December 22, 2010
Seeds of Financial CatastropheBy Fred N. Sauer
Although our economy is still struggling to recover from what is now the longest recession since the Great Depression, the latter was a much greater catastrophe. From 1929-1939, unemployment reached as high as 25%, industrial production dropped 46%, wholesale prices fell 32%, and foreign trade dropped 70%.
There is a general consensus about one of the most significant contributing factors to the financial crisis of the Great Depression:
Commercial banks for the most part are lenders to persons and businesses whose borrowing requirements are too small to utilize public markets. Commercial banks have to have detailed personal knowledge of their borrowers. And they lend to local borrowers in their local communities.
Investment banks, on the other hand, tend to raise money for larger businesses from the sale of common and preferred stocks and longer-term corporate debt. The criteria for borrowing in the public markets are more rigorous than those of local bank lending. Therefore, it is much more expensive and complicated to qualify. Investment banks also tend to make markets in the securities they issue or those already outstanding in the public market. This is all done by brokerages, the buyers and sellers of public securities for private and institutional investors.
To remedy these problems, Congress passed a historic piece of legislation:
The most important part of the Act was the creation of the Federal Deposit Insurance Corporation (FDIC). This insured deposits placed in commercial banks from the risk of loss in the event of the failure of a commercial bank. Depositors are in effect "lenders" to banks, which relend the deposits to other borrowers. In the absence of such insurance, when the banking system started to collapse in 1933, depositors' funds were wiped out. And so, the money supply shrank considerably.
In separating commercial banks from investment banks, Federal Deposit Insurance was not provided to investment banks, and for what used to be obvious reasons, commercial banks are considered less risky businesses than investment banks. Therefore, all other things being equal, investment banks will always have to pay a higher rate of interest to borrow money than commercial banks have to pay their depositors.
When you open up your bank statement, whatever the amount of your balance, about 60%-80% of it has to be paid off with loans made to borrowers, while the rest is covered by required reserves and other sources of income. Everyone with a positive balance on his bank statement is in fact an invisible partner to a business or individual who has borrowed money from the depositor's bank using the depositor's funds. And as we said, bank loans historically have not been marketable because typical bank borrowers could not meet the market's qualifying criteria.
And so, commercial banks used to be experts in knowing their customers, knowing their collateral, and getting personal guarantees to provide their successful history of making unmarketable loans. These then benefit the borrower, the depositors, and their stockholders. And banks usually held these loans to maturity, and everyone involved lived with the consequences.
In February 1970, the U.S. Department of Housing and Urban Development created the transaction using a mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans.
In the case of Ginnie Mae securities, no matter what the quality of the individual mortgages in the pool amounted to, when the securities were combined into a single security issued by Ginnie Mae, their value was enhanced by the existence of the implied guarantee of the federal government (i.e., the United States taxpayer). Through Ginnie Mae purchasing and securitizing pools of mortgages, banks could unload their portfolios of mortgages. This would result in a further loss of accountability over the quality of the mortgages originated. When commercial banks held mortgages to maturity, they were more careful about their quality. In a short period of time, asset securitization allowed commercial banks to offload bad loans over which they otherwise had institutional responsibility to other investors and depositors.
Not surprisingly, banks started pooling together other types of bank loans for securitization:
These would become the fodder for the sub-prime mortgage debacle we just experienced.
Here is a short course on this asset securitization and how it is attractive. Commercial bank "A" has 1,000 individual mortgages. There is no market for just one of them. But there is a market for 1,000 securitized into a single security whose composite yield is 6.5% and composite duration is twenty years. Investment bank "B" knows that it can sell a $100,000 pool of securitized mortgages to high-yield mutual fund "C" for a yield of 4.5%. Commercial bank "A"'s $1,000,000 pool has a monthly cash flow, principal, and interest of $7,455.74. Investment bank "B" knows that it can sell this pool of mortgages for a yield of 4.5%. In order to induce commercial bank "A" to sell the pool to it, investment bank "B" offers to pay commercial bank "A" $1,083,860 and will then give the pool a yield of 5.5%. Commercial bank "A" makes a profit of $83,860. When investment bank "B" resells the same pool to high-yield Mutual Fund "C," which needs only a yield of 4.5%, it receives $1,178,494 from high-yield Mutual Fund "C." Therefore, investment bank "B" makes a profit of $94,634, and so on. In addition to the initial profit, there are placement, distribution, and administrative fees to be earned. This is quicker money than holding mortgages to maturity.
Chart 1 - Value of $1,000,000 Pool of Mortgages
Accountability and responsibility declined as securitization increased, with everyone earning fees on originating and issuing securitized pools of almost anything. Both the commercial banks and the investment banks love this environment. They make a lot in fees and turn over their capital rapidly. And each one of them wanted to get into each other's business. Unfortunately for them, the Glass-Steagall Act stood in their way. Then, in 1995, everything started to change, under the leadership of a former Goldman Sachs CEO:
The recent financial crisis completely obliterated every intended meaning of this financial elite member's statement. The repeal of the Glass-Steagall Act allowed Citicorp and Travelers Insurance Company to merge in 1998. This merger ignited a wave of other commercial banks absorbing investment banks. The amount of government aid to these banks and financial institutions, including aid provided by the Treasury Department through TARP and the Federal Reserve, aggregated over $1 trillion through 2009. This and the near-collapse of Citigroup, and several other major financial institutions, demonstrate that the removal of the Glass-Steagall Act was a complete and utter catastrophe for America. Nonetheless, the recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 does not come close to adequately addressing the issue.
Fred N. Sauer is an American patriot, St. Louis resident, and businessman whose blog can be found at www.americasculturalstudies.com.