The Year That Changed Everything: 1970

The story begins in the year 1970 when something profoundly changed the financial sector.  Banking used to be a simple process: banks would accept deposits from customers. The banks would pay customers interest on their checking and savings account balances and would then take the deposits and lend those funds out to other customers.  These loans were made for many purposes, but by far the largest group of borrowers were homebuyers. The banks would extend loans to new homeowners in the form of a mortgage (a loan with a house used as collateral). The borrower then repays the loan with interest - usually on a monthly basis over an extended period of time; typically thirty years.   The bank makes money because it is able to charge the borrower (the mortgage borrower in this example) a much higher interest rate than it offers to those customers which deposit funds at the institution.  One of the problems with this business model is that when the bank extends a mortgage to a borrower, it must patiently wait upwards of thirty-years to recover the money it lent.  If the bank wants to keep extending more and more loans, they will run out of money to lend to borrowers. Remember, the bank’s main source of money to lend comes from depositors of checking and savings accounts. The pool of deposits is not infinite.

So what happened in 1970?  The first mortgage pass-through security was created.  For the first time ever, banks were able to sell thousands of loans, which they had just previously originated, and within days, package them into one big loan and sell that big loan to someone else.  The bank no longer had to wait thirty years for the borrower to pay back the loan and free up funds to extend new loans. Now, with the cash received from selling these mortgages to someone else, the bank could now continue to extend more loans. It was a cycle that could be repeated almost endlessly and proved extremely profitable for the banks.