Thursday, August 27, 2009

How the financial system is the pipes to the economy, not the economy

Made the chart myself from my notes from various classes during my MBA. That is the financial system in a nutshell; not so difficult.

As the headline indicates the financial system is not the economy, it is the pipes that bring money from savers to entities who will invest the money. The investors will purchase capital and sell a product or service, portions of those earnings plus the initial investment will be returned, hopefully, to the savers. Now the genius of this system, at least before the financial crisis was its ability to securitize certain loans so that additional entities on the right side could purchase them. Thus more investment could be made and thus more capital added to the system and therefore productivity could be higher which increases the GDP of the country.

So before securitization, banks would loan money to a homeowner with the house as collateral. Unfortunately, there was a limit to the amount of loans the bank could make. This is because of its capital requirements imposed by the Federal Reserve and also because it was exposing itself to a concentrated risk in a particular market. Imagine, that the bank is in Detroit, given the well noted decline in the prospects of that city, the bank would have died just extending loans to commercial and residential real estate in the greater Detroit area.

So in the early 1980's a process was discovered to create a pool of loans and sell them to investors. Of course, Fannie Mae and Freddie Mac had been created to do this according to their charter. These entities tried to create a national mortgage market, thus money given to them through debt and equity offerings was used to purchase mortgages from all over the country. The thinking was that a property's value was tied to its local economy and by diversifying their risk by investing in all locales, plus the implicit government guarantee would allow investors to buy the bonds and equity that they offered. This market was a lucrative monopoly that investment banks broke into by the creation of sophisticated models.

This created a nefariously named "shadow banking system." That is mutual funds, hedge funds, pension funds and insurance companies now owned mortgages and other loans that had been pooled, which had previously been the domain of banks only. Banks I might add that were under the regulation and protection of the Federal Reserve and the FDIC.

The problem that was run into in this crisis is one as old as banking itself. Basically, a ___ [bank, mutual fund, hedge fund, insurance co] will use money [CD, savings account, mutual fund share, claim, policy] that is of a short maturity to buy an investment that is of a longer duration or maturity. [commercial real estate loan, residential real estate loan, private equity loan] This is done to take advantage of a normal interest rate environment where longer maturity investments earn an increasing rate of return the further out in maturity that one moves out. This spread between short-duration, low interest rate and long-duration, higher interest rate is how _____ [bank, mutual fund, hedge fund, insurance co] make money to return to their investors. So when I leave 10,000 dollars at Bank of America, it turns around and offers a loan of 90,000 dollars to a couple buying a home in Omaha. (This is the money multiplier that is a an effect of the reserve requirement affected by the Federal Reserve, I am assuming a 10% requirement.)

Here is the visualization:

The green is the money the entity makes by "playing" the spread.

The problem comes about when savers panic. Maybe the have been lied to by rating agencies charged with deciding how "safe" a security is, maybe regulators are asleep at the wheel, or the regulators have been "captured" by the industry in which they patrol or the investors have been lied to by the firm selling the security. Thus the right side calls in its claims and invest directly into the government securities, the so called return of principal instead of caring about return on principal. Or they could just hold cash under the mattress or spread their money about in various accounts at different banks making sure not to breach the protection offered by the FDIC. Of course consumers are not the only ones, companies will also do not with the FDIC but instead by moving their funds into the Treasury market.

This leads to no one purchasing the previous securities and the securities value falls precipitously and possibly more than the actual underlying value of the investment. As always "Res tantum valet quantum vendi potest," or an item is only worth what some one else will pay for it.

The allocation of capital, a scarce resource, is vital to the economy. However, the value it creates versus the losses it makes in bad times may net out or even be negative. Moving forward, elected officials must discern a more virtuous manner in which to allocate monies; the system cannot be seem to be based upon an expectation of bailouts.

Later, I plan on writing about National Income Accounts and the market for funds.

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