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KAI RYSSDAL: Bank stocks were up big today. Merrill Lynch and Citigroup looked particularly tasty. They got a bump after Kuwait's sovereign wealth fund said it might be interested in snapping up a bigger share in both firms. Citi raised a bunch of money earlier this week by sellling off some new stock. Still, it probably won't turn it's nose up at Kuwait's cash. Citigroup's just one of the big banks working hard to reduce what folks on Wall Street call leverage. Marketplace's Amy Scott explains why.
AMY SCOTT: Anyone who's bought a home knows the power of leverage. Let's say I want to buy a $300,000 dollar house. All I need is maybe $30,000 of my own money. That's my equity. I'd be putting 10 percent down. I can get a mortgage to cover the rest.
That's leverage -- the use of borrowed money to increase gains.
Richard Sylla teaches financial history at New York University's Stern School of Business. He says leverage is great as long as home prices are going up. With that 10 percent downpayment, if the price of my house rises just 10 percent, I've doubled my money. But if it falls 10 percent, Sylla says, my equity's gone.
RICHARD SYLLA: So you magnify your gains or returns and you magnify your possible losses when you have leverage, because the money borrowed you have to pay back no matter whether the price of what you buy goes up or down.
Just as homeowners put less and less money down during the housing boom, financial institutions also boosted their leverage.
BRAD HINTZ: What we're looking at is we're looking at the leverage ratios of the brokerage firms, all right?
Brad Hintz walks me through the finer points of leverage on his computer. He's a securities industry analyst with Sanford Bernstein.
A chart shows that five years ago the big brokerage firms borrowed about $21 for every real dollar they held on their books. By the beginning of this year, they were borrowing more than $30 for every dollar of equity.
That's like me putting less than $10,000 down to buy that $300,000 house. Only, because a lot of the brokerage firms' debt is short-term, Hintz says, it's a bit like me buying my house with a credit card.
BRAD HINTZ: If you financed your house with a Mastercard and the Mastercard company sent you a notice saying we want all of our money back tomorrow, what price would you get for your house? Well, not a very good price, right? That was fundamentally what happened to Bear Stearns.
Hintz says when Bear Stearns' lenders and investors wanted their money back. The firm couldn't sell assets fast enough to pay them.
So how did banks like Bear let their borrowing get so out of hand?
Anil Kashyap teaches finance at the University of Chicago business school. He says just like in the housing market, when returns were good, taking on more and more leverage didn't seem that risky. And no one wanted to miss out on the party.
ANIL KASHYAP: Because when you're being cautious, the other guys are using their equity more efficiently than you are, they're earning more money, getting higher bonuses. It's very difficult to be the grumpy guy that keeps insisting on watching out for some problem that's yet to materialize.
But shouldn't the government have been that grumpy guy?
Kashyap says all that leverage was fueling the boom in home ownership. He says regulators were reluctant to interfere.
KASHYAP: Now what would that have got spun as? It would have said, well, there's all these often low-income borrowers who would like credit, but the government's telling us we can't give it to 'em.
Of course, now everyone's grumpy.
Regulators look likely to clamp down on how much investment banks can borrow. The banks themselves are working to reduce their leverage. Citigroup raised $4.5 billion yesterday by selling stock. Lehman Brothers recently raised $4 billion. It wants to boost its capital reserves and reassure investors it won't be another Bear Stearns.
But Kashyap says there's a downside to de-leveraging. He says institutions less willing to take on risk will be less likely to lend money. And that credit crunch we're hearing so much about could get a lot worse.
In New York, I'm Amy Scott for Marketplace.