In the past three posts, we've talked about the history of money in the U.S., the creation of a fiat monetary system, and the inflation that occurs with such a system, and the Ponzi Scheme known as Fractional Reserve Banking. Today our topic is derivatives. Before your eyes glaze over, buck up. We'll learn this hideously--well, hideous-- subject in the form of a fairy tale.
Once upon a time, there was a bank, and this bank made money by taking in deposits from customers and then lending that money to other customers for a fee called interest. The bank did ok. A lot of the time, the deposits it took in were free. People just put their money in the bank to be safer and more convenient to use, and the bank didn't pay them any interest in return for holding their money. Sometimes those people would even pay a fee to the bank for holding their money for them. This fee was called a service charge.
Other deposits, the bank had to pay for. The people who owned the money would agree that they wouldn't take the money out for a while, and in return for that promise, the bank would pay them a small amount of interest--maybe a couple of percent per year.
Whenever the bank had deposits it would lend that money out to another customer. It would figure out how much it had to pay to get the deposit, and then it would charge more to the customer getting the loan. Not a whole lot on each dollar, but there were a LOT of dollars, and so the bank did well and made a profit.
But the people who owned the bank, its shareholders, didn't think they were making enough money and they threatened they would take their money and buy shares in a company making televisions or something flashier than a bank unless they started to make more money on their investment.
So the bank figured out that lending money and waiting years for it to be paid back was just too slow. The bank got the idea that if it lent the money and charged some fees and so on and then turned around and sold the right to be paid back to someone else, it could get a little profit from the fees up front and a little profit from the sale of the loan, and then it could turn around and lend the same money again and make more profit. So it started to sell loans to investors like Fannie Mae and FreddyMac and other banks who had some extra money lying around. This worked especially well when interest rates were falling, because the bank could make the loan at say 8 percent interest and charge a 1 percent fee to make the loan, and then if interest rates had fallen in the meantime, it could sell the loan for a premium because the investor couldn't get 8 percent on new loans--it might only get seven.
Soon, though, interest rates weren't falling anymore, and the bank couldn't charge much premium to its investors anymore, and so it was only making a little bit on its loan sales. And the bank's investors said they were going to take their money and go invest in a company that made DVD players, or something flashier unless they started to make more money.
So the bank started to make loans that it could charge higher interest for. People who had some credit problems, or people who didn't have much money to put down on their purchase were willing to pay more interest! The bank knew that the risk of those people not paying their loan was higher, but they also knew that they were going to sell the loan and it would be someone else's problem to try to collect it, so the bank didn't mind. But eventually, the investors started to say, 'wait a minute,' these aren't good quality loans, so we're going to pay less for them, and the bank only made a little bit on each one.
And after a while, the bank's shareholders got tired of only making a few percent in dividends and they threatened to sell their shares and invest in a company making i-pads or something flashier than a bank unless they made more money. And so the bank thought and thought.
And a bright young analyst said to the bank, "Hey! What if we put a whole bunch of these loans in a pot and chop them up and stir them so that no one knows exactly which loan is which. And we'll do all the paperwork and collecting on the loans, so that no one else knows who the borrowers are or whether they are good or bad borrowers. And we can still charge the borrowers the fee up front for loaning the money in the first place. And we can charge a fee to the investor for the servicing of the loans. And we can also sell the loans for a premium, because we'll say that there's so many loans in the pot that while one or two may default, overall, the percentage that will pay will make up for it." And the bank said, "Good idea! We'll call the pot a Collateralized Debt Obligation. I'll go have lunch with my friend the credit reporting agency and I'll get them to say that this pot is a VERY SAFE INVESTMENT." And so the derivative was born.
And the bank did very well. It collected money from the borrowers. It collected servicing fees. It collected premiums on the loans, because they were said to be VERY SAFE INVESTMENTS, and it always got paid back its principal too, because it sold the pots of loans before any could default. And this worked for quite a while. Whenever business would slow down a little, the bank would make up an even gimmickier kind of loan to attract more customers to borrow. After a while, the bank was making loans for really high interest rates to people it knew were lying about how much money they made and whether they could pay back the loans, but the bank didn't care, because it was going to chop them up and sell them in pots.
And since the investors who bought the pots couldn't ever see the actual paperwork on the loans, no one else knew that they were low quality. Every so often, loans would default, but because of inflation, the collateral had gotten to be higher priced, and so the bank would sell it off for enough to pay most or all of the loan, and no one was any the wiser.
And then, one day the bank got up and read the newspaper and it said that its friend the big bank, the Federal Reserve, had been printing so much money, and its friend the government had been spending so much money fighting wars and paying people not to complain about the wars that the debt of the United States was REALLY REALLY BIG.
And investors were saying the the United States couldn't pay all that debt, and some investors stopped loaning money to the United States anymore at all. And suddenly, investors wouldn't buy its pots of derivatives anymore because they were worried about the economy. And it kept getting worse and the bank had to keep the loans, but it knew that a lot of them were bad loans. And as people got more worried, they borrowed less, and as they borrowed less, the bank made less money, and so on, until the bank wasn't making even enough to pay back the deposits it owed to its customers--it was BANKRUPT.
And the bank couldn't let everyone know that it had been making and selling really bad loans and telling buyers that they were REALLY SAFE INVESTMENTS, because that would be FRAUD, and the bank would go to jail.
And so the bank went in its office and shut the door and cried. And after a moment, the bank's fairy godfather appeared. The fairy godfather said, "Hi. My name is Hank Paulson. I'm from the government, and I'm here to help you." And the bank knew it was all going to be ok.