Investment banks and other non-depository financial institutions play their role of intermediating between large institutional investors and homebuyers in one of two ways. The first is analogous to the commercial banking most of us are familiar with; that is, the investment banks borrow from the institutional investors and use those borrowings to buy and hold mortgages. With the principal and interest payments they receive from the mortgages, they pay the interest they owe the institutional investors. (Investment banks do not usually originate mortgages themselves; usually they buy them from commercial banks, S&L’s, and other mortgage originators.)
Here a word might be useful on borrowing by selling bonds, which is what investment banks generally do in this kind of situation. A bond is best understood as an IOU. Suppose the investment bank Goldman Sachs wants to buy, say, $10 million worth of mortgages. It might borrow the money it needs for that purpose from a big institutional investor such as, say, Yale University’s endowment fund. When Yale lends Goldman the $10 million, Goldman gives Yale a formal document, called a bond, in which it promises to pay back to Yale—or, more likely, to the “bearer” of the bond so that Yale can sell it to someone else if it chooses—the $10 million on a specified date (ten years in the future, perhaps), and also pay Yale interest on the loan of a specified amount on a specified schedule. Figure 8.2 gives a simplified version of a ten-year bond we imagine Goldman Sachs to issue to the Yale endowment on October 17 of 2013, paying 6 percent interest, on receiving a loan of $10 million from Yale.
Figure 8.2 A Basic Bond
BOND
Goldman Sachs Inc.
promises to pay the bearer
$10,000,000, on October 17, 2023
and interest of $600,000
on October 17 of every year until then.
Signed Irving G. Eyeshade, Treasurer
Notice that to say that Goldman Sachs sells a $10 million bond means that Goldman Sachs borrows $10 million from whoever buys the bond. The bond is the contract, the formal record of the loan, entitling its holder to the interest and principal repayment from Goldman Sachs.
Returning to investment banks and the two ways in which they intermediate between large institutional investors and homebuyers, the first way is to borrow from institutional investors by selling them bonds and then to use that money to buy mortgages from the commercial banks that originated them. (The banks that originated and sold those mortgages then can use the proceeds to make new mortgage loans to additional homebuyers.) In this first kind of intermediation, the investment bank would hold the mortgages in its own account. It would collect the mortgage payments, use as much of that revenue as required to pay interest and principal on its bonds, and keep what remains (if anything) as profit. To flesh out our simple example, Goldman Sachs might use the ten million dollars it borrows from Yale’s endowment to buy a hundred mortgages that average $100,000 in size and pay interest rates of 7 percent on average. If all goes well for Goldman Sachs, it will collect 7 percent interest on the $10 million in mortgages, pay 6 percent on the $10 million bond it used to finance its purchase of the mortgages, and have the 1 percent difference, or $100,000 per year, to cover its costs and leave something for profit. In such a case it is said that the bond Goldman Sachs sold Yale is “backed by” the hundred mortgages it has bought with the money.
The second way in which an investment bank intermediates between large institutional investors and homebuyers is to act as a broker, not buying mortgages itself, but helping the investors to buy mortgages—or, as we shall see, to buy pieces of a large number of mortgages. Altering our example to fit this second way, Goldman Sachs could initially buy those one hundred mortgages but then compose them into a bundle or a pool. The pool itself becomes an independent legal entity. Goldman Sachs would then sell the pool of mortgages to the Yale endowment. Yale would pay a one-time commission to Goldman for arranging the deal; that’s how Goldman would make its money. Yale then owns the mortgage pool and receives (if all goes well) the 7 percent average interest payments. (It would also pay an annual fee to some service company hired to collect all the individual mortgage payments and send Yale a check for the remaining income.)
A pool of mortgages such as we have described here is called a “mortgage-backed security” (MBS); these were very important in the housing boom and bust and the financial turmoil that followed. Mortgage-backed securities usually have one other important feature: they can have multiple owners, each of whom owns just a portion of the pool. In our example, Yale University’s endowment might want to buy only $1 million worth of the $10 million mortgage-backed security. In that case, Goldman Sachs might arrange with nine additional institutional investors—such as, say, The Hartford Insurance Company, a T. Rowe Price mutual fund, a Proctor and Gamble employee pension fund and others—each to buy $1 million worth of that same MBS. In this example, we imagine only ten investors with equal shares of a $10 million MBS; in practice many MBSs had scores of investors owning different sized shares, and there were often hundreds of mortgages worth many millions of dollars in the pool.
Over time, depending on how well they create value for their customers, some commercial banks and investment banks earn profits with which to expand, while others suffer losses and have to contract or be taken over. Those that do well, becoming not just intermediaries but large institutional investors in their own right, purchase for themselves mortgage-backed securities and the bonds of various major enterprises.
As the secondary market for mortgages took off and it became commonplace for mortgages to be sold shortly after origination, another kind of business arose whose role was simply to originate mortgages for immediate sale to a big enterprise that would bundle the mortgages into MBSs. These businesses are called mortgage originators.
