All business decisions are bets on an unknowable future.[1] Faced with uncertainty about the future and the risk that some bets will go bad, businessmen have long sought to build in certainty through contracts and off-set possible losses through hedging. Commodities futures—promises to deliver a set amount and a set price at some future point—have been contracted for and traded for a long time. Commodities futures guarantee sellers a buyer and an income, while guaranteeing purchasers a product at a fixed price.

If uncertainty is one fixture of business, so is innovation. In the 1990s lenders developed a new form of betting on the future. Housing prices had risen steadily in the United States since the 1970s. Believing that housing prices were on a long-term or even permanent upward track, some lenders perceived mortgages issued today as a promise of secure returns tomorrow. Large numbers of newly-issued mortgages were bundled together into securities which were then sold to investors seeking the promise of above-market rates of return. In all lending there is the danger that the borrower cannot or will not repay the loan. The theory appears to have been that a few bad mortgages in any one bundle would not impair the value of all the other sound mortgages in the security.

Democrats wanted to bring these new financial instruments and markets under federal regulation in the same way that the Securities and Exchange Commission over-sees the stock market. Republicans defeated this effort. Indeed, Senator Phil Gramm pushed through a law which exempted such “financial derivatives” from federal regulation. Potentially, the derivative market had become the Wild West. On the other hand, it was a pretty small market in the later 1990s. What’s the worst that could happen?

The “dot.com boom” was one of the hall-marks of the late 1990s.[2] It turned out to be a bubble and the bubble popped in 2001. Then the 9/11 attacks administered a second shock to the system. Rather than put the United States through a financial crisis and recession, the Federal Reserve Bank pumped a lot of money into the economy and cut the short-term interest rate from 6.5 percent to 1 percent. Banks borrowed money cheaply, then re-lent it to others at a somewhat higher rate of interest. Pretty soon all the reasonable loans had been made, but there was still a lot of money to lend. What to do?

Make unreasonable loans, that’s what. Mathematical risk models for these loans, based on an extremely shallow historical record, predicted only a few defaults and constantly rising house prices. The usual standards for making a loan to someone were diluted. This allowed banks to lend to people and for purposes that normally would not have been acceptable. Some of it went to home loans that were labeled “sub-prime”; some of it went for auto loans, credit card debt, student loans, and commercial mortgages. In short, it financed a lot of consumption by ordinary Americans that otherwise would not have been possible.

So, the banks and non-bank financial institutions (mortgage originators) made all these loans. What to do with them? One answer would be “sit on them and collect the interest and principle until the loan is repaid, then make another loan.” Another answer would be “sell the loans (i.e. the right to be repaid by the original borrower) to investors looking for a steady income stream.” Mostly the banks chose the latter course. Selling the loans brought in cash immediately and earned fees for the banks. It transferred the assets to the “investors.”

[1] “Wall Street’s hidden time bombs,” The Week, 10 October 2008, p. 11.

[2] “The ‘toxic debt’ tsunami,” The Week, 20 March 2009, p. 13.