You're now on the archive server. Commenting has been disabled.
Gary Gorton On The Shadow Banking System Run, And The Interplay Of Shadow And Traditional Banking
- Apple
- Bank of England
- Bank Run
- Ben Bernanke
- Capital Markets
- Commercial Paper
- Congressional Budget Office
- Consumer protection
- CPI
- Federal Deposit Insurance Corporation
- Federal Reserve
- Financial Crisis Inquiry Commission
- Gross Domestic Product
- Institutional Investors
- Lehman
- Market Share
- Monetary Base
- None
- Paul Volcker
- Repo Market
- Shadow Banking
- Unemployment
There are few people as qualified to discuss the stresses of (and on) the financial system over the past several years as Yale and Wharton Professor Gary Gorton, who just incidentally has held positions at the Bank Of England, the Federal Reserve and the FDIC. In a submission to Zero Hedge, Professor Gorton provides some unique perspectives into what we have long claimed was the immediate catalyst for the near collapse of the banking system: the bank run, not so much on depository institutions, but on the much more critical shadow banking system. And when one considers the parallels between the two, whose existence in any case is merely contingent on the persistence of trust in the workings of the broader financial system, Gorton observes that the Great Panic which commenced really in August 2007 (with the first salvo fired by none other than the HFT quant community, on August 6, discussed extensively here previously and in Barron's today most recently), is really no different from the Panics of 1907 or 1893, except that in 2007 "most people had never heard of the markets that were involved, didn't know how they worked, or what their purposes were. Terms like subprime mortgage, asset-backed commercial paper conduit, structured investment vehicle, credit derivative, securitization, or repo market were meaningless." And just like deposit bank runs earlier, the securitized banking system, which is in essence a real banking system, "allowing institutional investors and firms to make enormous, short-term deposits" was vulnerable to a panic. What should be more troubling is that the event commencing with the August 2007 waterfall, were not a retail panic involving individuals, but a wholesale panic involving institutions, where large financial firms "ran" on other financial firms, making the system insolvent. As some other witty writer once put it best, "banks opened up their books to each other, and hated what they saw."
The scariest thing is that we have still done nothing to address the propensity for institutional panic to come back, which courtesy of money now being electronic 1's and 0's, will certainly take an even faster time to hit its plateau when it appears next. Keep in mind that post the Lehman crisis, it only took 3 days before the money markets locked up and were in need of governmental guarantees, while the broader repo market was shut down within 48 hours. As retail investors tend to enjoy obtaining physical delivery of their asset (read FRNs), for institutions, the wave can turn at a heartbeat, and next time around the administration will likely not even have 12 hours before a complete financial, systemic, and irrevocable lock-down is in place. The only backstop to this risk- the Federal Reserve. Yet the question remains: how long before nobody in the world dares to take the Fed head on. It is no secret that the entire investment community now realizes that the Fed's experiment is doomed. The US is no longer a viable going concern: when the CBO notifies the public that the debt/GDP in a decade will be 90% and that total marketable debt will double to $20 trillion, the game is over. And just like in any good old game theory construct, the first defector is the one to benefit the most. The Fed can not, be definition "defect"; so when one of the whale account does, and the avalanche of enjoinders jumps on board, the proverbial "you don't get in front of the Fed" will be a memory. What we know is that we now have a t-10 years timer before the US economy is certainly finished. But the real question is when the defections against Bernanke et al will begin in earnest.
Back to the repo system: As Gorton points out - "Times change. Now, banking has changed again. In the last 25 years or so, there has been another significant change: a change in the form and quantity of bank liabilities that has resulted in a panic. This change involves the combination of securitization with the repo market. At root this change has to do with traditional banking system becoming unprofitable in the 1980s. During that decade, traditional banks lost market share to money market mutual funds (which replaced demand deposits) and junk bonds (which took market share from lending), to name the two most important changes" [incidentally, this is precisely the reason why Paul Volcker has historically been so adamantly against money markets, and for a dramatic, and some say terminal, overhaul in the MM system, whose mere ongoing existence is a substantial destabilization of the financial status quo as investors funnel trillions of dollars to and fro MM's whenever the Fed plays around with the Fed Funds rate, adding massive instability to capital markets]"Keeping passive cash flows on the balance sheet from loans, when the credit decision was already made, became unprofitable. This led to securitization, which is the process by which such cash flows are sold."
