Western governments have pumped trillions of dollars into financial markets in the past few months in an attempt to shore up trust in them. This expense exceeds by many multiples anything ever spent on recovery from an earthquake or hurricane, and is more on the scale of a largish modern war. Such a scale indicates the value of trust to financial markets, and its key role in enabling modern society to function.

Society requires financial markets so that people can do things like use credit to buy a car or house, or build retirement funds in pension plans, or invest personal savings. One crucial part of the system is financial intermediation. For example, I might like to borrow to buy a house with an interest rate that is fixed for five years, but on my own it might be hard to find someone willing to lend to me on those terms, or to communicate the reasonable certainty that I will pay that person back. That is where intermediaries, such as banks, come into play.

By accepting deposits from someone else or, for example, selling five-year guaranteed investment certificates (GICs), and lending the proceeds to me, intermediation makes markets work better. The person who invests in GICs is better off than if she lends directly to me, because she does not have to seek out information about my ability to pay off my mortgage, and can rely instead on her assessment of the bank’s reputation – or on its public financial statements and reports to government regulators – to establish her confidence that she can get her money back in five years.

The bank, in our example, takes on a commitment to honour depositors’ potential future withdrawals, or to honour a redeemed GIC, yet it becomes exposed to the risk that I might not be able to repay my mortgage. What if the bank could reduce the cost of bearing that risk? It could then afford to charge me less for my mortgage, or pay depositors a higher rate of interest on their savings, or pay employees more wages or shareholders more dividends.

This is where the next level of intermediation comes into play. The bank could pool together mortgages that it holds on homes in different regions, or of different maturities or sizes. It could then sell partial interests in that pool to other investors looking to earn returns by lending at prevailing mortgage market interest rates – higher than they could earn in a bank account – in exchange for taking on some of the risk that some borrowers may fail to repay. The proceeds of selling these interests would be used to honour the original GICs, and these third-party purchasers would earn their returns from the stream of income generated by monthly mortgage payments. That is why the partial interests they buy from the bank are called mortgage-backed securities.

And that is where it all started

One of the differences between the world as it is now and the world as it was in 2007 is that there are now few people in Western countries who have not heard of mortgage-backed securities (MBS), for it is these instruments of intermediation that lay at the heart of the recent financial market debacle. And it is the failings of the U.S.-government-guided system for generating and distributing MBS, and misplaced trust in that system, which must shoulder the biggest burden of blame.

In a typical mortgage market transaction in the United States, a financial institution’s loan officer receives, sometimes examines, and approves (for a fee) a mortgage loan application. To avoid having the institution retain significant residual risk on its own balance sheet, the loan is often sold on to or insured by one of two government-sponsored enterprises, known as Fannie Mae and Freddie Mac. In fact, the market for underwriting and insuring home mortgages, and hence the market for MBS in the United States, has for years been dominated by Fannie and Freddie which, while shareholder-owned, are governed as to what they can and cannot do, and the terms under which they do it, by federal legislation.

So what could go wrong? The answer appeared in a Steven A. Holmes story in the New York Times on September 30, 1999:

Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers, whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates – anywhere from three to four percentage points higher than conventional loans.

“Fannie Mae has expanded home ownership for millions of families in the 1990s by reducing down payment requirements,” said Franklin D. Raines, Fannie Mae’s chairman and chief executive officer. “Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.”

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.

“From the perspective of many people, including me, this is another thrift industry growing up around us,” said Peter Wallison, a resident fellow at the American Enterprise Institute. “If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”

Fannie and her private-sector coconspirators sought aggressively to expand their loan books, and they generously funded their congressional champions. The market expanded by trillions of dollars, and institutional investors in the United States, Canada, Europe, China and elsewhere invested in the securities that underwrote U.S. mortgage borrowing. Those investors did so because notwithstanding official denials, they guessed – correctly – that the U.S. government would be forced to backstop the loans should anything go badly. And thus did regulation and confused financial and political incentives shatter the ordinary trust that ought to have governed the parcelling out of ordinary mortgage market risk.

Few among us who spotted the risk Fannie Mae posed also guessed how broadly the poisoning of trust could spread thereafter. Financial institutions that ordinarily lend to each other cheaply in the short-term and overnight markets began this summer to hoard cash instead: they needed to be ready to honour debts if called on, and they had a difficult time establishing that their counterparties’ assets were of sufficient security that they, in turn, could repay if called on. More recently, counterparty risk has put sand in the wheels of large banks’ day-to-day currency transactions, potentially limiting the ability of people and businesses to undertake ordinary crossborder trade.

If financial institutions were to become unable to facilitate ordinary buying and selling of houses, cars or groceries, if people could not save or invest with sufficient confidence that they would get their money back when they needed it, then we would be in grave trouble indeed.

That, in turn, is why governments have been feverishly backstopping financial institutions and pumping financial capital onto their books. Banks need to know that their counterparties have the capital to withstand fresh shocks to their asset values, and depositors need to know that their banks are financially stable. It is an unfortunate situation, and one that perhaps did not need to happen, but it is the one we are in. As the months wear on, we will learn how much trust governments can buy with trillions of dollars.