Because banks tended to hold on to the loans that they made they were rather more cautious about the financial state of their borrowers and the terms they set for the loan. Huge loans to low and middle income borrowers might look good on paper. Bankers knew, however, that they were taking serious risks if they made such loans. Holding their own paper made bankers more prudent.

Nevertheless, even the most prudent banker could run into trouble if his local economy took a turn for the worse. When an industry moved to Mexico or experienced lower demand, local banks could find that a lot of their prudent loans had gone bad.

Ever willing to serve their country - for a proper profit - investment bankers and financial economists saw that this was a situation that demanded creativity and innovation. They invented mortgage backed securities. The idea here is really very simple: If I get together large pool of mortgages, some from Kansas, some from Florida and so on then the overall risk that I take will be considerably less. If Topeka is suffering the boom in Orlando will make up for it. 

Mortgage backed securities are essentially shares of a large pool of mortgages. The finance guys have added a great many wrinkles and twists to this, which I do not claim to understand, but this is still the essential concept. It can be proven mathematically - under certain assumptions - that mortgage backed securities are less risky than individual mortgages.

So sometime at the turn of this century banks begin to discover that they could easily sell almost any loan that they could make to investment banks. The investment banks would then take the loan and package it with other loans to make a variety of highly rated securities. These were easily marketed because sophisticated mathematical models proved them to be low risk and high return. 

Naturally bankers became a bit less careful with the quality of the loans that were making. Local adult education classes appeared where people of unknown origin sang the praises of exotic loans of various sorts. Wonks Anonymous and his spouse were almost seduced and probably would have fallen if they did not have a fantastic rent on a great little house.

And all the time bankers made these loans, they had no worries because some investment bank would take the loans off their hands and give them cash which they could invest in low risk, high return securities.

And what, you may ask, were these low risk, high return securities? They were mortgage backed securities of course.

And it would have worked if the initial assumptions were true. If the individual mortgages were risky because they depended on the performance of local economies or the unrelated fortunes of many different individuals then a package of mortgages was safer. If, however, the risk came from overall national conditions - for example a national housing bubble or a national increase in imprudent lending - then no amount of diversification could make mortgage backed securities safe.

Expect more bank troubles in the near future.