Fallout: The Financial Crisis

Leverage can be a dangerous thing

Dan Grech Oct 24, 2008
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Fallout: The Financial Crisis

Leverage can be a dangerous thing

Dan Grech Oct 24, 2008
HTML EMBED:
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TEXT OF STORY

Renita Jablonski: The fallout is in the numbers this morning.
Stock markets in Asia and Europe were put through the ringer today. Now, it’s our turn.
The Dow is down 4.2 percent, or 368 points. Some immediate causes: word of negative economic growth in Britain, as well as more profit warnings from big companies like Sony. But a more fundamental market force seems to be at work. Some are calling it “forced selling.” Marketplace’s Dan Grech explains.


Dan Grech: In the not-too-distant past, investors around the world borrowed money to buy stock. It worked great when the market was going up: they paid off their loan and make a killing.

Robert Dunn is a professor of economics at George Washington University:

Robert Dunn: Leverage is a wonderful thing when asset prices are going up. But it’s a two-edged sword when prices go down. Leverage is very, very dangerous.

That danger is evident this morning, as stock prices sink around the world. As those stocks lose their value, banks demand highly leveraged investors pony up more cash.

Dunn: The deleveraging is quite something as the banks move aggressively to protect themselves against prices that continue to go down.

Dunn calls this forced selling, as investors sell off their stocks rather than borrow more money. This creates a downward spiral, as dropping prices cause more sell-offs, pushing prices down further. Dunn says we’ve seen this sort of thing before.

Dunn: And that happened in the 30’s.

I’m Dan Grech for Marketplace.

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