How One Million in Cash Can Be Used to Borrow 99 Million Dollars

by Alex Stenback on August 15, 2007

If, in trying to get your head around the credit crunch/liquidity crisis, you have yet to grasp the absolutely insane levels of complexity, leverage, and who knows what else that our financial markets are infected with, this should snap your mind into the proper orbit:

Mr. Nouriel Roubini, excerpted from here:

…Today any wealthy individual can take $1 million and go to a prime
broker and leverage this amount three times; then the resulting $4
million ($1 equity and $3 debt) can be invested in a fund of funds that
will in turn leverage these $4 millions three or four times and invest
them in a hedge fund; then the hedge fund will take these funds and
leverage them three or four times and buy some very junior tranche of a
CDO that is itself levered nine or ten times. At the end of this credit
chain, the initial $1 million of equity becomes a $100 million
investment out of which $99 million is debt (leverage) and only $1
million is equity. So we got an overall leverage ratio of 100 to 1.
Then, even a small 1% fall in the price of the final investment (CDO)
wipes out the initial capital and creates a chain of margin calls that
unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.

See that?  Just take your million, invest it, and by the time all the leveraging, upon borrowing, upon leveraging is done, you’ve got 99 Million dollars riding on just $1 Million in actual money. And we don’t blame you one bit for wanting to cash out your portfolio and buy precious metals after reading that.
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