As a boy, I heard people condemn ‘the middleman’ for low farm prices, but as an econ teacher, I appreciate the underappreciated functions middlemen perform for society. This is as true in financial services as it is in milling wheat and baking bread.
Efficient financial intermediation can help everyone by making an economy more productive. But being a financial intermediary inherently involves risk that if not properly managed can harm not only the intermediary herself but many others in society as well. The savings and loan debacle of the late 1980s was one manifestation, and the toppling financial dominoes in the fall of 2008 were another.
Start with the basics. At any given time, some people have money they want to save for future use, such as college, marriage, a business or retirement. Others want to borrow money to have things like a new car, house, vacation or business now and pay for them in the future.
Just as we all could buy our food directly from some farmer if we wanted, savers could seek out borrowers directly, and vice versa. But that is time-consuming and risky. Far better to go to intermediaries that specialize in moving funds from savers to borrowers. The most common of these are banks, but many other financial firms provide an intermediation function.
Size intermediation is one valuable service. Some people want to save in small amounts, say $100 per paycheck, while others want to borrow $250,000 at one crack to buy a house. A pension plan may save $100 million at a time while others want to borrow miniscule amounts, say $2 for a latte in the morning or $35 for gas on the way home.
Banks can combine many small deposits to make large loans or borrow wholesale and make many small loans.
Maturity intermediation allows for transactions to be arranged over varying time periods. Someone depositing a paycheck wants to be able to write checks whenever she needs to.
But someone borrowing to buy a house wants decades to pay off the loan. A college endowment wants to be able to lock in predictable interest earnings for years. A farmer wants to borrow in April and pay off in November.
Banks and other financial institutions such as investment banks and mutual funds serve to harmonize such mismatches in the time horizons of savers and borrowers.
A bank with thousands of consumer and business checking accounts knows it has a stable enough level of deposits to make multi-year car or business loans. A credit-card lender may sell bonds to an insurance company to get funds to lend out on a month-by-month basis.
Managed prudently, such coordination of mismatched maturities can be a safe business. But it has its dangers.
Savings and loans used to operate under a special set of rules in which they were able to take in household savings deposits (on which they could pay higher interest than banks), most of which could be withdrawn on demand, and made long-term fixed-rate mortgages.
The mismatch of maturities between deposits and loans was extreme. But with government regulation of interest rates, low inflation and few other savings vehicles for households, the system was stable and useful for society while it lasted.
By the late 1970s, however, with higher inflation, deregulated interest rates and new investment opportunities like money-market mutual funds, the SLs lost their deposits far faster than people paid off mortgages. The system was doomed. SLs still exist, but they no longer have an edge on interest rates or as many restrictions on the sorts of loans they offer.
The securitization of mortgages was designed as a way to manage maturity intermediation. Banks could originate mortgages by lending from their own short-term deposits. Many did so for decades. But they ran the same risks as SLs.
If, instead, banks packaged many mortgages together and sold them to savers with longer time horizons, like pension plans or insurance companies, they would have fresh cash to make new loans. It was a two-step maturity intermediation process that, if managed prudently, could have worked well over the long term.
But the process was not managed prudently. Big national financial institutions packaged mortgages into securities and sold them to other investors. The risk was then off their books. Many turned around and lent money, usually on a very short-term basis, to the very investors who had bought their mortgage securities.
Firms like Bear Stearns held billions in long-term mortgage securities that they financed with extremely short-term borrowing, often on a three-day or even overnight basis. As long as the economy was rolling along, it was easy to roll over hundreds of millions in short-term loans every day.
Once word got around that a particular firm like Bear or Lehman Brothers or Merrill Lynch was in trouble, their ability to keep rolling their short-term borrowing forward evaporated in days. The institutions were doomed.
The SL assumption of continued low inflation and regulated interest rates had some basis in reality. The go-go investment bank notion that they would always be able to borrow whatever amount of money they wanted on a 90-day or 24-hour basis, regardless of what happened in the broader economy, was stupidity to the nth power. But lots of brilliant people with MBAs and Ph.D.s found it plausible as long as the bubble kept inflating.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.