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What's Behind the US Financial Meltdown?

As officials and business leaders struggle to rescue the economy from serious problems, the news has been filled with strange terms like "mortgage-backed securities" and "leverage." We asked VOA's Jim Randle to translate some of this Wall Street-speak into more understandable language.

The financial crisis grows out of problems with mortgages, which are loans from a bank that helps a borrower to buy a home.

The borrower must repay the loan, as well as additional charges called "interest." Interest is rent paid to the lender for the privilege of using the money for a specific period of time.

Traditionally, U.S. lenders required prospective borrowers to prove that they earn enough money to repay the loan.

The borrower either pays back the money with interest or the lender "forecloses" - taking back the house.

University of Maryland finance Professor Elinda Kiss says that meant borrowers were unlikely to "default" or stop making payments.

"That is that people would keep up and make every kind of sacrifice to stay in their homes," he said.

But the risk of default grew when low interest rates cut bank revenue and prompted lenders to scramble for new customers.

Lenders boosted revenue by offering "subprime" loans that charged higher interest rates and required less verification of creditworthiness, things like whether the borrower has a job, how much money they make and whether they pay their bills on time.

But lower lending standards meant some subprime borrowers got mortgages they could not afford.

As long as home prices were rising, this caused few problems because borrowers who had difficulty repaying their loans could sell their homes at a profit and pay off the loan.

But when home prices fell, homeowners with financial problems were stuck and the number of foreclosures soared in the subprime market. This hurt borrowers who lost their homes and meant banks lost revenue they were expecting from loan repayments.

The impact of foreclosures was magnified by "mortgage-backed securities." These are created by investment firms that buy up a group of mortgages from lenders. The firm "bundles" these debts and revenues together in a package and sells them to investors.

Investors, including investment banks, usually get their money back with interest from mortgage-backed securities. But when subprime mortgages collapsed, they got huge losses instead.

George Mason University Professor Gerald Hanweck says mortgage lenders and investment banks who bought the securities that depended on mortgages badly misjudged the risk.

"The problem occurred because investors as well as the originators of the mortgage pool, did not price the mortgages correctly to take account of higher risk," he said.

The collapse of some mortgage-backed securities hit investment firms very hard because the firms were using "leverage" - huge amounts of borrowed money - to make investments.

When some investments went sour, some "highly leveraged" investment companies did not have enough money in reserve to cover their expenses and obligations, so some went bankrupt.

These losses shocked banks and other lenders and made them stop lending because they had no confidence that they would be repaid.

The head of the Economic Outlook Group, Bernard Baumohl, says without lending, the economy was paralyzed.

"Credit is the lifeblood, the oxygen this economy needs," he said.

Without loans, owners cannot build new factories, farmers cannot get seed and equipment needed to plant next year's crop, and the economy could stall.

The advocates of the massive bailout of troubled financial firms say their plan to buy up bad mortgage-backed securities and other problem investments is intended to restore confidence, spur lending, and get the economy growing again.