Leveraging and deleveraging

hi my name is patty Osama senior editor at marketplace today I want to talk about leveraging and deleveraging the reason for that is because a lot of people have talked about leverage as one of the biggest problems that's contributed to the financial crisis and talked about the need for deleveraging so let's first talk about what leverage actually is right up on the board here leverage is actually just a really fancy word for borrowing okay taking on more debt the way leverage is usually described in companies or in funds or whatever is as a ratio so say for example we have and it's using a ratio of in company's case of the debt to earnings into earnings or debt to capital all right so it's the amount of debt that you have on your books in comparison to the amount of capital that you have on your books it's expressed as a ratio say for example it might be in the case of a large company five to one so in this case the company has five times the amount of depth of its books that it actually earns in a year or in a funds case five times the amount of it's borrowed five times more and it actually has capital on its balance sheet so that's the way it sits it's described as a ratio and you've heard in some cases of funds and banks being levered as much as twenty five to one or twenty pinyon this is also described as leverage twenty five times I think in some cases as much as thirty times so clearly that like that looks like a lot of borrowing and they must believe we should say at this point that leverage isn't necessarily a bad thing when leverage has done a great deal to to promote the growth of an economy and companies that can borrow find it very difficult to grow so you know borrowing is is a good thing but people say too much borrowing can be a bad thing we're starting to see some of that now so let's say use a little metaphor which is a metaphor of a balloon so if you think of a balloon which has obviously it has a skin and inside the balloon goes air and whether when you have it so if we compare the balloon to the economic system it's this the the framework or the structure of the economic system is the skin of the balloon so we blow this balloon up a little bit in our economic system we've got a market with stocks and bonds and all sorts of other things trading and with these things over em they're working very well inside the balloon and the balloon ISM it's very robust you can beat it around a bit it can take a lot of take a little flak and it retains its integrity and it functions perfectly correctly so then say we start to get leverage involved we start borrowing things in order to grow say we borrow money in order to buying more equities or bonds or whatever they may be or if you're a company we borrow money in order to buy another company or to expand our operations so the economy that starts to swell and gets bigger but still the integrity of the economy is good we've used borrow when you use leverage to grow but the economy is quite stable still once again beat this thing around and you know the retained its integrity and it holds up well together but now say we start to over leveraged say we start to to borrow vast amounts of money as if I I don't know mortgage-backed securities collateralized loan obligations collateralized bond obligations CDOs I'm gonna blow this up anymore because we can tell that it's getting a little bit tense we've got an extremely strange system right now this is the situation that we found ourselves in once we kind of over levered so this implicit simplification obviously but it meant that the system the economy itself was being strained at the seams by all of this leverage anybody who's done any tricks of the balloon knows that the more you blow the balloon up and the more strained the the fabric is then the easier it is for for us to pop the balloon just takes one little thing but and the whole thing goes that's the problem with leverage the more do you the more that you borrow the the easier it is to wipe out everything that you have and it doesn't take much to wipe you out completely and that's the situation that we find ourselves in today so what's the solution well the solution is deleveraging but deleveraging doesn't just mean you know paying money back because once again we're talking about a ratio so what we're trying to do is retain the integrity of the organization that we have if it be whether it be an economy or a company so we've got the equation has two sides to it so say for example we are levered to that at the rate of twenty five to one in this situation here so in order to delever we have two choices two ways if you like of letting air out of the balloon the first way is to reduce the debt so you know the company or where the organization goes out the fund goes out and it sells things in order to make money and pay off its debt the other way of course is to do with the other side of the equation which is to raise your earnings or raise the amount of capital that you have on your balance sheet and how do you do that well again perhaps you might borrow some more in order to expand to make more money to build up that side so you balance things out so once the ratio starts to come down say twenty to one ten to one then you're starting to deliver because either your your earnings or your capital base goes up or the actual amount that you're borrowing goes down and that's the situation that we are in right now so if we have this economy which is strained and we're trying to return to D leverage what we're trying to do is is to improve the integrity of the economy itself to make sure that the skin is more robust and can handle what's inside of it and is less strained and what the Fed has been trying to do by adjusting interest rates is to try and try and keep a grip on the on the mouth of the balloon if you like on the exit the economy what it really wants to do is to let the arrows little by little that has little by little that's the ideal thing that we want but of course that's not happening the reason that's not happening and what we're getting is this the reason that we're getting that and you're seeing that reflected in the wild swings in the stock market that we've been seeing recently in the bond market also the reason is because people are trying to reduce their borrowings and the way that they're doing that is by selling because they're not able to go out because we're in a recession they're not able to go out and make more money and raise more funds phones can't go out and raise more funds from people because nobody wants to invest and it's very difficult in a recession to make more money from your operations because people are retreating and they aren't buying so the only solution is to reduce this size of the side of the equation which means selling things in order to make money to pay off the debt and the way that's happening what what's happening is that people are going on in there selling vast amounts of the of whatever they have in their portfolios there'll be bonds or stocks or commodities or whatever happens whatever it happens to be the more that's sold the more pressure that's put on the economy or that's more pressure that's put on the markets so you have that horrible sinking sound as moremore is squeezed out of the out of the markets and prices are driven down so the different the the deleveraging that we're seeing is some people are worried that it's turn is is turning into deflation for actually saying it's a massive move running out of the markets but less we're careful unless the Fed and the Treasury and all of the other government agencies or worldwide that a central banks that keep a grip on the because this outflow from the markets that's they're very careful what we're going to end up with it's a completely deflating like it something that in the end is rather flaccid and useless that's the last thing they want to to have but of course it is not quite as bad as if we have this enormous ly inflated economy where everything was blown up beyond beyond saving and then you had that one little incident that prints the bubble and exploded and left everybody very badly needing a drink

Channel: Marketplace APM

Views: 108,822

Keywords: Marketplace, business, money, shortselling, short selling, financial crisis, Paddy Hirsch, whiteboard, economy, economics, NPR, Kai Ryssdal, credit crisis, Borrow, Spend, Cost, Supply, Demand, Big banks, Put up dough, Stake, Trust fund, Exchange, Barter, Vend, Offer, Auction, Traffic, Unload, Deal, Dump, Hustle, Recession, Austerity, Financial crisis, Thrift, Layoff, Field, Trade, Work, Career, Livelihood, Occupation, Vocation, Commerce, Financial affairs, Money, Accounts, Analysis, News, regulation

Id: vKp-HGfT1SQ

Length: 8min 29sec (509 seconds)

Published: Mon Dec 08 2008