Last week we talked about the nightmare of the bankruptcy of Lehman Brothers, the sale, or give away of Merrill, and the $85 billion loan injection into insurance giant AIG.
There are some big lessons for all of us individuals, as well. Sure, our first thought is about our mutual funds and RRSPs. But how many of us live on credit and are buried in payments of one kind or another?
As long as our income keeps coming in, we’re fine. But what happens when we have to do without a paycheque for two months? That’s the same as cash-flow problems for companies.
What are the odds of doing well, over the long term, if we use borrowed money to do our investing? Now, it’s fine to get a one-year RRSP loan, that’s different. But how many e mails do you want from people who look a line of credit to buy gold at around $1,000 an ounce and it’s now around $800? How many examples would you like of second mortgages to buy tech stocks in the 90s because they were never going to go down and people didn’t want to get left out? It is not investing – that is gambling, pure and simple. When someone jumps out of a 50-storey building, for 49 floors they can convince themselves they can fly. But then reality re-appears in a hurry when they hit bottom.
It’s called leverage and it’s a very dangerous shell game. One of the bankrupt firms was leveraged 33 to 1. That is: for ever dollar of assets, they borrowed $33. When shares, or in their case, these mortgage portfolios they invested in, were going up they were making a ton of money. But with a 33 to 1 ratio if investments drop three percent – that’s all – three percent – their entire assets are wiped out.
When you invest with cash – that’s the most you can lose. When it’s on margin, through leverage, you can be wiped out AND still owe a ton of money after all your cash investment is gone!
The good news? These days the rich will absolutely get richer! Why? There are a bunch of companies who have been around for decades whose stock is trashed for no reason. They have great dividends and their shares just got sucked down with the whole market.
Could you have been one of the rich people? You bet. If you’d have the cash to put into savings instead of paying the credit card, the mortgage, line of credit or the car payments.