Congress with a three page plan to rescue the American financial system in paw in mid September 2008, everyone suddenly understood that something was wrong and that potentially we faced an economic collapse akin to the demise of the world economy in 1931. What was not adequately explained at the time, while Americans were running around complaining about bailing out greedy Wall Street bankers, as if Wall Street as we’ve historically known it still existed, was how the debacle in the mortgage credit market jeopardized the financial well being of everyone.
True we’d lost financial institutions by the bucketful since I was first licensed with the New York Stock Exchange in 1974. Hell, I worked for 10 member firms – all but two of which had gone belly-up, forcing an unplanned change in employers, sometimes without even moving my desk. None of this however, threatened the financial system like the almost instant collapse in the value of the average mortgage and the problem was hardly confined to the United States. The reason for this lies in how the lending industry had changed over the years and the way every financial institution was interlocked with every other financial institution around the world – potentially 1931 redux.
Historically banks tended to ‘borrow short and lend long’, meaning that their deposit base could disappear almost overnight while their loan portfolios were heavily weighted with loans that wouldn’t fully mature in five to thirty years. This created a two-edged sword. While banks cut the cost of their funds to what they paid for savings deposits and get a free ride on the float represented by their demand deposits (checking accounts), they relent this money longer term longer term at much higher interest rates and greatly profited from the difference between the two.
It also meant that they had to ‘warehouse’ these long term loans in their own portfolios and hope that depositors wouldn’t all show up at the same time to demand their money back. When this did happen, banks suddenly became illiquid and before deposit insurance, had to close down, costing those depositors who hadn’t been first in line their life savings. When faced with something like this, banks did make an effort to call in outstanding loans, often before their maturity date, from profitable corporations who never had enough cash on hand to pay off all their bank debts on the QT.
It also meant that companies that had deposited money in the special accounts they used to cut payroll checks lost the whole kitty, leaving their employees who attempted to cash these payroll checks out in the cold with no money. The same would be true for insurance companies disbursing claims checks, making annuity payments to retirees, and municipalities paying their vendors. In essence everyone suddenly becomes broke, despite being profitable and having money in the bank. Once the first group to get stiffed didn’t have the money they thought they had, they naturally couldn’t pay the people they owed, like the local electric company, and so on. Let’s just say that the misery rolled down hill from there.
To avoid this problem, the world of finance learned to match maturity dates for the funds they borrowed from the public (deposits) to the maturity dates of the loans they made. Additionally, through the acumen of Wall Street investment bankers, very liquid markets were created whereby banks could sell their loans to long term investors (think public employee pension plans) who could hold these loans in their portfolios forever without a problem – that’s how they accrued the money to pay liabilities due years down the road (think pensions again). This then is how all those toxic mortgages where up to 25% of the first time home buyers never even made the first mortgage payment spread throughout the world because the gate-keepers (federal agencies like Fannie Mae) failed to hold borrowers to traditional lending standards – just like a swine flu pandemic.
Now under stable conditions there is nothing wrong with this practice and the fact that banks could free up cash to make more loans by selling what they had in their portfolios meant that the capital owned by long term investors could be tapped for the benefit of the American mortgage market, making billions from all over the world available to the average home buyer. It also eliminated the inherent illiquidity risks of borrowing short and lending long. Unfortunately it all breaks down if a significant segment of the triumvirate consisting of home buyers, real estate agents, and independent mortgage brokers go about committing criminal fraud – which is what happened.
This is what created the morass of worthless loans that represented too much of the asset base of financial institutions everywhere and since on any given day every financial institution both owes and is owed money by every other financial institution, every bank, insurance company, and investment institution suddenly looked at their peers with whom they did business with daily and decided that they didn’t know who was solvent and who wasn’t because of all the bad assets on everyone’s books. Given the extensive leverage financial institutions use, most of their money is borrowed – leaving only a small portion that’s equity (the banks’ own money). Thus it doesn’t take much in the way of bad paper needing to be written off to eliminate a bank’s entire net worth and create an instant insolvency.
Once every financial institution assumes that all their counter-parties are insolvent, they stop doing business with them including the curtailment of check clearing (meaning that every check outstanding suddenly bounces despite there being money in the bank). Because one tries to avoid doing business with those who write rubber checks, the utility service known as the financial payments system, shuts down and bingo, neither you nor I have any money left despite carrying healthy bank balances in our accounts. This is how we all end up being general partners in the payments system (financial system). If too many can’t pay, then we all can’t pay – just like a general partnership where once all the other partners go under, the one with the deep pockets becomes obligated to pay the bills incurred by his other partners and thus ends up going under also.
Craig Boulton has written a number of books on finance, economics and political economy. He has written for Cato, and is a chartered financial analyst with more than 20 years of experience in the investment industry. He's also a combat veteran.