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[quote="stock guru"]Here is a scenario that might explain better:

Suppose that you are a hedge fund manager that manages $1 billion dollars of other people's money. You could use the $1 billion to buy some mortgage backed bonds that yield 7% per annum.

That 7% yield is really not very impressive, so you use the $1 billion as a down payment to borrow $10 billions from the banks with a 5% interest. You tell the banks that your investment is conservative because you are buying mortgage backed bonds. The banks approve the loan because the housing market is doing very well and the bonds are "highly rated" by S&P and Moody's.

You make money by pocket the difference in the bond yield (7%) and the loan interest (5%). Your return on equity is 20% ($10 billions * 2% / 1 billion) per annum, which is very good.

Now image the mortgage backed bonds that you bought worth less each day because people cannot afford to pay their mortgages and they cannot find buyers for their homes either.

The banks start to get nervous and demand you to increase the down payment. So you have to sell your bonds to raise cash. But it seems everyone is trying to sell the same kind of bonds and there are no buyers!

Eventually, you will have to close your fund and let the banks keep the now worth much less bonds...[/quote]

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