Gorton goes on to demonstrate just how the traditional and parallel (shadow) banking systems are intertwined:
As the above Gordian Knot chart indicates, there is much as stake here, and much reason for the authorities to distract the general populace with such silly concepts as a Consumer Protection Agency and Healthcare Reform. Indeed, shadow economy investors stand to lose over $70 trillion dollars should the traditional-shadow banking linkage be broken and the cash flow transfer process be disrupted. The bigger question: how much longer will such cash flows sustain in the current day and age when real demand has collapse courtesy of record domestic unemployment. The biggest question: what happens when there is a secular change to the prevalent level of capital flows into shadow banking. One of the primary reasons for the massive expansion in the money system (via the credit pyramid), has been precisely the shadow banking system, which is second only to the credit and interest rate derivative market (incidentally we were fascinated by the race to the currency bottom, and the technical associated short squeezes in the Dollar and Euro, in May 2009, long before anyone even considered such now daily discussion pieces).
Yet should shadow baning disappear, the tranche above it (or below it by seniority) would disappear as well. And with 90%+ of global liquidity gone, and no additional source of "credit" money to fill the Fed's infinite demand for monetary supply, asset prices will explode (forget about gold - one apple will be $6,000 an ounce). Deflationists are right that ceteris paribus asset prices will decline, and that the Fed is powerless to stop this. Yet deflationists take one huge variable for granted: that the existing liquidity pyramid will persist. It is obvious that should another systemic stress episode emerge and money contract by a massive amount, the end consumer will matter little when total global credit collapses from $600 trillion to mid double digits, thereby decimating the real shadow monetary base, and realligning global assets with a liability side in flux. After all, the key offset to CPI going stratospheric over the past 30, 50 and even 100 years has been precisely the emergence of the alternative banking system, with its influx of tens if not hundreds of trillions of "shadow" dollars, which almost ceased to exist in the 2007-2009 crisis. The netting of intangible money to tangible currency in circulation would be a forced explosion in the money multiplier by the same amount as the shadow economy has sucked out in a vacuum of expiring credibility overnight.
For this, and much more we recommend a read of the attached "Q&A about the Financial Crisis" in which Gary Gorton discusses before the US Financial Crisis Inquiry Commission, in very clear language, the big dangers still facing shadow banking.
Should readers demand for additional information, Gary Gorton has recently written a book, "Slapped by the Invisible Hand, The Panic of 2007" (you know it's good because it is not available on the Kindle), which discusses more of the same fascinating topics (and to which a just as interesting intro written by Gorton can be found here).
»
- 28949 reads
- Printer-friendly version
- Send to friend
This looks very interesting. I have been saying all along that derivatives are the issue ( www.DerivativesCollapse.com ), but this appears to tie a lot of the pieces together.
http://neubarth.blogspot.com/
Dont know if this has been specifically shown here but look at the crazy difference between seasonally adjusted unemployment and the actual real claims on that blog - it is crazy. It is still soaring higher.
What am I missing? $600 Trillion disappears and we have inflation, not deflation?! I think this guy is nuts.
I would guess that if $600 Trillion disappears, they will need a new word for what happens next. Whatever they call it, the net result will be most of us hunting squirrels and pigeons for food.
"Hrung"
http://www.hhgproject.org/entrie/collapsinghrungdisaster.html
Lol that fits. Now where did I put my towel?
You are starting from the assumption that currency will matter in such a situation.
I'll trade an apple for an orange, but if you want to use those pieces of paper with odd images, well then.
Derek
When 600 Trillion dissapears, the shadows dollars will also dissapear leaving their physical representations (i.e. the Federal Reserve notes in you pocket) as worthless as the paper their printed on. HTH
Outstanding read.
