Most people still don't know what caused the financial crisis. They know it had something to do with subprime mortgages and Lehman Bros, but beyond that, it gets rather hazy. Unfortunately, Congress appears to be in the dark too, which is why their attempt to regulate the system is bound to fail and pave the way for another crisis in the next few years. [Financial crises occur on average every seven years. Eds.]
The real source of the the last crisis is a design-flaw in the architecture of the modern banking system. This sounds more complicated than it really is.
You see, credit, which used to be strictly regulated--since it allows banks to create money out of thin air--has become a franchise which is shunted off to hedge funds, insurance companies, pension funds and other so-called shadow banks which are able to take advantage of loopholes in the system and create gigantic amounts leverage without any regulatory supervision.
At one time, when a bank made a loan, they made sure that the applicant had a job, steady income, collateral, and a good credit history. That's because the banks knew they would be holding the loans to maturity and any loss on the loan would impact their profitability. That's the only way that it's safe to allow private industry (aka--the bank) to create credit. The financial crisis proves that unregulated credit-generation is every bit as lethal as a neutron bomb, which kills everyone in the vicinity, but leaves the buildings still standing. The credit-mechanism cannot be handed over to unregulated speculators without putting the entire economy at risk.
The new system works differently. Now the banks are largely middle-men who originate the mortgages, (or other loans) chop them up into bits and pieces in their off-balance sheet operations, and sell them to investors in the secondary market. The process is called securitization and it magically transforms one man's liability (the loan) into another man's asset.(the security) But don't be fooled. The debt is the same as if it was still sitting on the bank’s balance sheet instead of some oddball structured-debt instrument, like a mortgage backed security (MBS) or a collateral debt obligation (CDO). What's really changed is the ability to generate credit has shifted from highly-regulated depository institutions to fly-by-night speculators whose only interest is to maximize leverage, create another bubble, and cash in before the mighty zeppelin crashes to earth.
Keep in mind, that a bank is any institution that takes deposits and agrees to provide ready access to cash for people who want to withdraw funds. A bank makes its money by "borrowing short" (deposits or repo) to "go long". (putting money in long-term illiquid assets) That means that a bank is required to hold liquid reserves and enough capital to meet its needs even in a crisis.
The banks have abdicated their role as credit producers, because the shadow banks can do the job cheaper. And the reason they can do it cheaper is because they are undercapitalized. Take AIG for example. They were selling insurance policies (CDS) but they didn't have the capital reserves to pay off the claims. Think of how easy it would be to make gobs of money if you could sell property that you didn't really own. The only problem, of course, is that if you engaged in such activity, you'd be dragged off to the hoosegow in chains.
So how do the shadow banks make so much money by increasing leverage?
Here's how it works: There are three houses on the block; all of them are identical and all of them are the same price, $100,000 each.
Harry buys the first house and pays cash, $100,000 on the barrelhead.
Joe buys the second house and puts 10 per cent down, in other words, he pays $10,000.
Frank, who works for a big chiseling hedge fund on Wall Street, buys the third home and puts 0.0 per cent down; so he has zero equity.
12 months later the value of all three homes has gone up 10 per cent; so now they are all worth $110,000. That means:
Harry has made a measly 10 per cent on his investment.
Joe has made 100 per cent on his investment.
And chiseling Frank has made $10,000 pure profit.
This simple breakdown is intended to help people grasp the real purpose behind securitization and derivatives trading, which is not to make markets operate more efficiently or to "disaggregate" (spread) risk (as the proponents of "innovation" say). It is simply to peddle garbage assets which are balanced on minuscule slices of capital. It's a shyster's dream-come-true; capitalism without capital.
All Wall Street's profit's derive from some variation of this low-capital, high-risk schema.
ZERO-HOUR FOR LEHMAN
The day the shadow system blew up
Before to the meltdown, the depository "regulated" banks were mainly funded through repurchase agreements (repo) with institutional investors. (aka---"shadow banks"; investment banks, hedge funds, insurers) The banks would post collateral, in the form of bundled "securitized" bonds, and use the short-term loans to maintain operations. When the bank’s collateral became suspect -- because no one knew which bundles held the subprime mortgages -- then intermediaries (primary dealers) demanded more collateral for the loans. Suddenly the banks were losing money hand-over-fist as the value of their assets tumbled. Lehman got trapped in this revolving door and couldn't roll-over its debt using its shabby collateral, which, by now, everyone knew was garbage. There was a bank-run on the shadow system; the secondary market collapsed.
In other words, the banks were going to the primary dealers the same way that I would go to a pawn shop, and borrow money by posting my lavish, fully-landscaped 4,000 ft colonial home and custom Maserati sports car for a $200,000 loan. That scam might work for a while, but eventually the owner of the pawn shop will wise up and realize that I don't really own a lavish, fully-landscaped 4,000 ft colonial home and custom Maserati sports car. Rather, I live in a makeshift clapboard-shack with a corrugated tin roof by the railroad tracks and drive a rusty Schwinn bicycle to my job collecting aluminum cans for the recycling center. That's what happened to Lehman.
When Lehman Bros collapsed, there was NOT a panic. That's another myth. Lehman merely triggered a radical repricing event, which means that the assets that had been trading for artificially high prices, suddenly fell to reflect what reasonable people thought was there "true" market value. This (collective) judgment was not made out of fear, but rather with the knowledge that the underlying collateral (shabby mortgages) was gravely impaired. Prices in the repo market for some MBS and CDOs fell more than 50 per cent.
Of course, Bernanke still clings to the idea that these are just "unloved" assets that will eventually bounce back. But what else can he say? "We're going to mark these turkeys down to their real value and shove the banking system off a cliff?" That's not going to happen.
So, it's up to congress to grasp the thistle and demand that the shadow banks be strictly regulated from here-on-out so we don't end up in the same pickle two years from now.
The state has a compelling interest to make sure that credit-generating financial institutions are strictly regulated. Credit expansion is vital to economic growth and to raising standards of living. But, in the wrong hands, it will increase inequality, divert money away from productive activity, and inflate asset bubbles that end in disaster.
The reforms which are now being debated in the congress, (Too big to fail, off-balance sheet operations, derivatives trading, securitization) miss the larger point. Regulators must have the authority to intervene WHEREVER they think it is necessary to ensure that institutions are adequately capitalized, that lending standards are strictly upheld and that credit production is carefully monitored by trained government supervisors.
