Basic Guide to Financial Market Infrastructure in the US

In the US, the financial sector operates at 3 basic levels of aggregation:

• The consumer market
  
• The secondary market
  
• The capital market.

The analogy is basically retail/wholesale- you don't buy your 24 packs of diet Pepsi straight from the factory, instead you buy them at the local grocery store.

Likewise, you don't borrow your money from TIAA-CREF, the giant retirement with a close to $400 billion dollars in assets- they simply don't have the time nor money to deal with individual consumers.

That's why when you get a loan, you get it at a local bank: consumer banking. Whether you get your mortgage loan at your local bank, credit union, or mortgage broker, the basic flow of money is the same: these guys lend you their money, then they have to sell your contract ultimately to the capital market, so they can replenish their source of capital and make more loans. If they cannot do that, they become insolvent and go out of business.

Let's keep going with the retail/wholesale analogy. Pepsi the soda maker might ship a whole container of soda to Safeway, but Joe's Deli has to buy its supply of sodas from a middleman- a distributor, if you will.

That's roughly what the secondary market is. It is very expensive for TIAA-CREF to buy a loan from CalFed, one from NASAFCU, one from Larry the mortgage broker etc etc. Additionally, secondary market is supposed to perform due-diligence function for the capital market; make sure that the individual loans are made honestly and that the loan does not have any bad risks. This market is performed by both GSE's and private market. To that extent the secondary market provides an important conduit between the consumer market and the capital market.

One question that might naturally spring to mind is why not create a vertically integrated financial institution? Why not have TIAA-CREF merge with a bank so the entire process is done in-house? Bank of TIAA-CREF originates a loan, keeps the mortgage loan using the fund from TIAA-CREF, and eliminate the middleman altogether?

Without pushing the comparison too far, that was essentially what the likes of CitiGroup and Bank of America was aiming for: create this vertically integrated unit that it keeps your money from the ATM to Wall Street and everywhere in between within its operation.

Sounds easy right? Well, not so much. You might save money on not paying a premium for the middleman, but it turns out that it is very expensive and difficult to operationally integrate all these business units- it's no accident that Citi had always had one of the higher cost structures in the industry.

Which brings me back to Fannie and Freddie to finish the whole story. Why Fannie and Freddie? Why the extra $100 billion dollars commitment from the Fed? The most pragmatic reason is that there is no one else left in the secondary market. 4-5 years ago, private label securitization made up about 50% of the secondary market, now it's less than 10%, if that. This is not to say that Fannie and Freddie didn't do anything wrong- far from it. But they did less wrong than everyone else, and much as we hate to admit it, the world is graded on a curve.

What happened? On the supply side, this secondary market mechanism was the first things private conglomerates dismantled when the financial market imploded. It's very costly to keep this machinery running where the loan pipeline dried up, and the big banks cut this first. On the demand side? Well, keeping billions of dollars of mortgage in one's portfolio is a low leverage proposition: it takes a ton of capital to keep that in portfolio, the ton of capital banks don't exactly have right now. And the people who have actually the money to buy this stuff, like for example, Bank of China? Well, they trust Fannie and Freddie more than they trust private securitizations. GSE MBSs might not be a sure bet, but it's also not the super toxic stuff (subprime CDOs, HELOCS, Option ARMS etc) that the private label was securitizing.

That's where we are right now.