The respect that ZeroHedge as earned within the world-wide investing community provides an avenue for peons such as myself to receive high quality skilled writings written by very knowledgeable people. The writings are just dropped into our laps, no charge.
One can see that the intelligent people in our society are crying out to tell us what is happening and why. Just as we read these posts and try to explain to our deaf and care-free friends what we have read, what is about to happen and, that we all need to do to prepare, these writers scream out to us the information we must read and pass along quickly and coherently. They do this for free because they know how bad it is going to get. They do not care about the money any more. They care about us and the future us.
Imagine being Ben Bernanke and going home each night knowing that the future of his kids and and his grandchildren is gone and, he is responsible because he saved a dozen stockholders of Goldman Sacks from bankruptcy.
Next time you are watching Bernanke give one of his prepared speaches about how he is going to save us, turn off the sound and study his face, his eyes, his mouth. You will see a man that is lost and wishes he was not there.
Amen!
+1
Great point on Bernanke... you can see the same thing with Geithner and others... even more obvious with Paulson during the dark days of /08.
I'm wondering how much longer before the whispers of more sinister motivation than the obvious greed and incompetence begin to surface?
Good points, you maybe right with regards to BB, never thought of him this way, but would i wanted to be in his place? no, not in the current circumstamces, Greenspan was much more lucky than BB, he left before the grand collapse.
I never do this, but: +1, sir.
Next time you are watching Bernanke give one of his prepared speaches about how he is going to save us, turn off the sound and study his face, his eyes, his mouth. You will see a man that is lost and wishes he was not there.
Great observation waterdog. When this all began and the clip of Bernanke and Paulson was being played over and over on Bloomberg I had the volume muted (as it usually is during the trading day). After the umpteenth time it hit me as I watched them. These guys are AFRAID of something. The body language and the look in the eyes was unmistakable. It wasn't until later that I came to appreciate how accurate my observation was. Since then I have done as you suggest here. Most liars must cloak their lies in verbiage. The eyes tell the real story.
Well said Anon.
Fear was where I was going with my "sinister" comment. Paulson was even more obvious... with hundreds of millions in personal wealth, greed was not his motivation... it was fear. The masters of financial terrorism would stop at nothing to protect (and continue to expand) the fruits of their labour and, as you so succinctly say, "the eyes tell the real story."
Reading this paper is unsettling.
The author repeatedly describes the mechanism of "runs", which occurred (prior to deposit insurance) in individual-account banks, and in 2007 in the repo and other market (shadow system).
The unsettling part is that the fundamental cause of runs is completely ignored, as if it is accepted dogma that they just occur, when in fact there is only one cause of a bank run, and that is a failure to maintain proper available cash reserves (also known as fractional reserving).
The entirety of the root cause of every failure of every banking system is due to this mechanism, yet the author (and nearly all pundits, talking heads, and economic blatherers) ignores it and instead focuses on the second-order sequelae of this fundamental flaw.
Which means, of course, that bank runs haven't ended, and in fact, will grow over time, since the mechanism remains legal, accepted, and intact.
Reminds me of all those years that Semmelweis - who thought you should wash your hands before you delivered a baby, and thus prevent post-natal infections in women - was rejected by the medical establishment who just "knew better".
The only difference is, of course, that no politician or government benefited directly from the deaths of women who had just delivered a baby; they do, on the other hand, love the ability to create money out of thin air and thus defraud the rest of us...."legally".
How long until the "germ theory" of economics is accepted?
So is this why Sharia, orthodox Islamic law, disallows usury – knowing it will inevitably lead to collapse.
Non-sequitur.
Usury (interest) is not the problem. The problem is when a banker uses your DEMAND money as HIS, and loans it out without your consent. He creates two claims on the money at the same time; one is yours, who can demand its return, in full, at any time, and the other is the borrower whom he loans it to.
This is the fundamental flaw, and the reason for bank runs.
This little trick was, by the way, punishable by death in Rome.
Usury is perfectly acceptable if you LOAN the banker your money, for a specific period of time, to be returned in full at the end of that time, with interest (a CD, for example). Doing this creates NO new money, and exposes the initial lender (you) to standard counterparty risk (you have to trust the banker to know what he is doing). The rate of interest you ask for is determined by you, and by your assessment of said counterparty risk.
