Who created all of this money we've been spending?

The following is an excerpt from a paper I wrote about the interdependency of foreign exchange currency markets, and the mortgage crisis.

Traditionally the money supply has been fairly well understood and controlled by an age old system of leveraging reserves to loan money to borrowers. The federal monetary policy regulated the percentage of reserves required to be maintained by the bank, freeing the bank to lend the remainder, making profit form the interest. In the old days the bank would keep the loan on their internal books, which in turn acted as an incentive to minimize the risk of the loans they issued.

In recent times banks and non-bank lenders (good example of non bank lender in this article from 1998) have developed a system by which they package loans and sell them to investment groups. These groups then use the loans as collateral for securities and sell the securities to investors. This process does two things, first it eliminates risk for the lending institution by taking the loan off of the origonator's books. Second it provides a loophole for lenders to subvert the reserve requirements established by the Federal Reserve allowing them to lend up to 100% of the value of the property.

From a bank's perspective this is a real win-win situation. Banks can now reduce their overall risk profile by selling off all but the very best loans, making them very stable. The Fed using it's traditional means of monitoring a banks reserve requirements are very satisfied.

The investors using the loans as collateral are also very happy with this new business process. Using new technology to help police the default risk of the loan packages, companies securitize the loan packages with some degree of confidence. The new security is in most cases less volatile than many other financial instruments, and offer a good rate of return for a reasonable risk. Unfortunately there is a dark side to this portion of the securitization process, since the rating of loan packages as securities is relatively new, there are not strong regulatory standards established providing the FED with oversight capability. The result is that the securitizer, often faced with a conflict between profit and reliable transparent ratings, can inflate the rating of the security.

I believe that this conflict of interest in the risk rating of this type of security is at the heart of the current loan crisis. On one hand the securitizer makes the most money on his investments by giving the investor the impression that these are low risk real estate backed securities with a great rate of return. On the other hand, he has to encourage the lenders to make loans no matter what the risk to keep the gravy train rolling. Meanwhile, the investment firms are acting under a different set of regulations than banks while perfoming a banking function... creating money!

The investment companies are effectively augmenting the money supply outside the traditional means established and monitored by the Federal Reserve. Would-be borrowers with some equity (or in some cases the expectation of equity) now have a way of securing money against their collateral quickly and at a reasonable cost. Borrowers can now take their expectation increased equity and convert it into money quickly for near term projects or expenses. Although the mechanisms are quite different, this approach to securitization of loans provides a means to generate revenue much like public corporations have been able to do in the past by selling stocks against their future profits or securing ventue capital.

I hope this makes sense...