Rate Watch #775 The Shadow Banking System

Rate Watch #775 Shadow Banking System

May 13, 2011
by Dick Lepre
dicklepre@rpm-mtg.com
www.loanmine.com

The Shadow Banking System

If you want to give someone a good scare just say, "Shadow banking system." This expression was popularized by Bill McCulley of PIMCO in 2007. Before we talk about shadow banking let's first look at a traditional bank, what it does and what its risks are.

In a traditional bank depositors put money into accounts getting it back with interest and the bank loans out money to people and businesses charging them interest. If the bank is well run, its shareholders can share the profits. What are the risks? There are at least three:

1) the bank's liabilities are to the depositors. These are short term. Depositors can ask for their money back whenever they want. The banks assets are the loans it made. If the depositors, for whatever reason, all want their money back at the same time the bank cannot get the money back from the people it made loans to just because the depositors want their money. This is liquidity risk and this problem is solved by the Federal Reserve. It a bank needs cash, it can get it from the Federal Reserve by pledging some of those long-term assets. This discourages bank runs. In addition the FDIC insures the accounts of depositors so that they have no need to ask for their money if there is a rumor about the bank. Also the Basel banking accords require well-capitalized banks to keep reserves equal to 8% of their deposit liabilities.

2) the second risk is solvency. If too many of the banks loans go bad the bank will become insolvent having little or negative net worth. In this case the bank will be taken over by FDIC. Usually the liabilities (the checking and saving accounts) are sold to one bank and the assets (the loans) are sold to another. This almost always happens after close of business on a Friday so that, to a customer wanting to make a withdrawal, the effect is minimal. You go there on Monday and all you notice is that the name of the bank changed. The stockholders were wiped out but the depositors and anyone holding a check written by those depositors are protected. This last point about banks being the heart of our payment system is too easily glossed over.

3) the third type of risk is slower and less obvious. If banks make and hold fixed rate 30-year mortgage loans the interest rate on the asset side is locked in for years but the depositors will, if inflation picks up, move their money to a bank offering higher savings rates. The problem is that the durations of the bank's assets and liabilities are mismatched. Because interest rates can change substantially with time entities such as FNMA and FHLMC were created to buy mortgage loans from banks and sell them to investors who took the long tern rate risk.

Stop right here and realize that what is described above is the traditional banking system and the some of the regulatory structure which goes with it.

Let's Make Things Complicated

A large part of the shadow banking system consists of money market mutual funds. Money Market Mutual Funds, for the most part, take in money from investors who want interest rates higher than paid by commercial banks and S&Ls and lend money in the form of commercial paper to businesses and state and local governments. These are loans with terms less than 271 days. After the Lehman Brothers Bankruptcy on September 15, 2008 one money market mutual fund "broke the buck" meaning that its return to investors was negative. That week about $170 billion flowed out of money market funds as investors feared losses. Treasury announced guarantees to insure the depositors of these funds but there had been a mini-run on the shadow banking system. Having lost some of the confidence of its depositors, money market funds stopped buying commercial paper. This was disastrous to businesses and state and local governments and was not stabilized until the Fed announced the Commercial Paper Funding Facility to back commercial paper.

The fact that the commercial paper market seized was one of the most significant causes of the recession. Deprived of the ability to borrow, businesses had to downsize and we have not yet recovered from the effect.

The Rest of the Shadow banking system

In 1999 the Gramm–Leach–Bliley (GLB) Act was passed. The allowed for big banks to combine banking, securities and insurance companies under one corporate umbrella. The reasoning was that when times are good customers invest in equities and when time get tough they sell equities and keep their assets in cash (checking and savings accounts.) While some folks place the blame for the effects of the mortgage mess on GLB, I do not think that is accurate. Two points: 1) Wall Street was already well in control of non-GSE mortgage securitization long before that and 2) some of the big Wall Street investment banks did not merge with banks before the mortgage mess forced them to do so.

The problem with banks vis-à-vis the mortgage mess stemmed not from GLB but rather from something less apparent. The best explanation comes from the late economist Fisher Black. (Black was one of the creators of the Black–Scholes equation for calculating the correct price of derivatives. Since the Nobel Prize is not awarded posthumously Black did not share on the fruit of his work when Myron Scholes received the Nobel in 1995.) This paragraph is from the “Fundamentals of Liquidity” (1970):

"Thus a long term corporate bond [same is true for mortgages] could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the risk of default. The last two would not have to put up any capital for the bond, though they might have to post some sort of collateral."

