Once upon a time, in a land of commerce and trade, there lived a commercial bank.
This bank was called the People’s Bank and it took deposits from savers and made loans to borrowers. The borrowers paid interest to the bank on their loans, and the bank used that money to pay interest to the savers. The bank earned money by charging higher interest to the borrowers than it paid to the savers. Savers were happy because their deposits were optional, and they could take their money out of the bank whenever they wanted. And borrowers were happy because their loans were long-term—a 30 year mortgage to buy a house, or a five year loan to start a business, or a one year loan to buy inventory for their store to sell.
On a normal day, the savers of the land were happy earning their interest and only withdrawing a little bit of their money at a time, whenever they needed it. Borrowers were glad the bank lent them money to buy houses and fund the local stores where they shopped. But this mismatch between the short term savers’ deposits that funded the long term borrowers’ loans made the King of the country nervous. If the King was fighting with other territories or there was a disaster or a business went bankrupt, the savers got nervous and ran to the bank to get their money. And when they all went at once, there wasn’t enough cash to give them, because People’s Bank had made all those loans.
A run on People’s Bank would make the people scared and angry and the King didn’t like that.
Therefore, the King went to his council and said “Fix this problem!” The council got right to work and made up rules for the bank to follow to make sure loans only went to strong borrowers who could afford to repay them. They created mandatory tests to make sure the bank had sufficient cash to meet the average withdrawal demands. They instituted reporting requirements to make sure everybody knew what was happening at the bank.
Meanwhile, on the other side of the kingdom lived an investment bank. The investment bank was called the Business Bank and it didn’t take deposits or use other people’s money. Business Bank earned money by helping companies buy other companies and raising cash from investors to do so.
The King and his council didn’t worry too much about Business Bank because what they did didn’t impact the people’s money.
But the bankers at Business Bank looked over at the People’s Bank and saw those fat, juicy deposits and thought about all the things they could buy if they had access to that money. And they were covetous.
And the bankers at People’s Bank looked over at the Business Bank and saw how much money they were making without all of the rules and regulations holding them back. And they were envious.
So the Business Bankers and the People’s Bankers started talking and decided that they would petition the King and his council to let them work together as they had in the Before Times, when the rules were very lax …thus began the new Era of Not Too Many Rules.
Around the same time, the people started to notice and complain that People’s Bank was being very picky about the mortgage loans that they would make and was not treating everybody the same way. So the people went to the King and said “Fix this!” And the King issued a decree that People’s Bank would have to start lending money to more people to buy houses under penalty of law.
Well, People’s Bank didn't like this one bit. It was all well and good to try to be fair but it was altogether riskier to throw away their old ways of determining a good borrower and letting just anyone have a loan. So People’s Bank devised a plan that would let them comply with the law to make more mortgage loans to more people, without actually taking on the increased risk themselves.
People’s Bank began making mortgage loans to more people, and promptly sold those loans to investors who were much more willing to take the risk—at a higher interest rate. At first People’s Bank started slowly, but then they found that there was so much appetite for all those higher risk/higher interest rate mortgage loans that they began making more and more of them to people who didn’t really understand the terms of the loans and didn’t have the means to repay them.
The King was happy because all that lending meant so many people were becoming home owners and the value of everyone’s houses kept going up, up, up.
Meanwhile, elsewhere in the kingdom lived a broker dealer. The broker dealer bought, sold and traded stocks and bonds for a living, and was called Mr. In-Between Man. Just like with People’s Bank, the King and his council had lots of rules for Mr. In-Between Man to follow because way back in the Before Times, when too many people invested in the stock market with borrowed money, the market crashed. People lost their jobs and homes and the entire economy collapsed and the kingdom suffered a depression for many years, and they never wanted that to happen again.
But that was Oh So Long Ago! Now Mr. In-Between Man wanted to get in on the action with Business Bank and People’s Bank. Once they entered the Era of Not Too Many Rules, Mr. In-Between Man also started petitioning the King and his council, claiming the market would be so much more efficient if they all worked together.
