3: Securitized Banking
The traditional model of banking is one in which a bank generates a profit by lending money at a higher interest rate than it pays its depositors for the use of their funds. During the late twentieth century, a new business model emerged that enabled banks to make money by other means, many of which exploit anomalies in the financial system. Securitized banking is touted as an alternative business model, and is widely practiced in spite of its specious nature - so it's worthwhile to understand.
In order to have sufficient funds on hand when depositors wish to withdraw their funds, banks typically keep a reserve of capital - but any capital held in reserve is not "working" and earning interest. So banks are interested in minimizing the amount of capital they hold in reserves, and have been rather innovative in developing ways to get cash to cover short-term shortages when their cash reserves are insufficient to met depositors' demands.
A "repo" market has been established that enables banks to sell securities with the right to repurchase them at a later time (usually within a few days) from the buyer. Generally, they sell them at a little less than their value and repurchase them at full value to provide income to the investor. This enables the bank to cover gaps when it must make payment a few days before it is due to receive payment from its borrowers.
When all works out as expected, the bank is able to maintain the investment, sacrificing only a few days' income for the sake of being able to meet its own obligations. When it does not work out as expected, the bank is unable to repurchase the security and the person to whom they sold is is no longer required to sell it to them, whether at the agreed-upon price or at all. Investors in the repo market make small profits, but secretly hope that things don't work out for the banks so that they can get investment securities at a discount.
For corporate borrowers, there is the phenomenon of commercial paper - a short-term loan at higher than market rate that gives them the ability to raise capital quickly and then repurchase their debt obligation, such that they paid high interest for only a few days. Commercial paper is not backed by collateral - it is a loan on the reputation of the issuer.
The danger with both the repo market and commercial paper is the potential for the guarantor of the asset to go bankrupt during the brief period of the loan. Since the term is short, this is expected to be rare - but a company in crisis might seek to throw money at the problem, dumping assets onto the repo market and writing a lot of paper to get cash to fend off a serious disaster - and the damage of the disaster is amplified if it occurs.
A derivative is a contract that obligates one party to buy or sell a security to another party at a fixed price on a future date. The value of the contract derives from the value of the security, hence the name. Some common kinds of derivative:
- Forward - A private agreement between two parties to make an exchange. The agreement is non-transferrable.
- Future - An agreement between two parties that is transferrable to other parties - the right to assume the role of seller or buyer in the contract can be purchased by another party.
- Swaps - A commitment to engage in a series of transactions in the future
- Options - One of the parties is obligated, but the other has the right to cancel the agreement
- Credit Derivative - The right to collect payments on a portfolio of loans
Until banking deregulation in the 1980s, banks were not able to invest their depositors' funds in derivatives because of the high risk of these investments. But between 1980 and 1995, these restrictions were slowly repealed and banks were able to engage in increasingly risky behavior.
Traditionally, loan contracts were treated as securities unto themselves. A bank that needed capital could sell a mortgage to another bank - but the purchasing bank would be able to scrutinize the contract and assess the creditworthiness of the borrower.
Securitization, however, enabled a bank to bundle together a number of mortgages into a single package and sell shares of that package on the market - effectively making the buyers shareholders in a firm that owned those mortgages without the ability to scrutinize the individual mortgage contracts or their borrowers.
The problem of opacity is clear - and to make matters worse, banks who sought to securitize mortgages simply ceased to practice due diligence in qualifying borrowers. Since the risk would quickly be passed to the investors in debt-backed securities (called DBS, or ABS for asset-backed, or MBS for mortgage-backed), firms that profited from creating these securities were not concerned at all with the creditworthiness of the borrowers. This is evidenced by the low grade of mortgages and NINJA loans (no income, no job or assets).
Securitization is not necessarily a bad thing. In theory, it would allow small banks to be more efficient in reselling mortgages or purchasing smaller amounts of mortgage debt that could be more quickly and easily resold. And the DBS could be structured for better diversity and security overall. But this is not what happened in the years before the crisis of 2007.
The authors goes on to describe the system of "tranches" in which a small number of high-risk loans could be bundled with a larger number of low-risk loans so that the returns would be greater and the risk mitigated across the bundle.
They then mention another form of derivative based on securitized debt: credit default swaps (CDS), which are essentially insurance contracts that compel the insurer to compensate the buyer for any loss that might occur if the holders of mortgages bundled in a CBS failed to make payment. Because it was assumed that DBS were safe (in spite of their opacity), many investment firms saw the CDS as a sure-fire way of making money, and took enormous losses when the mortgage borrowers defaulted.
So while the DBS wiped out the personal wealth of those who had purchased them (individuals, nonprofits, and some foreign governments), the CDS wiped out the treasuries of large financial industry firms who issued them.
The Role of the Shadow Banking System
To answer the question of why no-one, particularly governments, saw the disaster coming is that much of the activity in the manufacturing of these questionable securities took place in the shadow banking system, which is not subject to inspection or regulation.
This is not to say that shadow banking is sole to blame: the problem began in the formal banking industry, and the shadow banks were merely the rug under which they swept their misdeeds.