Commercial bank

A commercial bank, the kind you and I deal with must retain ten percent of its assets but can loan out the other 90%. This 10% is called the reserve requirement and can be changed by the government. About 15 years ago banks developed something called Structured Investment Vehicles (SIV) in order to get around the reserve requirement. They would borrow short term money called commercial paper and put that into an account off the books. Then they would use that money to purchase longer term investments that paid a higher rate of return. They made a profit on the spread between what they paid on the borrowed money and what they earned in the invested money. This is what banks in general do but they use depositor’s money to loan out and in that case it is all on the books and is governed by the reserve requirement rules. Commercial paper is not backed by assets only a promise to pay so they can get as much as their reputation will allow. These loans last only up to 270 days and then they are rolled over. As the bank uses more of these loans the lenders become more comfortable and the loan amounts grow. When mortgage companies began to bundle home mortgages called Asset Backed Securities (ABS) that were paying a tempting interest rate the SIV’s began to purchase them to increase their spread. While the bank paid most of the spread to investors who bought the mortgage bundles they got a fee every time they made a sale. Since the banks access to commercial paper was almost limitless they could take on all the mortgages that were brought in and since they were making handsome fees they encouraged mortgage brokers to bring in all they could. While off the books investing is , in and of itself, it got a lot worse because of leveraging. The bank that had $100 million to buy mortgage bundles could in fact buy more than that using leverage like banks do in making loans with depositors money but with this money there were no reserve requirements so they were not limited to the 10% requirement. So the bank with $100 million could in fact purchase $1.5 billion in mortgage backed securities and some many times higher than that