Thu Jul 31st, 2008 at 11:42:34 AM EST
I'm confused about the present meltdown, the blame is focused on risky loans and those who facilitated them, but I think the problem lies elsewhere.
In the old days, if you wanted to borrow money you went to the bank, and if your prospects were good enough, and you had adequate collateral, they lent you the money. The money they lent you was obtained from depositors. The bank made money by paying interest to the depositors which was less than they charged to borrowers. When everything worked right, everyone came out ahead, and the banker was ensured a steady income. Banks were low growth businesses. Many were even mutual savings associations which meant they were owned by their depositors.
Somewhere along the way, a steady return and low growth were seen as an impediment to progress. This was certainly true in some cases, limited access to capital has made it difficult for businesses to expand, that's why many chose to raise money by selling shares rather than by borrowing.
Now a bank could grow by adding depositors and many have tried to do this, but the path was slow and those with large amounts to invest didn't see banks as suitable. This is where the picture gets fuzzy for me. Why couldn't banks issue bonds like any other business to raise capital? I assume there were banking restrictions in place that prevented this, but why? I'm going to suggest that this is because other interests didn't want the competition.
So rather than allow banks to borrow the government came up with a convoluted scheme where banks would sell off their mortgages to an intermediary who would then provide the capital to the banks to lend out again. The intermediary raised the capital to do this by issuing bonds based upon the mortgages and by selling stock. So the banks weren't trustworthy, but Fannie Mae and Freddie Mac were. This is where the slight of hand came in. These firms implied that they were safer than Main Street Bank and Trust so those with capital invested in these middlemen instead.
There has to be more to this story as well, the returns promised by the middlemen had to be higher than what the banks could offer. This makes no sense, the interest on the mortgages didn't change just because they were repackaged, so the extra income had to come from somewhere else. The somewhere else was the Ponzi scheme that underlies the whole thing. There is no way that a sustainable business can pay out more than it takes in, except by borrowing from the future. The future has arrived. The losses now being taken by all the sectors in this scheme will probably add up to the excessive gains generated by the pyramid investing. Like all Ponzi schemes the total amount of money is fixed, but who wins and who loses depends on when you get in and out.
Could this have been prevented? Suppose you had wanted to create a traditional banking system which was not capital constrained and could service growth demands, what would it have looked like? Well, if individual banks are seen as too risky to allow them to float large bond offerings then an intermediate institution could be created which would sell the bonds and redistribute the funds, a bank for banks. This what the Federal Reserve claims to do, but it doesn't tap into the public market for funds. The difference between this idea and the mortgage bundling scheme now in effect, is that the local banks would have retained their loan portfolios and would have thus had a vested interest in lending only to low risk borrowers. In addition the returns to the investors of the bank for banks would be at a similar rate to what bank depositors get, speculators need not apply. The returns would be slightly higher because of the lack of insurance that the FDIC provides to normal bank deposits, but not much higher.
As long as speculators seek 15% return in a world where real returns are 4% the system has to be unstable. Either someone is getting fleeced, or they will be shortly.