To understand what role the investment banker had in this mess, an explanation of how an investment banker differs from a traditional banker is required. With a traditional bank, depositors put their money into the bank, and the bank then turns around and lends out about 95% of that money to someone else to buy a car, run a balance on a credit card, buy inventory for their store, etc. They charge a higher rate to the borrower than they pay to the depositor and take the difference to cover the costs of carrying the money they are required to keep on hand, to cover any loan losses, and for their profit. An investment banker does much the same thing except they do it through the creation of a security, or bond that is bought and sold in the investment markets. We see their creations as corporate bonds, government bonds, and of course, mortgage backed securities.
The Holy Grail of investment banking, however, is the creation of a new investment instrument. Investor bankers are always looking for some way to get investors and borrowers together. One of the best examples of this was what Michael Milken did in the 1980s with the securitization of “Junk Bonds.” Prior to then, if someone had a struggling business, or great idea for a business, they had few choices: they could find someone with money and partner with them, they could start small and hope to build, they could sell everything they owned and max their credit cards, or they could just keep dreaming. What they could almost never do was get money from a bank; banks don’t like risk – they like well secured loans to established businesses.
But some of these ideas were really great – especially since the invention of a thing called a computer that nobody really understood how to use yet. Milken convinced a few investors to put-up some money for some of these start-up companies that had already maxed their credit cards and were in desperate need of cash. In exchange for a really high rate of return these investors risked their money by buying the first “Junk Bonds.” Some of the investments didn’t pan out, but many of them did. The huge returns on the bonds that didn’t go bad more than made-up for the few that did. That did it. Soon everybody and their uncle wanted to invest in these magic “junk bonds” and Milken was flooded with cash to invest. This caused a problem; there were really only so many really good junk bond investment opportunities, and even these still sometimes failed. But he did the best he could, putting together investors with more and more marginal businesses in need of cash. At the height, standards dropped to absurd levels, but the money kept coming in. (This is when he started dumping his own investments because he saw the writing on the wall. The SEC didn’t think this was kosher and so he had to give them a lot of money and spend a little time at Club Fed.) Eventually the whole thing crumbled because too many borrowers just couldn’t make it and the bonds failed in high numbers. However, the junk bond industry is still around; it learned how to better evaluate the risk involved in this kind of investment and the investors are correctly leery.
Well guess what. In the 1990s the investment bankers found the sub-prime mortgage industry. These Mom and Pop companies coupled with a few comparatively small-potatoes players were making huge returns. And it was just in time! Stocks weren’t doing that well, and bonds weren’t much better. People who had become accustomed to double digit rates of return were eager for the next big opportunity. So they started securitizing these loans, billing them as slightly higher risk investments all backed by the homes of hard-working Americans who were not having their needs met by those overly-picky traditional lenders. And it worked; they created the sub-prime mortgage backed security – the funding source for sub-prime loans.
It was just a few at first – after all there are only so many borrowers out there who have lots of equity or cash who will accept these ugly (but profitable) loans. But then something strange happened: the loans performed way better than anyone dreamed they would. Defaults were low, and even those that did default didn’t cause losses to the investors because the loans were well secured. But how could they increase business? They had lots of potential investors! So they lowered the standards – just a bit to see what would happen. Well two things happened: one – they did a lot more business and two – the loans still preformed well – really well! But how could this be? These are supposed to be challenged borrowers. But hey, don’t look too deep, we’re on a roll!
Then the cash really started rolling in, so the standards had to drop even more to meet the investor’s demands. Since these were a completely new type of security, there was really no history to evaluate their true performance. That, and the rating agencies were so cozy with the investment bankers that they just rubber stamped whatever they wanted to do in exchange for the business. Basically everyone just gave the green light to these lower standards. Lower standards would again increase business; and again the loans would perform well. This cycle of lowering standards with little effect on the performance of the loans that made-up the sub-prime mortgage backed security continued for a few years. Of course, after a while these early pioneers of the new lending order were pretty sure they had re-invented the mortgage business. And it was hard to argue with them. They were making hundreds of millions of dollars; the loans were performing and everybody was getting rich. The old-guard of lending was all but replaced by these new lenders and investors, and they absolutely knew that the good times would never end. What they didn’t understand was that the loans were performing well because the value increases were bailing-out all of the bad loans.
What happened next can only be compared to what happens after that 5th tequila shot; things get a little blurry and it’s hard to put a finger on just where and when it all went wrong. At some point, the subprime industry created its own firestorm; lowering the standards created more “qualified” buyers, more “qualified” buyers created more demand, and that drove up the prices even more. Even these terrible loans continued to perform well, but only because the appreciation rates were higher than the interest rates on the loans. Unfortunately these new lenders and investment bankers that were buying the loans and creating these new mortgage backed securities didn’t want to hear this, and the rating agencies just turned a blind eye in exchange for their fees and continued business. To their minds, this was a new reality and those of us who disagreed with them were just a bunch of jealous has-beens.
Eventually, standards were lowered to the point where just about anyone who could write their name could walk into a mortgage company and buy whatever home they desired. This is when it collapsed. They couldn’t lower the standards any more because there were no standards. Without this ability to create more demand with more and more unqualified buyers, home prices stopped going up and then – very quickly they began to go down. This put a lot of heavily-leveraged borrowers underwater. With nobody to bail-out the unqualified and over-leveraged borrowers, the house of cards just collapsed.
As Paul Harvey used to say… “And now you know the rest of the story.”