It doesn't take a genius to realize that the kind of person who does well in prudent investment and helping local enterprise get along is really not the kind of person who does well in the rough-and-tumble world of speculation. There was a time when the government saw to it that these two realms remained separate. This was way back in 1933 when the so-called Glass-Steagall Act was passed and signed into law. Its real name was the Banking Act of 1933, and it covered a lot of territory, but for our discussion here, it separated commercial banking from speculative banking. Over time, of course, lots of folks started thinking this was old-fashioned and during Clinton's second term that was stated so definitively, in terms of the Gramm–Leach–Bliley Act of 1999, which repealed the affiliation restrictions that Glass-Steagall had imposed.
It will be recalled that back in "Through a Gla$$ Darkly II" it was shown that a bank can only lend out (or invest; that is, put at risk) about 10 times what is has "safe in the bank". Another way of saying this is that it essentially lends out (or invests) the same capital multiple times. The trick comes when we ask ourselves what is "safe in the bank". Let's take a look at this briefly:
If a bank has ∆1,000 "safe in the bank", it can loan out or invest up to, say, ∆100,000. Some of these loans – like we described in our examples then – are relatively safe. And, if the bank lends out, say, ∆1,000 at 5% for a year, it will get back – if all goes as planned – about ∆1,020 at the end of the year (it's actually slightly more but for the purposes of illustration here, inconsequential). In other words, it lent ∆1,000 but the "value" of that loan is ∆1,020. This is to say that the value of the bank is equal to what it safely has and what it expects to have at some point in the future.
The important point here is that the bank's value is actually a fictitious number. It's not real like the ∆1,000 upon which it bases its business is real. The art which allows us to keep track of such things is, of course, accounting. Or, as I like to say, it is not "counting" but "a [that is, one particular way of] counting, but that, too, is another story. But now that the door is open for all kinds of real, kind-of-real, and even imaginary things to happen, since commercial banks may now also speculate, let's take it all a step further.
In my bank, some of the loans that I have made are good, sound, loans. Some are, for whatever reasons, a bit of a stretch. Perhaps the people will lose their jobs when the factory shuts down or someone with a loan gets ill and loses their job for that reason, or perhaps someone simply misjudged the reliability of the loan recipient and it doesn't look like the bank is going to get their money back. In the traditional system, the good loans offset the bad ones and the trick was to make as few bad ones as possible. Now, however, we have other possibilities.
Let's assume that Mary, one of the bank's new employees, has a brilliant idea. Why not take some of the good loans and some of the bad loans and wrap them all up in one single bundle. You then get a rating agency to give it a AAA stamp-of-approval and then you simply sell the whole bundle to someone else for some set price, a price that is perhaps lower than the whole bundle if counted individually, but more than if the bad loans in there didn't get paid back. You have two advantages: first, you are rid of part of your risk, and two, you have immediate cash in hand to turn around and loan out or invest and not have to wait until all the individual payments from all those individual loans come trickling in. And that's what they started to do, in various ways, with various colors and variations and who knows what all, but pushing these bundles of paper around – which are, it should be noted, a "derivative"; that is, an "investment" that derives from other forms of investment – becomes so popular and so many folks are getting used to speculation of all kinds that before long side markets show up where these things are bid upon, traded, exchanged, and who knows what else and everybody is just have a grand old time making up such derivatives and finding others who are willing to buy them or bid on them.
Again, it doesn't take a genius and just a moment's reflection reveals that the value of these bundles is pretty fictitious too. All of sudden there are bundles upon bundles that are bigger and bigger and all of them are "safe" because they've been rated safe, which increases my safe capital in my own institution, which means I can loan out more money and make more investments to grow and grow and grow and get richer, richer and richer. The only problem is that deep down beneath all those levels of paper and in spite of all the creative ways of accounting for these "instruments", as they were called, there's really nothing real at all. The "value" and the "worth" of any individual bundle was not the same. The bundles were once backed by whatever those bundles represented but once bundles were bundled and further bundled – the process can theoretically go on indefinitely – well, if you ask me, it all just starts getting absurd. One day someone is going to wake up, realize they are being sold a bill of goods and the house of cards could come tumbling down.
Welcome to the financial crisis of 2008.