Leverage can be a dangerous thing
Some immediate causes of this morning's fallen Dow: word of negative economic growth in Britain and profit warnings from big companies. But Dan Grech explains the role of what some call "forced selling."
The floor of the New York Stock Exchange (Chris Hondros/Getty Images)
More on Wall Street, America's Financial Crisis
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.
Comments
Comment | Refresh
From Mesa, AZ, 10/24/2008
I laugh-out-loud when I hear so many economic pundits say that we could not have another great depression, because there are too many safeguards put in place after the last depression. The truth is that we created a super debt bubble, and a fantisy economy. It's like we all went on a four year LSD trip and It's going to take a long time to distinguish between fantisy and reality. I have faith in Paulson and Bernanke to avert disaster, but it's foolish to say it can't happen. After World War I the French fortified their border with Germany and figured that they had that whole German agression thing covered. Hitler took a little detour through Belgium, and ran them over like a steem roller! Anything is possible!
Post a Comment: Please be civil, brief and relevant.
Email addresses are never displayed, but they are required to confirm your comments. All comments are moderated. Marketplace reserves the right to edit any comments on this site and to read them on the air if they are extra-interesting. Please read the Comment Guidelines before posting.
You must be 13 or over to submit information to American Public Media. The information entered into this form will not be used to send unsolicited email and will not be sold to a third party. For more information see Terms and Conditions and Privacy Policy.