The Role of Commercial and Investment Banks in the Housing Crisis

Published: 12th June 2009
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For all of the bailout money being given to banks, it seems that more credit should be available to potential borrowers or, at the very least, huge Wall Street firms should not have gone out of business or converted to a different type of bank. But this has not been the case -- despite hundreds of billions of dollars directly handed over to the banking system, the only result has been fewer loans being made and more insolvent banks.

One reason for this seeming contradiction (taxpayers forced to make investments in banks, while lending is down anyway) is that many of the bailouts are being given to institutions that did not make direct loans to homeowners or borrowers anyway. These investment banks participated in a different part of the lending process than the commercial banks that typically make loans to consumers.

In fact, is is the commercial banks that most of us refer to when speaking about "the banks." But commercial banks can offer two types of services, called retail banking and commercial banking. Most large commercial banks participate in both types of financial transaction.

Commercial banking refers to dealing with large corporate or business banking transactions. Many of the largest banks are also the depositors for the largest corporations in the world and finance the construction of new locations for retailers, new plants for industry, or expansion plans.

On the other hand, retail banks make loans to and receive deposits from consumers. Of course, some of the same commercial banking giants are also retail banking giants. Many of these large banks have credit card and home lending divisions, as well as offering checking and savings accounts.

Most homeowners should be familiar with a commercial or retail bank, as these are the financial institutions they are most likely to pass everyday on the way to work or the grocery store. During the housing boom, these banks, depending on their size, were often more prudent in their lending decisions, as they were using their depositors' money to make mortgages and the risk of failure was increased for making bad loans.

The largest commercial banks, though, such as Citigroup, while also offering loans directly to consumers, also participated in the subprime lending market or invested in the securities created by investment banks out of subprime mortgages. Once the downturn in the housing market came, these banks were suddenly experiencing huge losses due to foreclosure and the evaporation of value of these mortgage securities.

While commercial banks are typically referred to as "the banks,' investment banking firms have typically been referred to as "Wall Street," due to the presence of the largest firms right in the heart of the largest financial sector of country in New York. By now, all of the largest investment banks have been absorbed by other companies, filed for bankruptcy, or been converted into commercial banks.

The role of investment banks in the economy, though, has typically been to issue and sell securities. They do this in the equity (stock) and bond markets. These companies also help companies raise funds for mergers and acquisitions, or provide consulting advice to such companies attempting to engage in the types of transactions listed here.

During the real estate bubble years, Wall Street investment firms acted as middlemen, funneling money from investors to subprime lenders to consumers, and then buying back the mortgages created, securitizing them, and selling them back to investors. At each step of the way, the investment banks took a share of the transaction, which greatly increased profits for the institutions.

Unfortunately, Wall Street did not want to recognize that the loans being created by the lenders were built on very shaky foundations. In fact, the success or failure of these companies started to depend to a great degree on the performance of loans made to people who could never afford them. This was a recipe for disaster once the housing market took a turn for the worse, and has resulted in the collapse most people could have predicted.

Congress and the Federal Reserve have made available more than $12 trillion for the "banking system" by now. These funds have mostly gravitated towards the investment firms in order to paper over their huge losses in subprime and derivatives investments, rather than going to commercial banks. But this may be a good thing, as $12 trillion created by the Fed can translate into close to $120 trillion by the banks.

But this is also why homeowners and American consumers are witnessing stable or rising prices when they should be falling as a result of the recession. The politicians and economic planners are create huge amounts of inflation, which is propping up prices, but none of this newly created money is making its way to small businesses or consumers. So the people pay for the inflation tax and receive none of the benefits.
Nick publishes articles for the My Foreclosure Lender site. These articles provide advice to borrowers facing the loss of a home, describing a number of alternatives they can use to delay foreclosure. The site describes numerous solutions, including mortgage modification, foreclosure lending, deed in lieu of foreclosure, filing Chapter 7, and more. Visit the site to find out more about how the foreclosure process works: http://www.myforeclosurelender.com/

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