Reason #62: Leveraging our Economic Future

Back in the 1920s, speculators got filthy rich on so-called margins. Instead of buying a thousand shares for a thousand dollars, they’d buy a thousand shares for a hundred dollars, or less, and borrow the rest of the money. As long as the market kept shooting higher and higher, margin traders always made back the borrowed funds and reaped a tasty profit on top of it. Sounds like fun, doesn’t it? But what happened when the market tanked? You got it: Those same speculators couldn’t repay their loans anymore. Next thing America knew, banks all over the country were going broke because they’d lent all their money for margin trades. The rest, as they say, is history: the Great Depression.

The hedge fund boom has brought back margin trading with a vengeance, only nowadays it’s known by a different name: leveraging. Like a teenager taking his dad’s visa to the horse track, whiz-kid traders like Nick Leeson put billions of borrowed dollars into derivatives and other high risk-high reward deals. When they’re right, they make their investors incredible returns. But take it from an old hand: Leverage works both ways. When things are going up, it’s great. But when things go south, leverage can kill you.

Back in 1998, leverage killed a hedge fund called Long Term Capital Management. In the process, it almost brought our markets to their knees again. Long Term had about $5 billion in real equity. But it used over a $120 billion in borrowed money to make its deals. It thought its derivatives would never lose money, but nothing’s a sure thing-even if you have two Nobel Prize-winning economists on your board of directors like Long Term did. They lost almost $5 billion in four months.

Worst of all, just like in 1929, the banks that lent Long Term all that leveraged money were in serious danger of going belly up. The Federal Reserve had to step in and force big firms on Wall Street to bail them out. The Fed knew if they didn’t, we could have had another disaster on our hands.

I almost wish the Fed hadn’t bailed Long Term’s creditors out, because since then hedge funds have only gotten bigger and more powerful. They were some of the main buyers of subprime mortgage bonds, which helped the housing bubble inflate to insane proportions. And everyday, they stake trillions of dollars on risky gambles that would easily shatter our economy if they fail to pan out. Maybe if we’d felt the pain back then by letting Long Term’s death hurt the rest of the markets, we wouldn’t be at the mercy of all the risky business on Wall Street today.

NEXT: Reason #63: Turn Out the Lights, The Party’s Over (And the Taxpayers Have to Clean Up the Mess)