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Deleveraging, demystified

Marketplace Staff Nov 13, 2008

Deleveraging, demystified

Marketplace Staff Nov 13, 2008


Steve Chiotakis: Maybe you’ve heard the business term “leverage.” It’s a fancy word for borrowing. So “deleveraging” should mean paying the money back, right? Ah — not-so-much. Maybe it’s time we consult with Sally Herships over at the Marketplace Decoder.

Sally Herships: Leverage has gotten a bad rap recently. But David Beim of Columbia Business School says borrowing isn’t a bad thing.

David Beim: If people are willing to lend you money, you can do more — you can buy more things.

But it can get out of hand. Beim said that’s what happened in the early 2000’s with the housing boom.

Beim: You could get money — I think I got something like four and five-eights percent. It was a really cheap rate.

And it wasn’t just people borrowing big to buy houses. Companies borrowed to buy competitors. Investment funds borrowed billions to buy mortgage-backed bonds. Many of them borrowed way too much.

Beim: We call it leverage because being in debt makes good times better, but it makes bad times worse. Sort of like alcohol.

Imagine buying a million-dollar home with $100,000 down. If the home appreciates ten percent, you double your money. But if the value of the home falls 10 percent, you could lose everything.

Some investment companies borrowed 30 times what they had in the bank. They bought mortgage-backed securities, which was fine when the value of those bonds was rising. But when they started to fall, the companies stood to lose a lot of money. And it was time to de-leverage.

Beim: There’s only two ways to do that. One is to build up more capital to meet the assets or to sell off the assets.

Building capital, or making money, in other words, is tough when the markets are sliding and the economy’s in a recession. So investment firms have to sell. And the more bonds, stocks and loans they sell, the more they have to lower the prices to find buyers — and that brings all the markets down.

Beim: Trouble is there’s not enough hands to hold all the assets that we’ve created. So the world is having trouble deleveraging all at the same time. We can’t all deleverage, because somebody’s got to buy the assets we’re trying to sell.

It’s not just the investment companies that are in trouble. David Beim says the average American household borrows 24 times what it earns. Most of the stuff that we’ve bought with that money is declining in value. And as we slip into recession, and that means we need to deleverage every bit as badly as the banks do.

In New York, I’m Sally Herships for Marketplace.

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