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The Looming Threat That Could Initiate the Next Economic Collapse

Lurking behind the big banks is a mess of unregulated finance that could trigger the next financial blowup.

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Money market mutual funds neither pay for nor are backed by federal deposit insurance, which insures up to $250,000 of a customer’s money against the failure of the bank where deposits are held. Yet, just like banks, they lend money to large corporations including commercial and investment banks. (It’s worth mentioning that money market accounts, unlike money market mutual funds, are held at regulated banks, and function like ordinary savings accounts. Although they generally earn less interest, they’re federally insured.)

Fund sponsors, and the government, according to Schapiro, bailed out money market mutual funds more than 300 times since the 1970s. Most dramatically, a money market mutual fund that had invested heavily in Lehman Brothers debt was caught out in September 2008 when that firm collapsed. The fund took the virtually unprecedented step of “breaking the buck” -- valuing its shares at less than $1. This decision led to panic withdrawals from other similar funds, with more than $300 billion withdrawn in one week. The U.S. government was forced to guarantee all money market mutual fund investments in order to stem the panic.

The Dodd-Frank Consumer Protection and Wall Street Reform Act of 2010 bans further government support for money market mutual funds. But it fails to correct the underlying problem. Funds could be caught short again. If this happens, a run on these funds might follow.  But this time, the federal government would be prohibited from stopping the slide. And if fund sponsors decide not to bail out their funds, or lack the resources to do so, your savings and your job are at risk.

3. Extending securitized mortgage madness to the rental market.

In 1988, the Bank of International Settlements introduced bank capital standards, a risk-based system to make banks safer. These rules encouraged banks to remove various sources of risks from their balance sheets by sending them to the shadow banking system.

In the mortgage world, the BIS rules spawned a system of loan production where those banks that made loans didn’t hold them to maturity.  One way banks protected themselves from mortgage risk – the possibility that borrowers would default on their loans—was by inventing mortgage-backed securities (MBSs). These securities are typically made by assembling a pool of mortgage loans, and then designing a security that will pay investors based on the revenue earned by collecting mortgage payments from that pool.

As was the case before the BIS changes, banks got fees from making loans. But they don’t hold onto the loans themselves, as investments. And since someone else—those who bought the mortgage-backed securities, including many state and foreign governments, charities, and pension funds—stepped in to serve as the investors, banks stopped worrying about whether borrowers could repay or not. For their part, banks just focused on volume—making as many loans as they could. Instead of making the regulated system safer, the BIS rules helped generate the factors that led to the financial crisis that began in 2007 and continues today. No one was responsible for making sure that loans made could be repaid. But plenty of people got rewarded for the number of loans they made.

Mortgage brokers, who operate largely independently, in the unregulated shadows, for example, originate mortgages and are paid based on production. The typical borrower assumes a broker represents his interests, but brokers actually had big financial incentives to place customers into what are the most profitable loans for banks, rather than the best deals for customers.

The end result of a system that paid people to make loans, whether or not they could be repaid, was lots and lots of bad loans. When conditions turned downward in local real estate markets, people found it difficult to make their mortgage payments. When mortgages weren’t paid, investors in MBSs weren’t paid either. These investors — e.g. your pension fund—suffered major losses.