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I used to work for a credit card/finance/mortgage company.  I always wonders how they got around the capital requirements I learned about in Money and Banking class.  Well know I finally understand the big picture.  Most of the expansion in the last 20 years has been a result of securitization.

What the Heck is Securitization?

The government requires that every bank hold a certain amount of money in reserve in case their loans go bad.  So for instance if you get a loan of $100,000 from your local bank, your local bank has to keep $10,000 in reserves.

Well the smarties on Wall Street said, wait, what if we can get around that safety requirement.  Instead of the bank holding the loan and tying up the $10,000 in reserve, what if the bank could sell the loan, making a profit and having the $100,000 to loan out again?  Enter securitization.

Securitization allows banks to bundle up debts (credit cars, mortgages, car loans) and sell them on a secondary market.  Anything with a future stream of payments could be bundled and sold this way.  Sub-prime mortgages could be sold to every one with a pulse and the bank could turn around and sell these on the secondary market therefore mitigating their risks and eliminating their reserve requirements.

Without risks, bank went crazy.  Credit scores didn't matter, "liar loans" were common.  With the mortgage brokers selling the loans as fast as they could book them, and Wall Street buying as much of this junk debt as they could get their hands on, an economic boom was in progress.

Just as there a speed limits for a reason, reserve requirements are a good idea.  Reserve requirements give the banks a cushion against non performing loans.  But with the banks not actually holding the loans, banks, credit card companies, finance companies, mortgage brokers and car financiers had no incentive to insure that the borrowers could pay back the money.  As long as they could book the loan and sell it to the secondary market everything was OK.

Hence cars, appliances, consumer electronics and houses flew off the shelf as fast as they could be manufactured.  A whole new class of consumer could afford the high life.  As long as financing was cheap and easy to get, life was good.

The Poop Hits the Fan

What happens when everyone has a house?  What happens when those that have houses can't really pay the mortgage?  You see to qualify poor people for mortgages, banks came up with Adjustable Rate Mortgages or ARMs.  The payments started out low then went higher.  The theory was that either the home would be worth more in the future so the home owner would simply flip the house and buy a new one, paying off the old one with the profits and then start again.

Well, turns out that houses don't always go up.  Gravity kicked in, people's ARMs starting costing an arm and leg (forgive the pun) and the poop hit the fan.

Weapons of Financial Mass Destruction

Now the new problem.  Because the debts had been sliced and diced and spread around, the holders of these debt "securities" didn't know what they had.  Were they sitting on a powder keg of sub-prime loans from Detroit?  Hard to determine.

People stopped paying, debt securities starting blowing up.  The investment banks, large holders of these junk debts, scurried to find capital to cover these debts.  You see the investment banks were also severely under capitalized because they had purchased investments with debt or as the industry calls it leverage.

Leverage sounds much nicer than debt or stupidity.  So the investment banks realized that they needed cash so they started dumping all the assets they had purchases on margin (with leverage) to raise cash.  The problem is the most of them ran out of cash and hence the government bail out package.

Banks Keep Figuring Out New Ways to Lose Money

So yes once again the banks were stupid.  They figured out new ways to lose money when the old ones were working just fine.  Consumers got what they wanted, banks got what they wanted and Wall Street made a ton of cash.  Until this year when everyone lost all the money they ever made plus some.

Like a crazy college party where everything seems to be a good idea, the hangover is pretty bad.  We're experiencing the hangover right now.  How bad will it get?  Who knows.

What you need to understand is that Wall Street does not have your interests in mind.  Wall Street is only out of Wall Street.

Tags    Banks    Crises

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