The Little Book of Economics

Yet, finance is as essential to economic growth as it is unpopular among Congressmen. The financial system channels capital from those who have it to those who need it, much as the circulatory system moves blood from the heart to the lungs and muscles. A simple example shows how. Imagine that you have money to invest while a colleague at work needs to borrow money to buy a house. Why not bypass the bank, and lend him the money? It seems like a win-win: you’d charge him more than you’d earn on a certificate of deposit and he’d pay less on his mortgage. Upon reflection, it is obvious why this seldom happens. He may need more than you have. He may want to borrow it for 10 years but you only want to lend it for one year. Most important, you don’t know if he’ll pay it back.

The financial system solves all these problems. It matches savers with borrowers with neither having to know each other. It conducts the necessary due diligence; if the borrower defaults on the loan, the saver still gets his money back. It also spares the borrower of the burden of repaying the saver before he’s done with the money.

One way of appreciating the importance of the financial system is to imagine what happens when it stops working. As Ben Bernanke reportedly warned in the wake of Lehman’s bankruptcy: the “economy’s arteries, our financial system, is clogged, and if we don’t act, the patient will surely suffer a heart attack.”⁷ An example of a country suffering such a heart attack is Iceland, whose gross domestic product (GDP) sank some 15 percent after all its banks failed in 2008. Inflation and unemployment skyrocketed, restaurants emptied, and the once globe-trotting population found itself grounded . . . literally.

The U.S. financial system is one of the most diverse and complex in the world—sometimes it is too complex for its own good. Thomas Philippon, an economist at New York University, estimates that in 1947, finance accounted for 2.3 percent of GDP. By 2005, it was almost 8 percent. That’s an awful lot of cake, and a lot of it was just sugary icing with no nutritional value: leveraged buy-outs, speculative stock trading, and financial engineering whose main purpose was to layer on more bets.

But just because finance has its periodic excesses shouldn’t blind us to the fact that most of the time it is useful. Much of that cake represented 401(k)s, life insurance, and taking Microsoft and Google public. The historical record has the same message: Financial innovation usually helps growth; it doesn’t hurt it. Something akin to joint stock companies in ancient Rome helped spread large-scale mining technology. Preferred shares were one of the financial innovations that made the railroad-building boom of the nineteenth and twentieth centuries possible. Countless studies also have found that countries with more developed financial systems grow faster.

Where Have You Gone, George Bailey?

Think of our financial system in two parts:

1. Institutions. This part includes regular banks, investment banks, and shadow banks (i.e., companies that act like banks but aren’t regulated the same way).

2. Capital Markets. This part is comprised of securities and derivatives that investors trade back and forth.

Let’s look at institutions first. A bank is the most basic part of the financial system, and the most basic sort of bank looks like the Bailey Building and Loan Association run by George Bailey in the film It’s a Wonderful Life. It starts with shareholder capital, raises deposits, and makes loans.

Banks have gotten a lot more complex since Jimmy Stewart played George Bailey in 1946. Deposits now contribute just 60 percent of their funding; they get the rest from bonds, short-term IOUs like commercial paper, wholesale loans from other banks and big investors, derivatives, and other things. They lend to countries, companies, and individuals through loans, securities, credit cards, lines of credit, and countless other avenues.

Although banks remain the foundation of our financial system, their importance has diminished over the years. In 1980, banks supplied 50 percent of the economy’s credit; by 2007, that had shrunk to 23 percent. Capital markets, which I’ll describe more below, and institutions that look, act, and smell like banks but aren’t regulated like banks have taken on a larger lending role. These shadow banks, as PIMCO, the bond fund manager, calls them, match savers and borrowers, but they don’t take deposits. Instead of deposits, shadow banks fund their lending by issuing bonds and short-term IOUs or by getting rid of their loans through securitization.

You’ve probably done business with a shadow bank. Some are neighborhood fixtures, like mortgage brokers, payday lenders, and leasing companies. Others are nationally known. Fannie Mae and Freddie Mac, for example, guarantee or hold mortgages; Ally Financial, the former General Motors Acceptance Corporation (GMAC), makes car loans, and General Electric Capital Corporation makes leases and loans to businesses. Subprime mortgage lending was dominated by shadow banks like New Century Financial, now bankrupt, and Countrywide Financial, now part of Bank of America. Finally, there are some that you’ve never heard of, such as Sigma Finance, a so-called structured investment vehicle that at its peak had $57 billion in such assets as mortgage-backed securities, more than most U.S. banks.

Investment banks, also called broker-dealers, are another type of shadow bank. Rather than lend money directly, they match savers and borrowers in the markets by underwriting and trading stocks, bonds, and other securities; delivering the proceeds to the borrower or company; and taking a fee in the process.

Over the years, the lines between banks and shadow banks have blurred. Commercial banks now trade stocks and bonds and investment banks make loans. Loans themselves are often chopped up and turned into securities. Commercial banks provide back-up credit to shadow banks, in effect acting as their lenders of last resort. Commercial banks and shadow banks may be part of the same holding company. Some shadow banks like Ally Financial and General Electric Capital own banks of their own.

