The banking crisis raises many questions. Do you wonder how banks that claimed to hold billions of dollars in real estate mortgage assets could go broke? And most importantly, how did a banking crisis involving mortgages turn into a global financial crisis that affects all of us?
The most basic cause is greed for more profits. But greed by itself is not enough. The banking crisis that started in 2008 resulted from a system that combined both greed and privilege. What bank privileges created the opportunity for massive profits? The banks greatest money-making privilege is that they can create money out of thin air. Every time a bank creates a new mortgage, the bank creates more money.
Banks have legal charters that allow them to make money with their depositors' money. In simplest terms, depositors put their money into the bank. The bank can then use these deposits to loan to other people as mortgage loans.
The most powerful benefit of this privilege is that the banks can make multiple loans on the same deposits. How much they can lend and how much they must maintain as assets is all regulated by Federal Reserve banking rules. Although greed was the motivation, the bankers needed more than greed to plunge the banking system into crisis. The bankers took advantage of changes in banking laws that allowed the banks to mix traditional banking with risky investment banking.
Did you ever see the classic Disney movie "Fantasia"? In "The Sorcerer's Apprentice," the young apprentice taps into magic he cannot control. Something very similar happened with the banks.
When you start with the bankers' legal privilege to make money out of thin air, and combine that with excessive greed, changed banking laws, and relaxed government regulation, it is easy enough to see how the whole situation could spin out of control.
Greed for more profits explains why banks began to make loans for mortgages they would never have financed before. They used new lending standards, such as "subprime" loans and "no-doc" loans. Sub-prime loans are typically offered to borrowers with poor credit at high interest rates. No-doc loans stand for "no document" loans that don't require the kind of careful verification of income, credit history, and ability to pay that traditional mortgage lenders required.
The names themselves are a clue that bankers were willing to make questionable loans. Why did they make such make such risky mortgages? They made risky loans because they didn't intend to keep them. They made their profit from creating the loans, rather than keeping them. After creating the loans, they sold these sub-prime loans to other banks. Then the mortgages were "securitized."
Securitization means that the mortgage notes were bundled together and then offered to investors in the form of mortgage-backed bonds. When a bank offers bonds to investors, it is borrowing money based on its assets. These securities based on sub-prime mortgages created a double problem.
Since many of the securities contained bad mortgages, the banks were not collecting enough mortgage payments to cover their obligations to bond holders. As borrowers began to default on their mortgage payments, the banks could not collect enough money to pay the investors who bought bonds in mortgage-backed securities based on subprime mortgages.
This is how banks with billions of dollars of mortgage assets on the books found themselves billions of dollars in debt. Although greed is at the heart of the banking crisis, no one can regulate greed. The real cause of the banking crisis is that the banks took advantage of their banking privileges and engaged in risky practices with their depositors' money.
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