The Italians make designer sunglasses; the Japanese manufacture precision vehicles. Russian vodka has no comparison, and until the subprime financial shock, everyone wanted some of America's financial ingenuity. It was our comparative advantage.
The efficiency of the U.S. financial system was the envy of the world; it could take the nation's paltry savings and direct it to financing investments that reaped big returns. Why save 50% of your income as they do in China or even 10%, as the Germans do, if you could put aside close to nothing and get the same returns or better, simply by making the right kind of investments? The U.S. financial system was better at this than anyone; the wizardry of America's financial engineers seemed unparalleled. Despite the complexity of the American financial system, its basic function is quite simple: Take what we save and lend it to others who can do something productive with it. In times past, this was done entirely by banks.1 Making a loan was very straightforward.
A bank would take cash from depositors and lend it to a household or business. The bank would pay the depositor some interest and make a profit by charging a little more in interest from the borrower. The bank owned the loan until it was repaid and took the loss if the borrower fell into unhappy circumstances and defaulted. Because the banks' deposits were insured by the government, regulators required them to hold some cash capital aside in case too many borrowers defaulted. Regulators also monitored the banks' lending to make sure it was prudent; if a bank made too many bad loans it could fail, putting the government on the hook to repay depositors' money.
The banks lost their tight grip on the financial system beginning in the 1970s and 80s. These were tough times for banking; volatile inflation and high interest rates made it difficult to make a profit.2 The high rates crimped lending and sent deposits fleeing to newly established money market funds, which offered higher returns to savers. Many banks also stumbled badly in the early 1980s by lending too aggressively to Latin American nations who mismanaged their debts and ultimately defaulted on billions.3 The collapse of the savings and loan (S&L) industry was even more devastating, with more than 1,000 institutions failing between the mid-1980s and early 1990s. The massive financial debacle left regulators to sort out hundreds of billions of dollars of loans from the defunct S&Ls.
The vicissitudes of financial markets and the financial chicanery of unscrupulous S&L owners created the S&L mess, and eventually high finance resolved it. The Resolution Trust Corporation (RTC), established by policymakers to dispose of the S&L's assets, gracefully employed a financial technique known as securitization. In a securitization, loans are combined or pooled, and their collective interest and principal payments are used to back a tradable security that is sold to investors. As a group, the investors become owners of the loans and are entitled to receive its interest and principal payments. The RTC securitized everything from auto loans to commercial mortgages, sold them to investors, and resolved the S&L crisis at a surprisingly low cost to taxpayers.
Investment bankers first applied securitization to the mass market via credit cards. Using borrowers' credit scores and targeted directmarketing techniques, banks had already figured out how to put cards in the hands of millions of average-income or even low-income households. The only limit on the banks' growth in this area came from their own balance sheets banks lacked sufficient deposits or capital to grow freely. Securitization lifted both constraints. When a credit card was securitized, banks didn't need deposits; the investors buying the credit card-backed securities provided the money. Capital wasn't an issue, either, because the investors not the card-issuing banks owned the loans. Credit-card lending soared, with receivables doubling in the mid-1990s.
Securitization also powered a boom in home equity and manufactured housing lending. Second mortgage loans had received a big lift in the late 1980s, when Congress eliminated the tax deductibility of interest payments on nonmortgage debt. Interest on a home equity line of credit was still deductible, however, giving homeowners a cheap and easy way of borrowing against their houses. Manufactured homes took off as house prices rose, making it harder for prospective firsttime home buyers to come up with down payments on traditional dwellings. Creative marketing also made manufactured homes seem attractive alternatives to apartment living. The amount of outstanding home-equity and manufactured-home loans almost tripled during the mid-1990s.
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06102010
1. Interest rates can be included in the contract and are very important
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