Mortgage-making is complex, isn’t it? Like pencil-making it involves many different skills and processes carried out by many different people, all of them self-interested and each of whom knows only his or her tiny portion of the whole. And no one is in charge; no one could possibly manage such a far-flung network of activities. Yet, when the principles of spontaneous economic order are allowed to operate, like pencil-making, the process of mortgage-making is smooth and dependable.
Coordination via the Principles of Spontaneous Economic Order
As complex and extensive as it is, mortgage-making accounts for just a portion of a fantastically extensive network that finances projects and enterprises of all kinds. Banks are approached for loans not just by house buyers but by an endless variety of businesses, too: a farmer needs a better tractor; a restaurant owner wants to expand her pizzeria; an inventor wants to put a new gadget into production, pencils must be made, and so on. Banks have limited funds to lend, of course, so they must decide who gets a loan and who doesn’t. How do they decide? How should they decide in order that people’s well-being will be best served?
Similarly, a host of large enterprises want to borrow money for a wide variety of major projects. An airport, say, Hartford, Connecticut’s Bradley International Airport, might like to borrow money with which to build a new runway; Hospital Corp. of America might want to build a new hospital building; Dow Chemical Corp. might want to establish a new research center, and so on. The major enterprises wishing to carry out these big projects can either seek loans from banks or try to borrow money by selling bonds to big institutional investors. Typically, if they sell bonds, investment banks act as intermediaries that underwrite the bonds and solicit big institutional investors to buy them. Thus, the same kinds of large institutional investors that might be interested in buying mortgage-backed securities—we have considered The Hartford Insurance Company, a T. Rowe Price mutual fund and a Proctor and Gamble employee pension fund, for example—might be interested in buying bonds from Bradley International, Hospital Corp. of America, or Dow Chemical Co. instead. How does a large institutional investor decide whether to invest in a share of a thousand home mortgages bundled in a mortgage-backed security or a bond for Bradl
ey International’s new runways, or in some other project? How should the investor decide in order that people’s well-being will be best served?
At any time, there are only limited quantities of investable resources available to devote to all these potential projects. There are not enough carpenters, electricians, accountants, engineers, machinists, software engineers, two-by-fours, steel beams, tons of concrete, pickup trucks, dump trucks, tanker trucks, PVC pipes, watts of electricity, forklifts, rolls of insulation, tons of paving material or any of the great variety of other productive resources needed to carry out all projects at once. If more investable resources are devoted to building a new house, then fewer resources are available for expanding a pizzeria or developing a research center. The tradeoff is like that faced by the Commissar of Railroads in our thought experiment in Chapter 1: the more steel is used to build the rail line, the less steel is available for vehicles and pots and pans.
Corresponding to the limited supply of investable resources available at any time is a limited supply of loanable funds—money that banks, investment banks, and other intermediaries lend to those who wish to buy new tractors, build new homes, pizzerias, runways, hospitals, or research centers, or engage in any of the infinity of other projects human beings conceive. It is important to remember that ultimately what is needed to build a house or tractor or runway is not money, but the intellectual and physical resources the money can purchase. (As Duquesne University’s Antony Davies says, “Money is just the conveyor belt.”)
This means that when borrower/spenders compete with one another for access to the limited loanable funds which saver/lenders offer to lend, they are ultimately competing for access to some of the limited investable resources available for use. Correspondingly, when saver/lenders and intermediaries choose the borrower/spenders to whom they will lend, they are ultimately deciding which projects get these precious resources and which don’t.
For example, if a bank chooses to make a $100,000 mortgage loan to a new home buyer instead of a $100,000 small-business loan to a restaurateur for expanding her pizzeria, then $100,000 worth of two-by-fours, pipes, carpentry work, painting and other construction resources are drawn into housing rather than into pizza-eating space. If the bank chooses to lend the $100,000 to a farmer for a new tractor instead of either the house or the pizzeria, productive resources are drawn into making steel and tires and tractor engines instead of into two-by-fours, pipes, carpentry and other construction resources.
All these zillions of investment decisions, taken as a whole, are critically important to society, because our standard of living depends on how well we use our scarce productive resources. If we use carpentry, pipes, and two-by-fours to refurbish pizzerias nobody wants to go to, or to build houses that people cannot afford to buy (because their incomes won’t cover the cost of construction)—in short, if we waste valuable resources—our standard of living will decrease or grow more slowly than it could. It is critically important to social well-being that resources go where they are most valuable, as far as that can be determined.
