Wealth

Part 5 - Bankruptcy

Bankers soon realized they could make more money by paying reasonable interest for other peoples money and loaning out these deposits in addition to their own money. If they paid out 1% interest on deposits and charged 4% for loans they made 3% on each transaction for the period of the loan.

But if they loaned out eleven dollars, using only one dollar of their own money and ten dollars from deposits (other people's money), they were making 30% on their own money. (This is called leverage).This was tempting. If they used one dollar of their own money and twenty from deposits the leverage was 20 to 1 and the gain was 60% per loan (3% x 20). 

 This was a marvellous way to get rich but there were two problems. If one borrower out of eleven did not repay the money, the leveraged worked in the negative direction and the banker lost his $1 stake. If this happened infrequently the occasional loss could be written off against the gains on all the other loans. The other main problem was caused when depositors got nervous and all withdrew their money at the same time and of course the banks never had enough money to quickly respond. The result was a run on the bank. 

 Bankers could respond to this lack of confidence by calling in demand loans and by borrowing money from other banks or insurance companies but these were often nervous about losing their own money if the bank went bankrupt anyway. 

 Eventually, governments were forced to introduced regulations to prevent bankers from taking too much risk. They set up state banks to control the money supply and insisted that banks carried insurance to protect against unexpected events. This worked for some decades until the US government relaxed many of the regulations. The result was the savings and loan crisis of 1989 when more than 1,000 U.S. savings and loans banks failed, costing U.S. taxpayers $132 billion. 

And in 2008, there was the mortgage backed security (MBS) disaster. Banks had traditionally loaned money to people they knew, or had carefully vetted, to ensure that the loans would be repaid, and the banks held the loans until they were paid off. The banks were protected, if a mortgage loan was in default, because the bank could legally sell the property to recover the money borrowed.

The problem arose when some bankers realized that the loans could be sold to investors anxious to obtain a higher rate of return than they could get from bank deposits. The bank then could take a commission and use the money for another loan. The bank was off-loading the risk.

This was not a bad idea until the borrower defaulted and the investor had the expensive business of selling the house and often lost some of the money invested.

Some clever financial wizards convinced bankers to reduce their risk by bundling a lot of mortgages and selling the package on the theory that if one or two failed the others would return cash and the lost would be tolerable.

This worked until the bankers ran out of good borrowers and realized that they were not taking any risk and making a lot of money on commissions. So they simple loaned money to anyone regardless of the risk and persuaded the buyers of these packaged mortgages that the risk was still tolerable. Insiders joked about loaning money to NINJA's (No Income, No Job).

To conceal the risk, they persuaded bond rating companies to rate their mortgage backed securities (MBS's) as low risk and convinced insurance companies to insure these. Many people bought these securities assuming they were low risk (mortgage backed), high interest products which was a total fraud. Too add to the chaos, a few financial wizards spotted the looming disaster and persuaded several financial institution to issue collateralized debt obligations (CDO's) that were in effect leveraging bundles of the weakest mortgages that offered a higher interest return. This allowed the wizards to borrow a CDO and sell it short, planning to buy it back when the price dropped.

When the housing market began to collapse prices declined and sub-prime borrowers started to default. People walked away when their homes were worth less than their mortgages. The MBS market dropped in value with the avalanche of non-payments and this meant that MBSs and over leveraged collateralized debt obligations (CDO) were vastly overvalued.

Everyone tried to unload bad MBS investments. Credit tightened as banks and financial institutions neared insolvency. Lending was disrupted to the point that the entire economy was about to collapse.

The financial crisis wiped out trillions of dollars in wealth, bring down Lehman Brothers, and roiling the world financial markets.

Finally, the U.S. Treasury bailed out the financial system with $700 billion to ease the credit crunch and the Federal Reserve bought $4.5 trillion in MBS's over a period of years to partially compensate some of the victims of this gigantic financial hoax.