The more we learn about the Wall Street banksters, the harder it becomes to tell them from the small-time crooks on the streets outside, hustling counterfeit Rolexes.
The crux of the problem was capital, the reserve that banks are required to hold against unexpected losses. While bank regulation is divided among four federal agencies, the Fed has long played the leading role in dictating how much capital banks should hold. By the late 1990s, those rules were outdated.
Rather than wait for borrowers to repay loans, banks were adopting a technique called securitization. The banks created pools of loans and sold investors the right to collect portions of the inflowing payments. The bank got its money upfront. Equally important, under accounting rules it was allowed to report that the loans had been sold, and therefore it did not need to hold any additional capital. But in many cases, the bank still pledged to cover losses if borrowers defaulted.
“It was like selling your car but agreeing to keep paying for any maintenance, repairs, oil changes,” said Joseph Mason, a finance professor at Louisiana State University. “You’ve sold the benefit of the automobile, but you haven’t sold the risk.”