A general understanding of the credit bubble requires a general understanding of how banks make money. For producing nothing, one has to give them credit (sorry) for being possibly the most politically influential industry in society. CEO bonus packages for questionable leadership—maybe with short-term profits but long-term calamity—are second to none among the financial sector. Mainstream media and popular culture have us oriented to believe that what is best for the private-interests of banks is best for all society; hence a legacy of huge government bailouts and ongoing morally hazardous regulatory policies.
Certainly credit and lending plays a role in the success of western industrial democracies, but the relative importance of banks seems out of place. Their operation is conceptually simple: borrow at low interest rates, and lend at high interest rates. That's it: this is called the "carry trade." Traditionally people put their money into checking and savings accounts, money markets, and cd's, which right now earn around 3% at best, and banks lend it out on the order of over 6%, with the difference of interest rates reflecting their profit. It's an easy system with the primary cost to banks being to accept the risk of default.
Back in the day most of their capital came from deposit accounts, but lately, during the credit bubble of the last few years, that was not enough. Even with a fractional reserve rate of 10%, banks still needed more. In order to underwrite the demand for credit instigated by suppression of interest rates by the Federal Reserve Bank (the pattern of rate drops to below 2% began in January 2001 and stayed there until September 2004), banks would have to rely on other sources of capital.
Where banks turned was to bond investors: either those buying commercial paper or securitized loan packages. Each played their own role in the unsustainable credit expansion of the early part of this decade, whose reactive contraction has only just begun.
As always, I argue, as credit contracts, then cash strengthens. The next two non-news posts will discuss these alternative sources of banking capital: mortgage-backed securities and structured investment vehicles.