Capital is like armor on a warship. More armor makes a warship more resistant to enemy fire, but slower. With more capital a bank can endure more loan losses, but it is less profitable because its profit must be spread among more shareholders.

The ratio of assets to capital is called leverage and it is an indicator of how reliant a company is on debt. Consider Bank A: It has $1 of shareholders’ capital, raises $9 in deposits, and makes $10 in loans. Its leverage is 10. If it gets another dollar of capital it can make $10 more in loans. Bank B, however, has leverage of 20: With each additional dollar of capital it can make $20 in loans. You can see why banks and their shareholders like leverage. But leverage works in reverse as well. Just as a thinly armored warship is more easily sunk, a thinly capitalized bank is more likely to fail. For Bank A to become insolvent and have its capital wiped out, 10 percent of its loans would have to go bad. For Bank B, just 5 percent would.

Federal regulations require banks to hold capital of at least 8 percent of assets, while shadow banks get by with far less. This is one reason why more of them failed during the financial crisis. For example, Fannie Mae and Freddie Mac operated with capital of less than 4 percent to juice their profits. But when mortgages turned sour, their capital disappeared and taxpayers bailed them out.

Liquidity refers to cash and things that are almost like cash that can be used to meet pressing needs. Your house may be worth $300,000, but that’s not much help if you need $5,000 today to replace a broken furnace. So you keep cash on hand or a home-equity line of credit for the unexpected. It’s the same for a bank. If it can’t pay back depositors and lenders, it will fail. So banks keep cash in the vaults, hold securities (like Treasury bills) it can quickly sell, or maintain lines of credit with other lenders. They can also borrow from the Federal Reserve.

If capital is a warship’s armor, liquidity is its ammunition. Too little liquidity is as lethal as too little capital. Without it, a bank would succumb to creditors pulling out their money just a warship that’s out of ammo will succumb to enemy fire.

The importance of liquidity was forgotten in the years leading up to the crisis when a tidal wave of easy money fooled many firms into thinking they could always borrow when they needed. But when panic hit, that assumption proved very wrong.

A popular source of liquidity is the repo market, which is kind of a pawn shop for financial institutions, but instead of pledging grandma’s jewelry, a bank might pledge $1.1 million worth of mortgages, loans, and corporate bonds in order to borrow $1 million from a money market mutual fund for one day. In early 2008, investment banks had borrowed $4.5 trillion via repo loans, more than banks had in federally insured deposits at the time. But repo loans have no federal guarantee. When lenders grew skittish about Bear Stearns and its collateral they stopped rolling over repo loans, precipitating its collapse.

As a result of the financial crisis of 2007, financial institutions now need more capital and liquidity, because both regulators and the investors who lend to them demand it. This will make them safer, less profitable and, for a while, less able to lend.

Capital Markets

Banks and shadow banks have a vital role to play in supplying credit, especially to small businesses and households. But larger firms can raise capital by issuing stocks, bonds, and other types of securities directly to investors. If you belong to a pension plan, have a life insurance policy, or own a mutual fund, you are helping finance business investment as surely as your savings account makes your bank’s lending possible.

Debt (also called credit) and equity (also called stocks) serve different purposes. Debt is temporary with limited upside . . . at best. Debt holders get back their principal plus interest, nothing more. They do, however, get repaid first if the venture goes bad. Equity is a permanent: The company has no obligation to ever repay your investment. Equity brings ownership. Stock holders share in the rewards of success and the losses of failure.

Most companies have one common equity or stock. It trades on a public exchange like the New York Stock Exchange and NASDAQ Stock Market where everyone can see it. A company may, however, have numerous types of debt: short-term, long-term, secured, unsecured, convertible to shares, and so on. A lot of this debt is seldom traded so it is poorly suited to a public exchange. Instead, you buy it from, or sell it to, a dealer.

Stocks are simple and glamorous. Cable television tracks minute-by-minute moves in the Dow. Friends share stock tips and magazines celebrate entrepreneurs made rich by their initial public offering. By contrast, debt is complicated and dull, usually relegated to the inner pages of the financial papers. Yet it matters more to the economy. Most companies don’t issue stock; they are privately held. Households and governments don’t issue stocks at all. At the end of 2009, all the stocks in the United States were worth about $20 trillion. All debt was equal to about $52 trillion of which households owed $14 trillion; businesses, $11 trillion; financial institutions, $16 trillion; and governments, $10 trillion. This means that an interruption in the supply of credit hurts a lot more parts of the economy than a fall in the stock market.

An important difference between banks and capital markets is that while a bank usually holds its loan until it matures, securities in the capital markets change hands often, and are valued at whatever price they could fetch in the market today. But there have to be a lot of buyers and sellers willing to trade at that price. Straightforward, popular securities like Treasury bonds and shares of IBM are thus highly liquid. Wall Street’s propeller heads have made some securities so complex that in times of panic it became impossible for buyers and sellers to agree on a price. What were once liquid markets became dry as the Gobi Desert.