Banks actually do have your consent to do whatever they want with it.
No, banks actually don't.
What they do have is a series of common-law court decisions from paid-for judges which makes it "legal" to do it.
But they don't have "consent" - ask anybody in the world if they believe that their "demand deposit" is there, waiting for them, on demand, and they will say...."yes".
But it isn't.
"There is no mystery to projecting the pattern of failure engendered by any purported economy subject to interest."
"As interest multiplies debt in proportion to a circulation, ever more of every existing dollar is dedicated to servicing multiplying debt, and ever less of every existing dollar can be dedicated to sustaining the commerce which is obligated to service the multiplying debt. Everything around you can be understood from the obvious consequences..."
Can you hear Alice down in that rabbit hole? She's yelling Keep It Simple Stupid... Kiss
http://www.perfecteconomy.com/pg-inherent-pattern-of-failure-of-economy-...
No the Islamic idea of exponential usury is just an old rusty religious antique not anchored in any fundamentals and no system of usury ever failed before. Nothing to see here, move along.
Again, usury is not the problem. Fraud (fractional reserving) is.
Every single bank in the western world operates on this fraud - the fact that a "demand depositor"'s money, with a "warehouse account", is defrauded EVERY SINGLE DAY, because the bank where his money is deposited DOES NOT HAVE IT.
The fact that a bank gets away with this for years on end, because it does not suffer a run (or because it has a "lender of last resort", the FDIC in the US, which will simply counterfeit money to replace the money the bank has loaned out in the event of a run... up to $250,000, anyway :) ) does NOT mean that the fraud is not occurring.
It only means that they don't get caught.
I don't think Islamic finance is good. Here's why:
Buyers A and B both buy a 550k home next door to each other. Both could have afforded a more expensive home, based on income and debt levels. They earn the same, neither have any debt and both have put down 50k as a deposit.
A gets a 10 yr interest only loan at 5%. A will pay 25k/yr interest, but if he pays down the principal each month by x his payment will be reduced by cumulative x multiplied by 5%. At any point in time, should A sell the home, he simply has to clear his principal balance, plus the closing costs to come out neutral.
B goes Islamic finance for a 10 year payoff. The 'lender' does the paperwork [only available in select areas] to avoid double closing costs. The lender holds the title and B must pay 750k for the property. [The amount of interest paid by A is put into the purchase price] His annual payments are a whopping 75k per year. If at any time B wishes to sell the property, it is my understanding he would owe the full 750k. [If I am wrong on this, please correct me]
B is much more likely to be 'stuck' with the home. Additionally, even if the amount due at settlement is pro-rated, I don't see how B comes out ahead of A.
To me Islamic finance is just a fancy way of charging interest without calling it as such.
Furthermore, in some countries, such as Turkey, entire buildings remain vacant and half completed until all of the purchasers have paid for their unit. No quiet enjoyment while you and numerous others pay off the debt.
Yep, as long as banks owe more than they have, on whatever level either deposits or repo, there is risk of a 'run'. The authors insight into the 'haircut' factor was interesting, I hadnt read such an understandable treatment of the subject before, thanks ZH and Tyler.
The solution, as I understand it, is two have two types of banks:
1) Money warehouse banks, who charge a fee for holding your deposit securely
2) Speculative banks who borrow from the market to lend at higher interest
And these have to be separate.
That, and only that, will remove the structural inevitability of a run on the banks.
The downside, if you can call it that, is that the money supply will be reduced. Implementing it in the short term would likely cause massive deflation, and require massive debt forgiveness. I think we just missed the best opportunity in decades to really reform the finance industry, but given the exponential rule at work here, we will get another one in a few short years.
William black tells us that crisis frequency
is increasing along with crisis Magnitude.
The crisis currently building is going to be a
whopper.
Thanks ZH for the article and the education.
That article pretty much ties all the pieces
together for me....and IMHO, supports the
holding of PM's..