So the council convened and made new laws allowing the banks and broker dealers to do many of the things that they couldn't do under the old laws, even though those old laws were put in place after the market crash and depression specifically to prevent bad things from ever happening again in the land of commerce and trade.
And everyone promised they would follow the new rules and police themselves, so help me God.
Pretty soon, things began to get a little bit fuzzy. The People’s Bank wanted its own Mr. In-Between Man operation, and Mr. In-Between Man wanted to offer Business Bank services, and the Business Bank wanted to earn money arranging all those mergers and acquisitions between the banks and broker dealers. It wouldn’t be long before People’s Bank, Business Bank and Mr. In-Between Man were part of one big company, called Too Big To Fail.
But before that happened, People’s Bank went to Business Bank and said “We have a problem. We are making and selling all these mortgage loans but there’s so much paperwork and it’s so time consuming and costly that we want to find a better way to do it.”
And the Business Bank said “Oh, we are good at this—that is what we do, after all. We are very smart and we will come up with an efficient way to turn your loans into magic beans and then our broker dealer friend Mr. In-Between Man can sell them just like regular stocks and bonds. The easier they are to trade, the easier it will be to sell them. Just pay us a fee and we will be very happy to do that for you.” The People’s Bankers were clever and said “OK, but you will only get paid from the proceeds, after you sell the magic beans.”
And so the smart Business Bankers and the clever People’s Bankers created magic beans packaging up all those new mortgage loans. The bankers understood that more investors would buy these magic beans if they had a Good Housekeeping Seal of Approval. Luckily, Business Bank knew people at the neighborhood rating agency, called Ratings For Hire, whose business it was to analyze and rate magic beans--for a fee, of course. So the Business Bank and People’s Bank went to Ratings for Hire and explained how it all worked, and paid their fee, and got their new magic beans a bright, shiny A+ rating.
Now, anyone who bought them would believe that they were making a safe investment.
And then, the smart Business Bankers and clever People’s Bankers went to their friend the helpful Mr. In-Between Man and said “If you can just sell these to your clients, then we will all make money and none of us will have the risk of owning these magic beans which are oh-so-very-safe for everyone else— just look at that A+ rating!”
And Mr. In-Between Man said “Yes, that is a very good idea and we would like to sell these magic beans—that is what we do, after all— and we will be quite happy to charge our clients a fee when they buy them, and split that fee with you.” Mr. In-Between Man had many interested client investors including pension funds and mutual funds and insurance companies and state governments and foreign sovereign wealth funds (just to name a few.)
The investors liked the magic beans so much, the bankers began making more and more mortgage loans—even to borrowers with bad credit—just to have enough loans to create more magic beans to sell.
Then Mr. In-Between Man said to People’s Bank “We would very much like to help you and Business Bank to sell all of those magic beans that they invented to take the mortgage loans off your hands. But our clients don’t always have the cash to buy them right away, and they will need to take a loan from us. But we do not have enough money to make all those loans. Could you please lend us the money to buy the magic beans so that we can have them in inventory to sell to our clients later?”
And People’s Bank said “Well certainly, we can make you a loan and charge you interest—that is what we do, after all—and we’ll take those magic beans (that we never wanted to own in the first place) as collateral for our loan, just in case you don’t pay us back.”
So the People’s Bank made mortgage loans to the people secured by their houses...and sold them to Business Bank who packaged them up into groups of loans and turned them into magic beans…and Mr. In-Between Man bought the magic beans using money borrowed from People’s Bank...which took them back as collateral until the magic beans were sold to investors.
And this circle of life worked so well, that the industry started doing the same thing with car loans and credit card debt, taking the monthly payments due from the borrowers and turning them into more magic beans that could be bought and sold all day long. And the availability of all this credit allowed the people to live well and they were happy using their credit to buy things they could not afford if they were required to pay cash, and they didn’t mind just paying the minimum due each month, and certainly didn’t think too much about the interest rates or what would happen if they had to pay back the entire amount they borrowed.
The King and his council remained very interested in what was happening.
But the economy was roaring and housing prices were going up, up, up and the people were so happy buying houses and cars and giant TVs on credit, and everyone who was anyone was making money… so who were they to interfere with the markets?