep.
When you are buying and selling pieces of paper using leverage, the paperwork is a lot simpler than the auto loan in the example and you don't (generally) face the prospect of making monthly payments on the loan. You just have to pay off the balance when you sell the pieces of paper.
Why is leverage attractive?
When you expect the value of your asset - your pieces of paper - to increase before you sell it, leverage seems almost magical. Instead of getting one $100 piece of paper for $100, you can put down that $100 and get 20 such pieces of paper (assuming a 5% down payment - 20 to 1 leverage). If the price of the pieces of paper goes up by a little bit, you might sell it for a profit. With a 2% increase - bringing the price to $102 - you could sell the one share you bought outright and make a $2 profit. Or you could sell the 20 shares you got with the leverage and make a $40 profit from that same $100 investment. As the leverage ratio gets higher, the down payment gets smaller and the profit multiplier gets larger.
The speculators and institutional investors are not putting down $100 at a time. They are more likely to be using $50,000 to get a million dollars worth of the pieces of paper. That 2% increase becomes $20,000 profit. And with leverage ratios as much as 1 to 30 and 1 to 40 being common in certain markets, that $50,000 investment could produce as much as $40,000 from that same 2% increase. And an additional $20,000 for each percent the price increase goes beyond that 2% before you sell it.
Why is leverage dangerous?
Have you ever heard the common advice "Never gamble with money you can't afford to lose"? If the price of the asset falls, the leverage can be just as powerful when turned against you. In the above examples, a price decrease causes you to lose money. If you just bought the asset, a 2% drop in price would mean you lose $2 when you sell it. With the 1 to 20 leverage, you have lost $40 of your original $100. Bad, but you still have something left.
The real trouble comes when the drop in price is greater than the down payment. A 10% loss in the price of the asset you bought outright just means you lost $10 of your original investment. But with the 1 to 20 leverage, that same 10% loss has wiped out your initial investment and you owe another $100 out of pocket. As the leverage ratio gets higher, the down payment gets smaller and the loss multiplier gets larger. If the leverage ratio was 1 to 40 and the loss was 50%, your $100 investment would leave you $1,800 in the hole. Now imagine the effect of that 50% drop on a $50,000 investment with a 1 to 40 leverage ratio - $900,000 in the hole. And in most cases, even those high rollers do not have an extra $900,000 in cash sitting around.
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