Shadow Banking 101

This article originally appeared in the May 1st edition of The Occupied Times.

Meet James. James bought a house. It cost him $150,000, of which $30,000 had come from his own savings, leaving him with a $120,000 30-year fixed-rate mortgage from the WTF Bank, with a final cost (after 30 years of interest) of $200,000. Now, up until the ’80s, a mortgage was just a mortgage. Banks would lend the funds and profit from interest as the mortgage is paid back.

Not so today. James’s $200,000 mortgage was packaged up with 1,000 other mortgages into a £180 million MBS, (mortgage backed security), and sold for an immediate gain by WTF Bank to Privet Asset Management, a hedge fund. Privet then placed this MBS with Sacks of Gold, an investment bank, in return for a $18 billion short-term collateralised (“hypothecated”) loan. Two days later Sacks of Gold faced a margin call, and so re-hypothecated this collateral for another short-term collateralised $18 billion loan with J.P. Morecocaine, another investment bank. Three weeks later, a huge stock market crash resulted in a liquidity panic, resulting in more margin calls, more forced selling, which left Privet Asset Management — who had already lost a lot of money betting stocks would go up — completely insolvent.

Confused?

You should be. This is of course a fictitious story. But the really freaky thing is that this kind of scenario — the packaging up of fairly ordinary debt into exotic financial products, which are then traded by hundreds or even thousands of different parties, has occurred millions and millions of times. And it is extremely dangerous. When everybody is in debt to everybody else through a complex web of debt one small shock could break the entire system. The $18 billion debt that Privet owed to Sacks of Gold could be the difference between Sacks of Gold having enough money to survive, or not survive. And if they didn’t survive, then all the money that they owed to other parties, like J.P. Morecocaine, would go unpaid, thus threatening those parties with insolvency, and so on. This is called systemic risk, and shadow banking has done for systemic risk what did the Beatles did for rock & roll: blow it up, and spread it everywhere.

Deregulation

The banking system has blown up multiple times in history, when depositors have panicked and withdrawn funds en masse in what is known as a bank run. So traditional banks have become party to a lot of regulations. For example, banks must keep on hand 10% of deposits as a reserve. This reserve is a buffer, so that if depositors choose to withdraw their money they can do so without the bank having to call in loans. Of course, banks can still suffer from a liquidity panic if a large proportion of their depositors choose to withdraw their money. Under those circumstances, traditional banks have access to central bank liquidity — short term loans from the central bank to guarantee that they can pay depositors.

Shadow banking arose out of bankers’ desire to not be bound by these restrictions, and so to create more and more and more financial products, and debt, without the interference or oversight of regulators. Of course, this meant that they did not have access to central bank liquidity, either.

Essentially, shadow banking is still banking. It is a funnel through which money travels, from those who have an excess of it and wish to deposit it and receive interest payments, to those who want to borrow money. Shadow banking institutions are intermediaries between investors and borrowers. They can have many names: hedge funds, special investment vehicles, money market funds, pension funds. Sometimes investment banks, retail banks and even central banks. The difference is that in the new galaxy of shadow banking, these chains of intermediation are often extremely complex, the shadow bank does not have to keep reserves on hand, and shadow banking institutions raise money through securitisation, rather than through accepting deposits.

Securitisation

With securitisation, the financial industry creates the products which populate the shadow banking ecosystem, and act as collateral. Rather than accepting deposits (and thus accepting regulation as traditional banks) shadow banking gets access to money through borrowing against assets. These assets could be anything — mortgages, credit card debt, commodities, car loans. These kinds of products are packaged up into shares, sold and traded. There are various forms: collateralised debt obligations, collateralised fund obligations, asset-backed securities, mortgage-backed securities, asset back commercial paper, tender option bonds, variable rate demand obligations, re-hypothecation, and hundreds more exotic variants. (Hypothecation is where the borrower pledges collateral to secure a debt – i.e. a mortgage, and re-hypothecation is where that collateral is passed on and someone else borrows against it, even though it remains in the original debtors hands). The function of these assets are essentially the same; securitisation is a way of creating products with an exchange value, and bringing money into the shadow banking system; so much money that the shadow banking system in 2008 was much larger than the traditional banking system:

Plummeting Junk

So securitisation — as well as its siblings hypothecation and re-hypothecation, allowed for pre-existing securities to be re-posted again and again as collateral, sucking more and more money into the system — became a pretty significant way of funding lending. The problem in the financial crisis beginning in 2007 was that a lot of the assets securitised to bring money into the shadow banking system turned out to be junk.

