I wish I could take credit for the words you’re about to read. Instead they’re written by someone much smarter than me. The link below is to a blog post not by some simpleton like myself, but a blog for Critical Review, a publication written by academics that takes a critical stance on other academics.
The author of this post is the publication’s founder, a Brown, Berkeley, and Yale educated professor. Brand schools don’t make the man, but all I want to illustrate is that he’s not just someone like me. His specialty is political science, not economics, but as you’ll see he makes a good argument and knows a thing or two about finance.
Here is the article. If you like reading Weakonomics then you absolutely must read what Jeffrey Friedman wrote.
Now if you’ve already opened up another tab hang on a second before you start reading. You read Weakonomics because you don’t want a bunch of technical mumbo-jumbo. Friedman’s post has some of that jumbo. So I want to make sure you understand a few terms before you start reading.
AAA rated bonds: AAA (triple A) rated bonds are the business equivalent of a credit score. Instead of a FICO score there are three ratings agencies that rate the debt companies issue. Bonds can be debt issued by a company to raise money, known as corporate bonds. But in the case of this post the bonds are the ratings on the mortgage backed securities we all know and love today. When they were packaged together, the ratings agencies would rate the overall credit worthiness of the security based on the credit worthiness of those responsible for paying the mortgage (you and me). AAA bonds are the best possible rating. AA are good, but not as good. The full list of ratings for one of the agencies can be found here. The other agencies use similar, but slightly different ratings codes.
Capital Requirements: Imagine you’re a bank with $150 in deposits. You want to loan out this money. Federal regulations require that for loaning out money to an individual you must keep 50% of the value in cash. So if you wanted to loan someone $100 you must keep $50 in cash to cover yourself in case the loan goes sour. This helps protect the money your depositors are keeping with you. The $50 you must keep is the capital requirement. Now imagine that you could sell the $100 loan to an investment bank, who then packages it into a mortgage backed security and sells it back to you. Do you still have to keep $50 on hand? No, due to the Recourse Rule (a federal regulation) holding the security only has a capital requirement of 20%. This means instead of holding $50 now you must only hold $20. That frees up another $30 to lend. Now multiply that by about $100 billion. The downside for the bank is that if the loans go bad they have less capital to hold themselves up. If you dip below a certain capital requirement long enough, the FDIC swoops in and takes over your bank. This is a simplified explanation but will get the job done for the purposes of this post.
So now you’re ready to go read the post. Get to it, you do not want to miss this one.