Black was spot on long before this actually transpired. The buyers of Mortgage Backed Securities supply the money. Interest rate swaps bear the rate risk. Credit default swaps (CDS) bear the default risk. What happened was that commercial banks and investment banks joined forces to get both the rate risk and the default risk off the balance sheets of banks. Banks generated mortgages and sold all three parts - the money flow, the rate risk and the default risk to other entities. The risks were relocated from the banking sector to the shadow banking sector. To suggest that the shadow banking system was responsible here is only partially accurate. This was done with the knowledge and encouragement of banking regulators. Regulators wanted risk off the balance sheets of the banks they regulated and were not cognizant of the fact that the same risk would wind up in a less regulated segment of the shadow banking system. Risk was not eliminated but only relocated.

The problem with the mortgage mess/liquidity crisis was simply that too many bad mortgage loans were made. This inflated home prices by expanding the demand to people who would not be able to make the payments. The system for separating off rate and default risk while it did not create the demand for bad mortgages certainly made the process of generating them easier. The fault was with 1) HUD for mandating that FNMA and FHLMC do subprime 2) banking entities such as Countrywide which plunged headfirst into non-GSE subprime and 3) the debt rating firms for providing bogus ratings for the debt. More accurately perhaps was that the debt rating firms treated mortgage default risk as static paying too little attention to the fatal combination of diminished underwriting guidelines and the housing bubble.

The whole thing blew up only when it was apparent that one of the entities which provided the credit default swaps - AIG - had never hedged its positions. It sold CDS but never purchased them. It was not until the week of the Lehman Bankruptcy that Moody's announced that it was less confident that AIG could actually pay all of the CDSs which it was holding for mortgage debt. That meant that not only AIG was in trouble but that anyone who thought that AIG was going to deliver if the mortgages defaulted had to go out and buy a back-up policy just at a time when the cost was increasing dramatically. The Federal Reserve and the Treasury Department moved in to mitigate the damage created by the collapse of AIG.

The problem was not that there were CDSs but that AIG did not hedge its risk. AIG was the whale at the dice table with all its chips on "pass" when the economy rolled craps. Worse yet, that whale could not cover his markers.

Now that most large investment banks are part of bank holding companies and are part of the Federal Reserve system there is less shadow banking than there was before the liquidity crisis. Sizable entities comprising the shadow banking system are: hedge funds, monoline insurance companies (these provide credit insurance for municipal debt), and money market mutual funds. Significant parts of the shadow banking system such as structured investment vehicles disappeared.

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Dick Lepre
RPM - SF
1400 Van Ness Avenue
San Francisco, CA 94109
DRE License # 01143973
NMLS Individual ID 302379
California Department of Real Estate - real estate broker license #01201643
dicklepre@rpm-mtg.com
Web site: www.loanmine.com
Blog: economy.typepad.com
(415) 244-9383
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Comments

[Greg Free]

I like what you write, because you write in plain terms for knuckleheads like me. I actually believe I 'get' what you are saying, which gives me a _chance_ to agree/disagree.

Rather than say your conclusions are wrong (they aren't), I would characterize the problem differently.

"We" invented credit swaps as something other than insurance so that they would not be regulated. No accident, in my mind. This enabled perps (who should be prosecuted IMHO) to bet the world's collective wealth at 33:1 odds. Greenspan admits he was wrong in assuming that big companies like AIG would regulate themselves. The Basel accord you cite requires 8% reserves, almost 3X what we did. Sadly, those perps were investing our retirement money, be it in pension plans like CalPers & CalSTRS or 401ks or private hedge funds. We wanted growth so _we_ offered incentives to them with no accountability to make this certain loser of a collective bet.

I knew the boom was driven by accommodative policy, I regarded elevated defaults as a given, but I had no idea the entire system was so highly leveraged. My bad.

Now I am privileged to subsidize housing in several states and help pay salaries at tooooooo many financial institutions as penance for my sin of greed. I expected a correction, but no one really expected the complete collapse of the world's financial system. As I think you have pointed out previously, we have done nothing substantive to protect ourselves from a recurrence.

[Dick Lepre]

Greg,

CDS were invented after the Exxon Valdex accident. See: http://economy.typepad.com/the_economy/2011/01/rate-watch-758-credit-default-swaps-rate-watch-758-great-new-rpm-jumbo-mortgage-credit-default-swaps-january-21.html
AIG was an insurance company and not under driect control of the Fed.
As for bank reserves I am not sure what you mean by "requires 8% reserves. Almost 3X what we did." Commercial banks did have 8% reserves. Investment banks did not. What is worse is that while the housing bubble was preparing to burst the SEC actually halved the capital requirement for investment banks.
The housing bubble was driven by HUD which destroyed FNMA and FHLMC and also by bad banking practices of the likes of WAMU and Countrywide. You are most certainly correct that accommodative monetary policy (low Fed funds) made the problem worse.