Think back to the MBS bundle containing James’s mortgage: if 90% of the mortgages in the MBS were defaulted upon, that MBS would yield a huge loss for whoever was currently holding it. If that MBS had been posted as collateral against further lending, those debts would be called in. For shadow banking institutions that were highly leveraged this turned out to be a huge problem. To raise capital, they started selling just about anything that wasn’t bolted down. This meant that prices — even of securities that weren’t fundamentally weak — plummeted. And because of the problems with a lot of existing securities, the funding source for a huge part of global lending completely dried up, worsening the economic contraction.

The risk — that debtors would default upon their loans — rather than being confined to a single bank, came to be spread about the entire economy, with bad debts that had been securitised, hypothecated and re-hypothecated coming to sit on the balance sheets of tens or even hundreds of financial institutions.

Pseudo-Money

This entire system creates another problem. Securities came to be a kind of pseudo-money. In other words, they became a unit of exchange and a means for payment between banking institutions. With the 2008 shadow banking implosion, this meant that many prices, including prices of products like equities that were superficially disconnected from the shadow banking system, fell precipitously simply because there was less money floating around in the system.

Friedrich Hayek wrote about this problem long before anyone coined the term shadow banking:

There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.

Thus, as the shadow banking system expanded, it caused inflation, and as it imploded it caused deflation. It was a big toxic bubble waiting to burst.

The Future

Ultimately, markets are a little crazy. People will do all manner of wacky things trying to turn a profit. All kinds of weird and wonderful systems will emerge. Some systems work better than others. And — as might be sensibly expected — the shadow banking system’s wacky idea of financing banking operations through the securitisation of debt failed. But because of the wider implications for the financial system, central banks began throwing money around in order to save these broken institutions and systems.

The Federal Reserve’s first quantitative easing program bought up tranches of defunct MBS. This stabilised markets to the extent that while securitisation virtually ground to a halt in 2009, by 2011 the shadow banking system was growing again. But this is surely just a temporary measure. Simply, there is no reason whatever to doubt that the same problem — of bad debt coming to be spread around the entire financial system through securitisation and re-hypothecation — will take root once again, causing similar turmoil in the future.

The status quo is that we have a broken and dangerous system that doesn’t really work, surviving on government subsidies. Sure, a full collapse of shadow banking in 2008 would have been painful. But we may have created a bigger and more painful collapse further down the road.

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48 thoughts on “Shadow Banking 101

  1. @ Aziz “The status quo is that we have a broken and dangerous system that doesn’t really work, surviving on government subsidies. Sure, a full collapse of shadow banking in 2008 would have been painful. But we may have created a bigger and more painful collapse further down the road”

    I agree with this. Early in my career I was lucky enough to be part of the creation and establishment of a small bank (Backed by capital from a European parent). It started out with a chequebook, a leased office and our first branch build. It was ethnic based and targeted deposits from this ethnic base. Loans were targeted at the wealthier business people from that ethnic group. A classic lesson in banking!

    We had to report into the Central Bank daily. I must admit having a Central Bank as a liquidity backstop makes life easier but it does cost if you rely on them. Luckily the Bank grew its deposit base and the credit department was very conservative.

    I recall the securitisation of the early 2000′s. It was eating up our market share in house loans. We could not compete on rates as we needed to attract depositors. In my youthful exuberance I proposed we sell our book and securitise it as well. Concentrate on house mortgages. I was scolded by the conservative leadership who said we are concentrating on business loans as there is more margin, and securitisation is cowboy banking.

    I can see why securitisation worked. It was easier to sell housing loans and bundle them up and sell to willing participants. If the Bank’s leadership was greedy and open to new practices, we would have jumped on the securitisation process as well.

