Guest post by Market Authority 

Yesterday, I highlighted the financial panics of the 19th Century (aka bank runs), how they start, and the government’s response to prevent future runs (the Fed and FDIC). As noted, regulators and economists are only able to locate the problems with the engine after the car breaks down. 

Today, let’s take a look under the hood of our current financial system to better understand how the economic machine overheated and was left stranded by the side of the road. 

Businesses are more profitable than ever with record amounts of cash on balance sheets. The following chart depicts the rise of corporate cash as a % of GDP: 

Since this cash must be invested somewhere (usually short-term), Wall Street created the repo and commercial paper markets. This allowed Wall Street to borrow cash from Main Street on a short-term basis. Just like a pawn shop, lenders of cash need some type of collateral that they can liquidate if the borrower doesn’t pay back the cash on time. Wall Street took the borrowed money to finance higher-yielding assets, profiting on the spread between what they paid on the corporate cash versus what they received on the higher-yielding assets. 

Historically, the collateral that Wall Street pledged in order to borrow short-term corporate cash was AAA-rated US Treasuries. However, the government surplus of the late 90s mopped up too much Treasury supply. Wall Street needed another asset to use as collateral. And then Wall Street developed a game changer: securitization. 

This process moves long-term bank loans off balance sheets by packaging them together and selling them to the capital markets. Securitized loans, also knowns as Asset-Backed Securities (ABS), are backed by mortgages, auto loans, credit card loans, or student loans and now comprise one of the largest markets in the world. A market large enough to provide collateral for the enormous amount of short-term borrowing. 

Technology made securitization possible. Software programs can easily package millions of similar loans, something impossible to do by hand. Furthermore, easy-to-obtain credit scores allow lenders to assess the likelihood of default of each individual loan. 

Here’s a brief primer on how these loans work: 

Let’s say you live in a town called Springfield where 10,000 residents own houses with $200,000 mortgages that are held at the local Citibank. The average resident is paying a 10% rate on their mortgage and they all have 20 years to maturity. Since the bank can expect interest payments totaling $200mm per year (10,000 x $200,000 x 10%), they can create a new special purpose vehicle which separates these payments into different buckets. Because the bank can guarantee that the first $50mm of interest payments will go to the first bucket, the rating agencies give this a higher rating (even though the underlying collateral may be lower rated). 

Securitization provided the necessary AAA collateral for Wall Street to borrow from the rest of the private sector. 
 

Now think of this operation like the world’s largest pawn shop. The corporations (with the cash) are the pawnbrokers willing to lend cash to the banks as long as they provide adequate collateral. Typically, the corporations would lend cash at a rate of 1 to 1. So if Wall Street brought in a gold chain (or a AAA ABS) that was valued at $1000, the pawnbroker would lend them $1000 and hold onto the gold chain until Wall Street paid them back. 

Wall Street would then take this cash and use it to securitize more loans, which could then be used as more collateral. This process drove the credit super-cycle in a very pyramid-scheme like way. 

Tomorrow, I’ll discuss how the system began to crack when the pawnbrokers began requiring more collateral.