Business | Investment
Fat cats and surging collateral risks
I have yet to figure out if I gained or lost from the recent financial turmoil that spilled over from Wall Street and engulfed the rest of the world.
- By Babu Das Augustine, Banking Editor
- Published: 23:41 October 3, 2008
I have yet to figure out if I gained or lost from the recent financial turmoil that spilled over from Wall Street and engulfed the rest of the world.
My eight-year old daughter, blissfully unaware of the harsh realities out there, thinks she has made a windfall from Wall Street's troubles.
The reason for her joy is her latest acquisition, Morgan, a golden Persian cat, which an investment banker friend of mine gave her when he was forced to move on as his company decided to downsize.
Morgan seems to be facing difficulty in adapting to the frugal and chaotic home environment of a journalist from his previous opulent investment banking lifestyle. His extreme brand-consciousness about food and accessories is already challenging my budgeting skills.
My wife thinks Morgan is a delight. Although he came as the sad legacy of a troubled investment bank, she believes that spending money on him was "any day" a better idea than investing in the bonds of the Wall Street banks.
The horror stories I hear from some of our readers compel me to agree with her.
Last week, a friend from the media industry called me and said he lost half a million dollars in a bad investment he made in principal-protected notes issued by the collapsed investment bank Lehman Brothers.
For a moment, I was shocked. More shocked about the amount of money he had for investing than the losses he claimed to have suffered.
When I heard the whole story, I did not know if I should sympathise with him or blame him for his greed and folly. In reality he did own only a quarter of the money he invested, while the remainder was taken as leverage from a local bank.
With Lehman gone into bankruptcy, the bond values have shrunk to about 15 per cent of face value, while banks that had offered the leverage are now making margin calls ranging from 50 to 90 per cent.
Borrowing to invest, or leveraging, is an investing strategy that has been in existence almost as long as money itself. For thousands of years, borrowed money has built empires and financed new ventures.
If your leveraged investment appreciates in value, you stand to make much more money than with a non-leveraged investment. Of course the opposite is also true. If your investment struggles, you stand to lose a lot more money if you're leveraged.
Leveraged investments can be a powerful tool for building wealth when asset prices rise, but in a falling market an investor's equity can be quickly wiped out.
One of the key risks a leveraged investment could suffer is the collateral risk. It simply means the underlying asset's value is not enough to stand as a collateral for the leverage that triggers the margin call - as happened to investors in Lehman's notes.
With Lehman's bond values unlikely to recover in the near future, investors face losing most of their capital, losses likely to be compounded when the interest on the borrowed capital is added.
Morgan is indeed a fat cat with a Wall Street connection. But I am convinced that he certainly is one of a less risky variety.
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