    One thing I have learned in business, is the influence of the Sales type “A” personality in the groupthink decision making process. These are your people who propose new ideas to make a sale. Admittedly they are the innovators, but they are also the ones peddling over the cliff, chasing their sales. The more conservative technically minded risk adverse types “C” who tend to be less assertive tend to get overheard. They are less persuasive, and generally CEO’s have to keep EPS targets, so they take risks. This is what drives business innovation and progress, but as John notes above, this can have a multiplication affect across the system.

    For this reason we do need regulation in banking and I think the creators of the Glass Steagall Act in the 30′s had simpler anecdotal evidence to help them draft their plans. They understood the frailties of human personality.

    Remember, sometimes the deposits of elderly people who worked their whole lives, in an honest fashion, foregoing consumption so they could survive in retirement are at stake. Why should they earn 1% on their savings yet face inflation of 5% on their consumption. This is technically theft. If these people can’t be rewarded with 6-7% interest then why should people save? My lessons in banking tell me that if a business can’t make money borrowing at 10% then why should people trust their saving with an intermediary?

    Everything learned in business is all screwed up. This is not going to end well.

  2. Something I didn’t get into here is the bizarre fact that QE1 effectively offered deposit insurance for a banking system that invented itself explicitly in the hope of avoiding the regulatory stipulations that are entailed through deposit insurance .

    • You are right.

      BTW I watched the speech of France’s new President, Francois Hollande.

      I had to laugh. He was offering Hopium and Euro Change to the fanatics who booed him when he gave respect to Sarkozy.

      He was watering down the radical left for a move to the centre. I bet Angela Merkel warned him, that if he pursued an aggressive socialist platform, powerful business interests will back a fanatical right wing leader in Germany.

      Like trying to herd cats from different alleys to meet in the one place, this will end badly when promises are broken.

      Shadow Bankers are a powerful force!

  3. The whole thing would be moot if the government didn’t step in to recapitilize bankrupt institutions. As far as I’m concerned, these banks can do any crazy crap they want; They’re private businesses. For me, the problem starts when their losses get tacked onto my tax bill. THAT is the problem. There’s always been businesses and individuals who take high risks, and often they lose on those bets. As long as I’m not made responsible for picking up the tab, it’s none of my business.

    Also, regarding regulations, they’re completely useless without ENFORCEMENT. There were myriad institutions that should have been subject to PCA by the FDIC here in the states that were not when the ‘crisis’ hit. Where are the cops??

    There’s nothing really wrong with our laws. The problem is that .gov has been captured by large companies who bribe / coherse / cajol .gov into turning away when .gov should actualy be ‘stepping to them’ quickly.

    • For me, the problem starts when their losses get tacked onto my tax bill. THAT is the problem. There’s always been businesses and individuals who take high risks, and often they lose on those bets. As long as I’m not made responsible for picking up the tab, it’s none of my business.

      For me too, but the preservation of bad businesses that wrecks the market mechanism and leads to a misallocation of capital is a bigger problem than any tax bill (although that is just the other side of the same coin).

    • There is a grand exception to the idea that if a private entity wants to take risk, and as long as it’s not on your tax bill, it’s none of your business. What happens if they destroy an entire industry, so you no longer have a job? What if they pollute the environment so badly that you, your spouse or your children get cancer (or some other disease) and no one cleans it up? Hundreds of years ago, people taking risks to make money, wiped out fisheries off Newfoundland, whales were driven to the point of extinction before petroleum and electricity provided an alternative to whale oil. Today, the North Pacific salmon fisheries are on the verge of collapse. I had a book “Tulip Bulbs and Other Manias” that says a lot about how unregulated self interest and human nature does not change. There is a broad argument to be made for the necessity of rational regulation to protect our common interests. I agree, without enforcement, regulation is useless. If we don’t keep the foxes from being in charge of the hen house, and the arsonists are in charge of our hay barns, the consequenses are predictable! One needs only to look at the long term effects of the Exxon Valdez oil spill and the recent BP (Bloody Popaganda) oil disaster in the Gulf of Mexico, to see what won’t show up in your tax bill.

