How To Start A Financial Crisis Part 3

Guest post by Market Authority 

First, in the last three decades, low interest rates and increases in productivity are mostly responsible for record amounts of corporate balance sheet cash. That cash needs to go somewhere. 

Second, banks devised a pawn-like scheme to take corporate balance sheet cash and use it to finance the purchase of higher-yielding securities, earning the difference in what they pay to borrow and what they earn on the purchase. 

Third, the borrowed cash needed to be backed by AAA-rated collateral. To fulfill this need, Wall Street securitized packages of loans, thereby creating a new form of AAA-rated collateral. 

This spawned the “shadow banking system”: corporations would lend money to banks through repo and commercial paper markets in exchange for a low interest rate and the banks would back these loans with securitized products. Even after Dodd-Frank, this system still remains largely unregulated. 

Today, I’ll explain how the whole process led to higher asset prices through the creation of more credit. 

Think of it like this: banks enter a pawn shop with a gold chain. The pawnbroker lends the banker $1000 at a 1% interest rate and keeps the gold chain as collateral. Banks take the $1000 and purchase another gold chain, and promptly return to the pawn shop to borrow another $1000. This process is repeated ad infinitum until all the cash on corporate balance sheets has been lent to finance the available supply of gold chains.

Suppose these gold chains weren’t your average run-of-the-mill gold chains. These gold chains have Mr T-like mystical powers and pay a 6% dividend to the owner. For every $1000 that the bank borrowed from the pawn shop at 1%, they earn a 5% return (the difference between what the bank borrows and what it receives). Each time the bank is due to pay the pawnbroker back the original $1000, he tells him to keep the gold chain and renews the agreement on the funds for 1%. Thus, borrowing money from the pawn shop to finance the purchase of higher yielding gold chains is a very lucrative endeavor.