Fractional Reserve Banking has a great deal to do with everything. It’s true that the concept has been around for a long time, but so what? Home equity loans have been around for a long time, but it was only in the past few years that the banks went nuts with ARMs and no-money-down loans. Likewise Fractional Reserve Banking has been around for a while, but the fractions used to be sensible. In the past few years, our politicians stripped away reasonable regulation.
The sane system worked like this. Banks must hold a portion of what they loan in reserve, in proportion to the risk. For a safe asset like a treasury bond, they don’t need to hold anything. For a good corporate bond, they need only hold about 20% of the value. For a junk bond, they need to hold the entire value. That’s the old system, and it worked fine for generations.
Under the new system, the banks can insure the risk using a CDS. Having done this, they no longer need to hold any meaningful portion of what they loaned in reserve, since they depend on the insurer to bail them out if loans failed. It worked fine for a short time, but obviously when the economy went down the tubes, failures became so common that the insurance company (AIG) went bankrupt, and now there’s no one to cover the banks.
It seems, then, that your last sentence takes away any force you could possibly have mustered against my comment. Fractional reserve is a tried and true system, in general. Particular regulation, namely adequate lack thereof, may cause us problems. But that’s a truism, is it not?
I’m not sure if is still true, but a few months ago the thrifts were in very good shape, especially the local ones who loaned to their communities. Now it is possible that they are teetering because of the general recession and fall in housing prices caused by the less regulated financial institutions.
Maybe the problem is that loans are not considered as assets by some people. If someone doesn’t, fractional reserve banking must seem like a terrible idea.
The purpose of the FDIC, of course, is psychological. They can’t prevent a run, but they can make one much less likely since depositors know they can get their money even if a bank does go belly-up, which makes that much less likely.
I wouldn’t say John Paulson did anything wrong in regards to his MBS trades.
The people on the other side of his trades were the bad ones - reckless buying, speculative excess, irrational exhuberance, etc. Paulson recognized what was happening, and spoke with his money by taking the opposite view.
If there had been more people on the sell side, as Paulson was, the bubble would have had met more resistance and wouldn’t have grown as large. How many people that are net short the MBS market are complaining right now of a lack of sellers? Paulson and people on his side of that trade are the only ones that were buying on the way down.