  4. It is obvious to any one with a grain of sense that if we give some people the power to create money from nothing and to profit from this, they will do so. Especially if they are operating within a corporate institution with limited liability and the option to force governments to bail them out because they are TBTF. It is the perfect crime caper. They will find wacky and wonderful ways to make money especially if we are talking about billions and trillions of units of currency, why wouldn’t they? Making money easily with little effort and using the state law to legitimize it is funky. It appeals to many people…why work when one can use easily created digital pulses in a computer to buy, sell and make deals? It is a giant casino and the game is rigged in favour of the house which always wins. If we want to win we must stop playing.

  5. ” the influence of the Sales type “A” personality in the groupthink decision making process. These are your people who propose new ideas to make a sale. Admittedly they are the innovators, but they are also the ones peddling over the cliff, chasing their sales. The more conservative technically minded risk adverse types “C” who tend to be less assertive tend to get overheard”

    You’ve hit the nail on the head there. In fact, you could say the whole financial system has been taken over by the type A sort, who’ve siezed power from the risk averse type Cs.
    The thing is, it’s a downward spiral, as short term, greedy type As who now run financial institutions will ruthlessly punish those few comapnies who stick to the old ways of doing business, by taking them over or paoching their clients.

    • Agreed. I was trained as an Auditor by the firm Arthur Andersen, and you should have seen the firm’s risk manual! It was sad when one cowboy partner ruined the whole firm (Enron) http://en.wikipedia.org/wiki/Arthur_Andersen. We had all files stored in a vault, and these were to be kept in future litigation. This Parnter should be hung for destroying the name of the actual Arthur Andersen who built up the firm.

      In fact I think it may go deeper as AA was probably the best Audit firm in the world, and you could not have the bubble economics with them around. I learnt a lot from them.

      • Yes. The financial system was taken over by short-term profiteers who outperformed the cautious.

        In a bailout-free system this kind of idiocy would be punished by failure for such firms, and a more cautious approach in future.

        But for the reflationists at the Fed, there is no problem with returning to the old broken business model with the psychopaths running companies into the ground and then taking bailouts.

        For everything I’ve said criticising Paul Krugman at least he is one of the few people who has asked the question of why we are returning to a failed shadow banking business model.

    • “Agreed. I was trained as an Auditor by the firm Arthur Andersen, and you should have seen the firm’s risk manual! It was sad when one cowboy partner ruined the whole firm (Enron) http://en.wikipedia.org/wiki/Arthur_Andersen. We had all files stored in a vault, and these were to be kept in future litigation. This Parnter should be hung for destroying the name of the actual Arthur Andersen who built up the firm.

      In fact I think it may go deeper as AA was probably the best Audit firm in the world, and you could not have the bubble economics with them around. I learnt a lot from them.”

      Ken Lay (Enron CEO) had a closed casket funeral. His timely death, between conviction and sentencing, means his criminal conviction is null. Are we sure it is Mr. Lay in that casket? A simple DNA test would put my mind at rest, to know that the man presiding over one of the biggest bankrupty/frauds in the world (before the recent bank difficulties) is not in fact, enjoying his ill gotten gains in some country without an extradition treaty with the USA. It’s a small enough thing to demand considering the monstrosity of the consequenses.

      And then there is the thought that those who love making money on bubbles, would happily be shot of AA, and do whatever they could to hasten their demise.

    • Yes, I’m sure he thinks I am socialist for believing in personal responsibility in banking…

      These shadow banks are composed of the top-educated people in the country, and the hardest working. Only a libtard pinko like you would ever consider not supporting them. What do you want to do, let Wall Street fail and then have a communist-Islamist-Marxist dictatorship install itself into power instead?

    • I reckon he is a smart cookie, just playing games with us. Most Trolls are highly intelligent but lonely wolf types who appreciate someone responding to them. It makes them feel important.

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  9. aziz—as any mere retired u.s. army combat vet would say—your shit gets better every day—leveraged debt is going to ruin us all—even ex-mercenaries like myself…

    • As an Australian who’s grandfather was shot in PNG, and was evacuated only because of US support in the pacific, my hat is off to the US Millitary personal. I just with your Government would treat you guys better instead of wasting you in unwinnable wars.

      I know if the gloves were off the US millitary could win any war. Going in and fighting freedom fighters with a UN glove tied behind your back is suicide.

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