You could combine the two into one, but given the ever-present temptation to loan "demand" deposits (tantundem), and the obvious inability of a banker to resist using someone else's money for his own gain, it probably wouldn't work in practicality.
As for the "reduction in money supply", all arguments that contain that as a phrase demonstrate the author's prior brainwashing by Keynesians; the "amount" of money is irrelevant. Any amount will do. It is completely meaningless to "increase" or "decrease" the money "supply", other than for counterfeiters (i.e., a central bank and a government) who take advantage of "increasing" it by "supplying" the increase, first, to themselves.
This refutes whatever the co-opted windbag elizabeth Warren has to say. There was no possibilty of an orderly unwind. There was no possibilty of bottom-up solution. It was too late. She's a dinosaur and nothing has to contribute is relevent. This was a global bank run that threatened the entire system. And what establishment economist like Warren has never understood is that fractional reserve banking is the cause. It's not banking executives that would take the haircut. Account holders in savings, checking, and money markets would have taken the hit. Those are the real equity holders here.
That is wrong. If one is concerned with joe 6 pack's checking, savings, and insurance contracts, those are easily backstopped for up to $100k, or even $250k. Most people just don't have much money.
The people who benefited from a global backstop instead of bankruptcy (with government guarantees for little people) was the wealthiest 10 percent, or really 1 percent, of the population. And they can take the hit. They benefited the most from the Reagan/Milken Clinton/Rubin orgy of debt. Now they can take the downside.
Completely agree.
The FDIC never had enough money to "backstop" that. The FDIC only ever had $50 billion.
The wealthiest 1% never takes the hit. They've already monetized their wealth with land, planes, and protection. They would have either flew the country or mobilized the military for martial law.
catullus: The FDIC never had enough money to "backstop" that. The FDIC only ever had $50 billion.
The wealthiest 1% never takes the hit. They've already monetized their wealth with land, planes, and protection. They would have either flew the country or mobilized the military for martial law.
-----------
The money in the FDIC's coffers is irrelevant. The Fed could lend the FDIC enough money to backstop anything.
The wealthiest 1% hold the a boatload of bonds. That means they would take a direc hit. They would take an indirect hit in their tangible assets because the prices of all of them is inflated through debt.
The wealthiest 1% are irrelevant... they are the foot soldiers doing the "grunt work." It is the top 0.00001% that are producing this criminal masterpiece, and who must be stopped at any cost (short of violence).
Its the over riding 300 year pillage concept itself which is to blame. 50 years from now this era will be seen as the 2nd dark age
OK. So basically the government needed to agree to trillions in guarantees and absorb billions of losses so that institutions and large corporations can earn 3% on their short-term deposits?
OK I know that effectively it is the "panic" that creates the losses and that these do not really reflect true asset values.
I think it sort of glosses over the main part and, of course, focuses a microscope on the actual "cause" of the panic. For a highly regulated business to become "unprofitable" means that the regulators were not paying attention somewhere or else they considered these "innovations" as a way towards profitability without the need for intervention or other encouragement.
I can hear the howls of the free marketers but essentially retail banking was (and still is) heavily regulated with government guarantees, etc. It would be as if we were saying now, darn too bad our public utilities needed to start cannibalizing their plants to make a profit and we were left relying upon stocks of batteries imported from China for our electrical supply.
Maybe the government just should have guaranteed short term deposits? So that way there would have been no big demand for silly securitized complicated bonds for use in the repo market?
I am in awe of the community ZeroHedge has created. The reads and your alls' take on them has become a staple of my life. Thank you.
For those who wake up in the night and worry about things, take a look at two Federal Reserve graphs:
http://research.stlouisfed.org/fred2/graph/?chart_type=line&width=1000&h...[1][id]=MULT
and
http://research.stlouisfed.org/fred2/series/WSECOUT
I see things becoming somewhat-less-than-healthful in the near future. What makes this scary is that everyone in the know, knows this is coming, yet everyone is busily rearranging chairs on the deck of a sinking ship.
What is the next shit storm that will cause the next banking panic? I am thinking it will be the sovereign debt crisis, but it might just be an ebola laden terrorist blowing himself up in lower Manhattan.
