Leverage

Leverage is the amount of loans compared to equity. If the leverage is 1 time, the amount of loan is the same as the amount of equity.

Some hedge funds are leveraged by 10 times. The borrowing is 10 times of the equity of the investors. This is risky.

I recalled that at the time of its collapse, Bear Stearns was leveraged 30 times. This is far, too high. To make matters worse, the borrowings are short term and their investments are long term. When the lenders refused to refinance the borrowings, Bear Stearns become insolvent. If they had to sell their investments, the markets would collapse. Bear Strearns had to be rescued by J P Morgan.

Lesson: It is very bad for hedge funds and investment banks to be highly leveraged. Leverage of 10 times is too high. Leverage of 30 times is madness.