How Hedge Funds Screwed Up On Subprime Morgages
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Expat Village is edited and published by
Iain Williams in Caracas, Venezuela.
By Graham Summers of Inside Strategist
For instance, let's say you only had
$10,000 in the bank and you borrowed an additional $90,000, bringing
your assets to $100,000 total. If you're only paying 1.25% interest on
the $90,000 loan, your interest payments come to $1,125.
Now let's say you invested all $100,000 ($10,000 of your own money and
$90,000 borrowed) in a mortgage-backed security yielding 8%. So you're
making $8,000 from the yield.
Altogether, your costs are $1,125 (interest on the borrowed money), and
you're making $8,000. With net profits of $6,875, your rate of return
is an incredible 69% ($6,875/$10,000).
But if the interest rates you're paying on the borrowed money rise
dramatically to 5.25% (as they did when the Fed raised rates 17
consecutive times), your profits vanish overnight. All of a sudden,
you're paying $4,725 in interest (5.25% of $90,000). But you're still
making only $8,000 in yield. Your profits have been more than cut in
half.
And let's say some of underlying mortgages to your mortgage-backed
securities foreclose. Pretty soon, the credit ratings agencies step in
and lower the ratings on the underlying assets... meaning that the
$100,000 worth of securities you bought are now only worth, say,
$80,000 – less than you owe the bank. Suddenly, your risk-free trade
has become a very risky investment indeed. And if you don't sell,
you're going to be crushed.
This is essentially what happened to hedge funds, banks, and other investment vehicles... only on a much larger scale.
Expat Village is edited and published by
Iain Williams in Caracas, Venezuela.
© Copyright 2003 by Expat-Village.com
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