Two popular types of debt security that played a starring role in the financial crisis is the asset-backed security, or ABS, and the mortgage-backed security, or MBS. An ABS or MBS is almost like a share in a mutual fund: It gives you partial ownership of a pool of mortgages, credit card receivables, auto loans, or other securities. They are structured to pay you interest even if some of the loans in the pool go bad.

ABS and MBS sound exotic, but they’re not. They have been around for decades. Here’s how they work. Suppose a small bank has made $100 million in mortgages. It can package them as an MBS and sell it to a pension fund or a foreign central bank. It then takes the proceeds of the sale, and makes $100 million more in mortgages.

Wall Street has a bad habit of taking a good idea to excess, and MBS were no exception. To appeal to more investors, financiers divided MBS into tranches with differing characteristics: some that were safer because they were paid interest first, and some less safe because they took the hit if any mortgages in the pool defaulted. Then they took these MBS and recombined them into new securities called collateralized debt obligations, or CDOs.

Years ago you would put your money in a bank and the bank would grant a mortgage to your neighbor. Now, you:

• Put your money in a pension fund

• Which is a partner in a hedge fund

• Which buys a collateralized debt obligation

• Which holds a mortgage-backed security

• That a bank put together

• Out of mortgages it acquired from a mortgage broker

• Who made the original loan to your neighbor

Did you get all that? Don’t feel bad, neither did some of the world’s most sophisticated investors. With so many steps, many investors didn’t know much about who they ultimately lent to, and simply outsourced their due diligence to credit rating agencies. Those agencies in turn thought the securities were worth AAA ratings because they badly miscalculated how much home prices would fall and how many of these loans would default.

The Teenage Boys of Finance

Derivatives are one of the most maligned and least understood part of the financial system. They are the teenage boys of finance—energetic and full of potential but the first to be fingered when someone totals the car.

A derivative is a contract whose value is derived from some other price or security: an interest rate, a currency, a stock index, a commodity. The first derivatives were on agricultural commodities. A farmer would enter into a binding contract with a food processor to sell his corn to that same processor six months later, locking in the value of future sales. Now, a U.S. company that plans to deliver parts to a European customer may use a derivative to lock in today the value of the euros he’ll receive in six months’ time. Suppose you want a 10-year loan but your bank would rather make a one-year loan. It can make you the 10-year loan, then use an interest-rate swap to make it resemble a one-year loan.

Currency and interest rate swaps are the clean-cut honor roll students of derivatives who almost never cause problems. Credit default swaps (CDS) are the tattooed skateboarders forever giving the school principal heart palpitations.

The idea of a CDS seems innocent enough. Suppose you made a $100 loan to your brother, but you worry he won’t repay you. You pay a bank $5 a year on the condition that if your brother defaults, the bank pays you $100. The CDS thus make it possible for you to hedge your loan. The problem is they also give you less reason to be careful about lending to your brother. CDS thus may be one reason so many bad loans were made.

The growth in derivatives has been nothing short of phenomenal. Between 1998 and 2009, their global notional value grew eight times to $615 trillion. Now, what’s notional value? Suppose you enter a contract to pay 5 percent interest on someone else’s $100 loan. The contract’s notional value is $100 but your actual exposure is only $5 per year. In this instance, notional value overstates the actual risk.

Nonetheless, this growth has brought dangers. Derivatives encourage leverage because they require less of a down payment than the same bet made with cash. They are also opaque: A company knows how much it owes to a bank or bondholders, but it may not know how many CDS are riding on its solvency. Orange County, Barings Bank, and American International Group lead a list of organizations that blew their brains out on derivatives. Consequently, derivatives have been prime suspects in many market blow-ups. Portfolio insurance, a popular hedging technique using stock index derivatives, helped cause the 1987 stock market crash.

Regardless of these dangers, ABSs, MBSs, and derivatives are too useful to disappear. Crises kill off stupid financial innovations—the 1987 stock market crash deepsixed portfolio insurance and the latest crisis has done the same for exotic mortgage securities. But, derivatives are here to stay. Like teenage boys, though, their potential is best realized with plenty of adult supervision. That means that they require plenty of capital and liquidity and, wherever possible, transparency in the open market, such as on a public exchange instead of in a private dealing room.

The Bottom Line

• You don’t have to hug your banker, but what he does is essential to economic growth. Banks and capital markets match savers with those who need capital.

• Over the years, banks have been joined by shadow banks that, like banks, made loans but don’t take deposits and aren’t as tightly regulated. All these institutions need capital to protect against losses and liquidity to repay lenders. Too much of either, and profits suffer. Too little, and the institution could fail.

• Equities get all the attention in the capital markets but the economy relies more on a healthy market for debt securities, such as money market paper, bonds, and asset-backed securities.

The Bipolar Financial System—Essential for Economic Growth But Sometimes It Goes Nuts

Where Have You Gone, George Bailey?

Capital Markets

The Teenage Boys of Finance