Financial Sectors' New Buzzword Is Deleverage

Leverage is a word heard frequently during the current financial crisis. It means borrowing heavily to maximize investment returns. The problem is that leverage was used to invest in mortgages that went bad. The new buzzword in the financial world is deleverage.

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STEVE INSKEEP, host:

Next, we're going to define one of the words that is part of the language of Wall Street. The word is leverage. We're told that failing Wall Street investment banks were heavily leveraged, and what that means is they borrowed colossal amounts of money and gambled it and lost. Our guide through this bit of jargon is NPR's Chris Arnold.

CHRIS ARNOLD: People use leverage because they have a problem. Cavemen did it. A rock is too heavy to lift, you go find a big stick and you lever it up. A problem for Wall Street was that it was getting harder to make money buying and selling stocks for customers. There was online trading and other technologies, and that made life tough. The billionaire New York Mayor Mike Bloomberg talked about this, this week.

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Mayor MICHAEL BLOOMBERG (Independent, New York, New York): Wall Street - because it's a very competitive industry and a lot of the products that they have, have been automated so they can't make any money anymore - had looked for a long time for a new ways to make money, and the mortgage business was a good business.

ARNOLD: It was an especially good business if you used the leverage. With financial leverage, the stick is borrowing money, and you use it to lever up your profits. Here's how it worked. Interest rates were low. The financial system was flush with money. So, the investment banks would borrow money cheaply and invest it in mortgages. That made a good profit, and the more that they borrowed, the more they made, even though, in retrospect, it was kind of like using your Visa card to gamble at a casino. You can lose a lot of money that you don't have. But...

Mayor BLOOMBERG: When things go up, nobody pays attention. You know, I mean, this is pressure on all of us, and you just throw your hands up and you say, hey, every day it's better. And we're Americans, we always think that every day is going to be better. And so, Wall Street got itself in a position where they were much too highly leveraged.

ARNOLD: Some of these firms were borrowing more than 30 times their assets. That's a huge amount of leverage, and it means that they were on the hook for a ton of money. Now, home mortgages had historically been very safe investments. But in order to generate more business, Wall Street was loosening its lending standards to ridiculous levels. They told mortgage brokers that they'd accept borrowers who couldn't even prove they had a job. As long as home prices went up, people who couldn't pay could just refinance. But home prices stopped going up. Andy Kessler is a former-hedge-fund-manager-turned-author.

Mr. ANDY KESSLER (Former Hedge Fund Manager, Morgan Stanley; Author, "Running Money: Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score"): Wall Street was borrowing at 30 or 35 to one. So, all you needed was a slight little downtick in home prices, which were backing up these subprime loans, and you completely wipe funds out.

ARNOLD: Now, this investment banks are full of really smart people. How could they take on such a crazy amount of leverage to invest in loans that were bound to go bad?

Dr. NANCY J. KIMELMAN (Author, "Common Cents: How the Economy Really Works-from the Global Market to the Supermarket"): Wall Street has rocket scientists creating securities.

ARNOLD: Nancy Kimelman is a former Wall Street economist. She says it would be one thing if the investment banks were selling toxic, subprime-loan-related securities just to other people, but they themselves invested in them. Part of that, she says, has to do with how complicated these securities are that these super smart people put together.

Dr. KIMELMAN: Scientists, sort of, in the back room with lots of test tubes and Bunsen burners, they've created monsters. They've created these securities that nobody has a handle on.

ARNOLD: Mayor Bloomberg says, too, these securities just got way too complicated, given the massive amounts of leverage that the firms were using.

Mayor BLOOMBERG: My theory is that most people couldn't understand them, people that worked in the firms. I don't know that the management of these companies really understood the risks and the volatility.

ARNOLD: Once they did, the investment banks quickly tried to deleverage. That's a word that's being used a lot these days. What it basically means is that all these investment banks have been trying to sell these dubious securities. But now, nobody wants them because they're tied to all these problem loans. Nobody knows what they're worth, and a string of companies have collapsed because of it. And that's why the government may now have to sweep in and basically take over these bad loans, before they strangle more of the nation's most prominent financial companies. Chris Arnold, NPR News.

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INSKEEP: Chris is helping us to define what we talk about when we talk about the market prices. There's a lot of jargon out there, which, I guess, we'd better know now that we're going to own all that bad debt. And we will define more key terms in the coming days. We'll do it right here on Morning Edition from NPR News.

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