In a free market, what determines which projects get funded, and how many get funded? How can entrepreneurs learn if there are enough investable resources available to carry a certain project through to completion? How might they find out if and when more investable resources become available, so that a project that couldn’t have been accomplished last year when there was less saving can be accomplished this year when there is more? How do people decide whether it’s more appropriate for them to save their money now and lend it to others, or to borrow money from others now and invest it in enterprises of their own? In general, how are the zillions of decisions to save and lend coordinated with the zillions of decisions to borrow and spend, so that the number and sizes of projects undertaken are appropriate to the quantities of investable resources available? How do we avoid having investable resources sitting idle and wasted, or having so many projects undertaken that there aren’t enough resources available to finish them?
What provides the coordination among the millions of people who save, lend, borrow, and invest, for innumerable different purposes? Note that this is almost exactly the same question we asked in Chapter 1 about what provides the coordination that makes the production of pencils so marvelously orderly. The answer … is exactly the same. What provides the coordination?
Prices do. Of course.
In this case, the relevant prices are interest rates—the prices of time. Based on interest rates—as long as those interest rates emerge in free and voluntary market exchange and therefore are telling the truth—people can answer all the questions asked three paragraphs back.
The particular levels of market interest rates at any time emerge from the ongoing negotiations among all the saver/lenders and borrower/spenders in various overlapping markets for various kinds of loans. Competition among the various saver/lenders tends to push interest rates downward, because each one must appeal to borrower/spenders to borrow from him rather than others by offering to lend at a lower interest rate than others offer. At the same time, competition among borrower/spenders tends to push interest rates upward, because they must appeal to saver/lenders to lend to them rather than others by offering to borrow at a higher interest rate.
Interest Rates: The Prices of Time
Interest rates may be the most important prices of all because they coordinate the exchange of goods and services across time. Interest is what the saver/lender is paid for waiting to use her buying power on herself. Instead of using it now by purchasing, say, a nice meal or nice car or nice house, she decides to wait some years to enjoy that kind of consumption, and let some borrower/spender use her money in the interim to purchase or hire investable resources. In the other direction, interest is what the borrower/spender pays to make use of more goods and services today than he can purchase or hire out of his own wealth. Interest is the payment for moving access to goods across time.
Because the future is uncertain, interest rates also have a "risk premium," or additional payment that rises with risk: lenders must be paid a higher interest rate on a riskier loan.
While we often speak of "the interest rate" as a kind of convenient shorthand, it is important to remember that in practice there are many different interest rates for different kinds of loans.
Like all prices, interest rates serve as “knowledge surrogates.” The Price Coordination Principle of spontaneous economic order applies. Interest rates are continually communicating the significance of the changing knowledge of saver/lenders, borrower/spenders, and intermediaries all around the economy. A relatively strong or increasing desire for investable resources on the part of borrower/spenders will cause high or rising interest rates as borrower/spenders bid against one another for loanable funds. High or rising interest rates might be caused instead, or also, by a relatively high or rising reluctance of lender/savers to lend—they require a higher rate to persuade them to lend away their buying power.
These high or rising interest rates have an important story to tell. They tell all concerned that for some reasons or other—the precise reasons are not important—investable resources are less available than before. The message to borrowers is to conserve, to undertake only those projects that create a lot of value for their customers and hence promise returns high enough to cover high loan payments and still leave some over for profit. The message to saver/lenders is that now is a good time to save and to lend more, because investable resources are urgently needed.
The reasoning works in the other direction for low or falling interest rates. These tell borrower/spenders that investable resources are relatively abundant, so they may borrow more freely and undertake projects that create less value for customers or require more resources or take longer to complete. Low or falling rates tell saver/lenders that there is relatively less need now for investable resources.
In a free market, interest rates determine which projects get funded. In general, projects receive loans as long a
s the value they are expected to create is large enough to cover the interest and principal payments; otherwise not.
Let’s illustrate this with another thought experiment: Suppose you are a banker approached by a homebuyer, a farmer, and a pizzeria proprietor, each asking for a $100,000 loan. How would you decide how many of these would-be borrowers, and which ones, to lend to?
On the other side of the possible exchange, suppose you are one of the would-be borrowers and the bank offers you a loan. Under what circumstances would you take the loan offered? Under what circumstances would you refuse it? Suppose a loan of $100,000 would mean that:
the homebuyer could purchase additional housing space worth $6,000 a year to her family—a 6 percent return,
the farmer could buy a new tractor that would help him grow an estimated $5,000 worth of additional crops each year— a 5 percent return, and
the restaurateur could refurbish her pizzeria in a way she expects to generate at least $7,000 worth of additional business each year—a 7 percent return.
Suppose you, the banker, and the would-be borrowers agree on these estimates of return and you believe in the borrowers’ creditworthiness. And suppose market interest rates at the time are relatively low, say, 4 percent. To whom would you lend? Presumably you would offer all three a loan (if you had enough funds; perhaps one would have to go to a different bank if you run short) and all three would be willing to accept it. The relatively low interest rate would mean that investable resources are abundant—there are enough to support all three projects. All three create enough new value to cover the $4,000 annual interest.
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