The words of the Subject are used frequently in descriptions of our present economic difficulties. One's eyes often glaze over when confronted with economic "tech-talk", but on closer examination these terms are not as fearsome as they may at first appear. Indeed they denote economic practices whose origins can be found in the Middle Ages, at the very beginnings of capitalism.

We'll do Hedging first. Hedging is simply a strategy undertaken to minimize a possible loss in the future. The easiest and most familiar example is insurance. Fire insurance will compensate you in the event of your domicile burning down; you will receive a substantial sum of money if this catastrophe occurs. You must of course pay to purchase this hedge, and the amount you will pay will depend on your and your insurer's look into the future. If all goes well and no fire occurs, you will suffer a minimal loss, namely, your insurance payments, and your insurance company will make a profit.

But already in this simple example we see complications. The insurance company will take care to protect itself against the possibility that you are a crook, that you've insured your $300,000 house for half a million, and that you will at the next opportunity torch said house. On the other hand, if you live in a "bad neighborhood", say in a house on the Malibu slopes, you will find that your fire insurance will be excessive, and a move to Beverly Hills may be indicated.

Many other opportunities for "insurance" may present themselves. One is often advised to diversify in one's investments. But one should diversify advantageously. Buying shares of both Ford and Chrysler is not wise; rather one should buy some car stock and some airline stock, and maybe even some railroad stock. The idea is: since people gotta travel, what the auto industry loses, the airlines will gain, and vice versa. In either case the investor either makes money, or in the worst case loses very little.

Clever financial minds take this idea and run with it. They devise schemes whereby by taking two separate positions one will -- if their probability models are correct -- make, with large probability, quite substantial profits, while losing very little on the downside. At least that is what they tell their customers.

And this idea can be iterated, passing thus to "derivatives", whose values "derive" from the value of underlying assets. An example would be the celebrated "credit default swaps". To quote from a NYTimes OpEd piece by Michael Lewitt:
"Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss."

Mr Lewitt goes on to say:
"The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small.

"As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized."

Couldn't really be clearer. I, a retired small businessman, can't go into the insurance business, even though I might for a while enjoy getting the monthly or semi-annual insurance payments. If a serious fire occurs, I don't have the wherewithal to pay off the value of the burned-down house.

And one can see that as a tower of derivatives, swaps, and hedge funds gets built, it would be very difficult for the analogue of a house inspector to go through all these instruments and see if, when worse comes to worst, they are sufficiently backed. Indeed, it seems that this industry was specifically left unregulated, due to former Senator Phil Gramm and former Fed Chief Alan Greenspan, and hence our present view of this former "tower" as a collapsed house of cards.

On to Leveraging. This too has ancient roots, going back to the medieval beginnings of banks in Venice and Milan and Amsterdam, where a merchant/banker would take in the gold of some other merchant or government or pirate and issue a "note" saying: "I have this gold and will pay it out to you on presentation of this note." That note could be used by the holding merchant/government/pirate to pay obligations; it is obviously easier to pass on this piece of paper, rather than trundle down to the issuing merchant/banker, reclaim the gold, and pass it on to the third party. Of course the merchant/banker was paid for his providing the convenience of taking care of the gold.

What took place next has always seemed to me to be the Original Sin of capitalism, putting "usury"(about which clericals made such a fuss) quite into the shade. For some scoundrelly merchant banker came up with the thought: "I have a bunch of gold here in my vaults, for which I've issued notes -- which I'm getting paid for! -- and which are out there in the world getting passed around in lieu of money. Them notes don't come back to me very often; so why don't I issue some more notes, promising to pay gold when the notes come back? I'll get paid for these new notes, adding to my profit stream. And SURELY IT WON'T HAPPEN THAT EVERYONE COMES BACK FOR THEIR GOLD ALL AT ONE TIME!"

We don't know when this first happened; at least I don't, and I doubt that anyone does. When was the first pocket picked?

But this sleazy act made bundles for the merchant/bankers who tried it. For it was tried all over and usually with great success. And treatises on economics will tell you, accurately, that this practice continues today and is the source of all of our money!

To be sure, the system has evolved over the centuries. Banks now do not issue notes; they give those who have according to their rules sufficient security a line of credit, which means a loan. The borrower gets a checkbook and an account entry at the bank with funds against which checks can be written. Banks are, in theory at least, well regulated by all modern states, and most states have national banks, or banks with the resources of the sovereign state, where an individual bank can go to "get money" if there should happen to be an undue call for the money that the individual bank has issued.

It is all still a bit daring, and is probably something which, like sausage- and lawmaking, should not be looked at with too much intensity. The ultimate weapon, sufficient to completely destroy a society without loss of life, would be a giant magnet swooping over all banks and financial data centers, and wiping clean all financial records. The records of who owns what would be gone. Thus: who could pay who? and with what? There would be riots in the street within 24 hours . . .

We avert our eyes from thie grisly vision, and say that Leveraging is simply how one makes new money from the original gold. Our original scoundrel merchant banker leveraged his holdings of gold into new profits by issuing his not-to-be-redeemed-all-at-once new notes. And our present banks, the ones we have in our neighborhoods, leverage their assets by lending for housing, new or expanding businesses, etc.

The history of banking is mostly the dramatic story of the abuse of leveraging and how it has been -- mostly! -- brought under control by regulation. It is a constant struggle between those who want to get richer by using their already acquired wealth to do so, and those who want money in order to grow things and those who want a convenient place to place what money they have.

If there aren't laws and controls, the desire to leverage becomes overwhelming. Issuing and selling new instruments like swaps and derivatives has been a source of great wealth for many for the past dozen years. One reads that Lehman Brothers, before its bankruptcy, was leveraged a multiple of thirty times. It is not at all clear exactly what that means, but roughly it means that when all the people whose "money" Lehman Brothers was holding came to Lehman Brothers for their money, they would have gotten only three cents for each dollar they were owed. Of course, this was prevented by bankruptcy, which is what merchants/bankers resort to when faced with unpleasant truths.