Securitization, the art of turning bank loans into cash.
Let's start with Glass-Steagall. Glass-Steagall was depression era legislation enacted in 1933 and repealed under Clinton. It had 2 aspects, one being separation of banking activities, which does not really concern us here, the second was establishing FDIC and
LIMITED THE AMOUNT OF DEBT BANKS COULD HAVE WITH RESPECT TO THEIR RESERVES.
The classic money multiplier model derives from this. There is a ratio (set at around 12) between reserves and credit-money. This states that if a bank as $1 in reserve it can emit $12 of credit money. This IN THEORY limited the amount of credit money in the system. In practice however, securitization turned it into a lie.
Imagine you take a mortgage out with a bank. Let's say $500,000. Under Glass-Steagall that meant that the bank needed to have roughly $45,000 in reserves to match that debt on their books. If they hold onto the loan it means they may not be able to issue more loans. This would limit the amount of credit money banks could issue. But the bank can "securitize" the debt and sell it. The banks would create a product based on the debt (see CDO below) and SELL IT TO THE PUBLIC. The public would then pay $500,000 for the product. So the bank GETS CASH and can LEND AGAIN. This of course leads to an explosive exponential growth in debt money.
By turning loans into cash, Securitization bypassed legislation and in fact created vasts amounts of credit money.
Collateralized Debt Obligations (CDO)
The way Securitization was achieved was through the creation of a product called CDOs. Most investors, many mutual funds, cannot invest in securities not rated AAA. A AAA security is an obligation that will not lose say more than 3% to defaults, it is then considered "safe". But let's say you have a bunch of sub-prime mortgage that will default at 30%, how do you sell that to mutual funds? The answer is that you create a CDO, which is a company that holds these mortgages, emits equity paper and obligations and takes the cash flows from these crap assets and directs them in priority to the senior paper. If your mortgage default at 30% it means you can pay 70% full and 30% will suck. Roughly speaking your CDO can emit 70% paper that can be rated AAA and the rest will be rated "complete junk". Got it? It is trivial to see. What happens with the toxic assets emitted by CDOs? it was recycled in "synthetic CDOs" where you take the toxic stuff, mix it again and emit new paper. Voila! from subprime you have created AAA paper up to 2 iterations. This paper was GOBBLED UP by investors around the world seeking yield above and beyond the depressed FED rates.
Special Investment Vehicles, SIV
The banks were busy running this machine and taking fees. But some of the toxic assets could not be sold, meaning the by-product of securitization was truly nuclear waste. How would they dispose of it? They would create SIV's that would buy the Toxic CDO tranches. These SIV's were considered "off balance sheet" in many cases. From an accounting standpoint, at least in the US of A, if you do not own more than a certain amount of the equity of a company (around 30%) you do not need to include its reporting in yours.
Conflict of Interest all along the chain
One feature of this setup, which quickly turned into a problem, is that the origination of the loan is separate from the holding. Why is this a problem? simply put, those that originated the loan in subprime, didn't give a rats ass about its quality since they would not hold the debt, they would get paid out. They thought this was OK since the machine would create CDO tranches that would legitimately get rated AAA. Originate to Securitize was the beginning of a slippery slope of "who cares". The system was ripe with fraud. The rating agencies didn't have the full information, blindly believed the assumptions that went into the CDO creation and rated these AAA and got paid for doing so. At the end of the line, investors wanted to believe in AAA ratings and snapped those up. Due diligence, the art of knowing what you are buying, had completely disappeared from the manufacturing line. This lack of lending standards plays an important role in the breakdown (Minsky narrative of debt explosion to be published).
The net result: credit money EVERYWHERE
So what we have just seen was an amazing machine to create and distribute credit-money while bypassing legislation aimed at limiting the amount of credit money in the system. What we have seen is that the simple mathematics of securitization in fact quickly demultiplied the amount of credit money distributed in the system. Legislation was trying to limit the amount of credit money in the system. Securitization had CREATED vast amounts of debt and DISTRIBUTED it everywhere.
Legislation needs to capture Securitization
The problem, technically speaking, with the legislation was that it was worded in terms of BALANCE SHEETS. But banks no longer held the bigger part of these loans. The public did. Securitization made sure those assets moved OFF the balance sheets and turned into cash which further enabled the banks to emit more debt. The system was absorbing this debt, way beyond what the money multiplier level (12x->40x) considered safe. Legislation that wants to capture total amount of credit money in the economy needs to encompass THE FLOW of credit money (Securitization) and not just the partial amount on bank balance sheets since in fact credit had moved off the balance sheets and was everywhere in society.
Greenspan's defense, bring back Glass-Steagall
To test your understanding of the above, read this. Krugman speaks out against Securitization: note I do NOT agree with his conclusion, Securitization should be revived but LEGISLATED, not just left for dead. For a more advanced read, you may try this. A bit more technical, it is Greenspan's own defense. That the FED had lost control of the money supply, it was Securitization.