by Gregg Elberg

Banks lend money to people and businesses. The money is used for investment purposes and consumer purchases like food, cars and houses. When these investments are productive the money eventually finds its way back to the bank and an overall liquidity of a well functioning economy is created. The money cycles round and round when the economy is functioning effectively.

When the market is disrupted financial markets tend to seize up. The liquidity cycle may slow, freeze up to a degree or stop completely. This is true because banks are highly leveraged. A well capitalized bank is only required to have 6% of their Assets in core capital. It is estimated that the residential mortgage meltdown will cause credit losses of about $400 billion dollars. This credit loss is about 2% of all U.S. equities. This hurts the bank’s balance sheets because it impacts their 6% core capital. To compensate, banks have to charge more for loans, pay less for deposits and create higher standards for borrowers which leads to less lending.

Why did this happen? Once upon a time after the great depression of the 1930’s a new national banking system was created. Banks were required to join to meet high standards of safety and soundness. The purpose was to prevent future failures of banks and to prevent another disastrous depression. Savings and Loans (which still exist but call themselves Banks today) were created primarily to lend money to people to buy houses. They took their depositor’s money, lent it to people to buy homes and held these loans in their portfolio. If a homeowner failed to pay and there was a loss, the institution took the loss. The system was simple and the institutions were responsible for the building of millions of homes for over 50 years. This changed drastically with the invention of the secondary market, collateralized debt obligations which are also know as collateralized mortgage obligations.

Our government created the Government National Mortgage Association (commonly known as Ginnie Mae) and the Federal National Mortgage Association (commonly known as Fannie Mae) to purchase mortgages from banks to expand the amount of money available in the banking system to purchase homes. Then Wall Street firms created a way to expand the market exponentially by bundling up home loans in clever ways that allowed originators and Wall Street to make big profits. The big stock market firms were securitizers of mortgage-backed securities and resecuritizers who sliced and diced different parts of the groups of home loans to be bought and sold in the stock market based on prices set by the market and market analysts. Home loans, packaged as securities, are bought and sold like stocks and bonds.