The Business of Banking

Borrow at 3% interest, lend at 6% interest, and be on the golf course by 3pm - Anonymous

The latest recession has been described as more serious than previous recessions because it's a financial recession. It's caused by and centered on the financial sector of our economy, and thus more serious than previous recessions based on oil embargoes or dot com bubbles. But what exactly is "the financial sector"? What role does it play in our economy?

Financial institutions (primarily banks, but also other entities such as brokerages and insurance companies) differ from other enterprises because they are in the money business. Mostly, they are in the business of "other people's money". They receive deposits, premiums, investment capital or some such from those who have a current surplus of cash. These people (or creditors) could be retirees with a saved nest egg. They could be a pension fund receiving contributions but not yet needing to pay the pensions. They could be mutual funds making investments. Most of them have a future need for the cash, but they don't have an immediate need. So they deposit their money in a financial institution, either as savings or as investment.

The receiving institution doesn't usually keep the money. Instead, they find a party with a need (or opportunity) that requires cash today. This could be a corporation wanting to build a new factory, a producer wishing to shoot a new film, or you wanting to buy a house or car, but not having the purchase price in cash. It could be your government running a deficit. These people (or debtors) borrow the money with a promise to repay, with interest.

So finance companies match investment capital with investment opportunities. As such, they are vital to nearly every other sector of the economy, particularly consumers and government, who represent the majority of outstanding debt.

Being important, and close to the money, means that financing is usually quite profitable. And so it has proven in the past 20 years, with the financial sector growing from 5% of our economy to 15%, and representing some 40% of corporate profits in 2006.

So what happened in 2007 and 2008? Well, one important aspect of finance is risk. Not all debtors pay you back. The riskier the debtor, the more interest you need to charge to cover that risk. If you don't charge enough, and too many default, you lose money. And worse, it's not your money. It's other people's money, those creditors who deposited or invested their surplus capital with you. Just because your debtor left you high and dry doesn't mean you don't owe back the money to your depositors. If you misprice risk, suddenly you becaume a defaulting debtor yourself.

During the frenzy of globalization in the last 10 years, China and other export-oriented economies ran a trade surplus. They sold more than they bought overseas, and found themselves with a mountain of cash. Much of the cash was returned to America as investment capital. But there were only so many good investment opportunities. The rate of return on many investments fell.

One sector, thinking itself clever, saw a chance to channel some of this cash their way. By 2005, residential real estate was seeing a strong boom start to tail off. Homes were getting too expensive for ordinary people to qualify for ordinary mortages. Real estate brokers "solved" this problem with a host of new types of mortgage. Sub-prime loans, teaser rates, liar loans and so on made otherwise disqualified buyers suddenly eligible. Admittedly, these buyers were riskier than the traditional type, but that was handled by charging these people higher rates. Besides, even if the buyer defaulted, the mortgage was secured by the home. Home prices in the USA hadn't fallen on a national scale since the Great Depression. So what risk was there? But, just in case, these loans were bundled with ordinary ones and sold in packages. The idea was that the typical loans would compensate for the risky ones. Since these bundles included high interest mortgages, their rate of return was higher than average, and everyone wanted some.These bundled loans were then sold by the billions to nearly every major financial institution in the world.

Then the real estate market, artificially inflated by this cash infusion, rose to unsustainable levels. It turned out that many of the new buyers couldn't afford their mortgages, especially after the teaser rates ended. Some mortgage payments doubled, and the overstretched buyers walked away. Forclosures began, and the market fell.

Now the logic of bundling took on a vicious reversal. Rather than the typical loans compensating for the risky ones, the risky ones poisoned the typical loans. The bundles became "toxic". No one wanted them on their balance sheets, but no one would buy them. Markets panicked, investors withdrew their money, and banks collapsed.

Banking by its very nature is unstable. Banks borrow money for six months, and loan it out for 30 years. The added stress of toxic assets undermined many of the most famous names in American capitalism. We understand the fall. But have we discovered how to rise again, and learned the lesson to prevent another collapse?