If you had a gut feeling that Congress and the executive branch were barking up the wrong tree with their financial "reform" proposals, this confirms it.
Another excellent article and reason by ZH is worth checking out on a regular basis.
I have trouble understanding the argument that "without securitization" banking is no longer profitable. As far as I know, Canadian banks were not involved in securitzation and they seem to be functioning fine...
And, again, I'm curious how does he value the "500mm of bonds from bear stears" Isnt the whole problem of securitization that risk formulas failed to adequately price the risk?
And finally, isnt the whole danger here that banks were essentially creating their own money, adding to too much liquidity and driving up asset prices all over the place?
As to his question "why did they engage in risky behavior"...why isnt 'greed' a valid answer? Think about the legions of MBA graduates and Ivey I-bankers and traders that were produced in just the last 10 years? Whole generations of physicists and comp scientists rushed into finance...so ya they wanted a bigger pie...and bigger bonuses...
anyway back to his concluding remark "the economy needs bank and banking" yes thats true -- but what kind of banks? Once Milken went down, junk bonds suddenly, and magically, started being crap too. But no one really think it was magic.
I am in Australia and our banks didnt securitize either.
I'm not sure how they are different to the USA banks. Perhaps its that MM funds are handled differently, or the availibility of cheap overseas finance? No idea really, maybe they just stay profitable through fees, I've heard that US banks are way more competitive than ours.
Regarding your comment that the "risk formulas failed to adequately price the risk", I agree and previously thought this as well.
The sub-prime 'ecoli' meant that all counterparties were at a higher 'percieved' risk of default, and that this risk was unmeaurable, due to lack of transparency on the part of the counterparty. Its interesting to note that not all were at actual higher risk of default, only those with subprime exposure, however the lack of information had the perverse effect of causing them all to be suspected.
Thus 'depositors' (people parking cash as part of a repo agreement) demanded a haircut to cover the risk, and it was this haircut which led to asset sales and eventually bankruptcy for the institutions on the other side of the repo.
It was a panic, nobody knew where the subprime rot was being housed, and so everybody demanded a risk premium which the likes of Bear Sterns were unable to cover. Its just some shit that happened I guess.
I guess it's simple. A well-regulated banking sector is basically a utility industry. A utility industry can be profitable but not if you add in $20m bonuses and a few corporate jets.
Therefore, you need to re-invent banking to make sure it's no longer well-regulated.
The US banking regulatory system is and has been seriously screwed up for at least a century.
Canada has 6 banks, and a bunch of credit unions.
If BC real estate goes real sour, the the sturdy Ontario/Alberta/Quebec/etc. mortgage payers keep the cash flow going, and the banks are solvent. That is what securitization does. Spreads the regional risks.
Derek
Out-frigging-standing. Nothing enlightens and surprises like the basics.
I read and followed Mr. Gorton's explanation, but in his example using Fidelity (F) and Bear Stearns (BS), I do not understand the implied obligation of BS to give physical possession of interest bearing collateral to F and suffering a $100million "withdrawl". Why did BS agree? What if F found no takers like BS to accept their overnight loans? Sounds like BS lost more than the interest gained overall. I must have missed something about repo's which on the surface was explained as a totally voluntary business transaction. If no one had to accept repo's because of the damage (i.e. haircut) they could do to a balance sheet, why did they become the central character in the crisis?
I remember the late 70's and early 80's well. I remember the creation of money market accounts to fulfill the demand for a higher return on savings in that hugely inflationary era. Poor Volker! The banks had done quite well for years with Reg Q suppressing the "real" interest rates that the banks were defenseless to raise. With all those dollars sloshing around from the Vietnam war and the Great Society and Nixon forced off the Gold standard, its no wonder that the banks were losing money, too. Yes, poor Volker. Another tool in his toolbox lost to the ingenuity of the market place. Its tough being in the government and living up to expectations delivered in campaigns. So this was the causality of banks losing money and subsequently "shadow" banks apprearing on the scene to reinstate profits to the investors. No one sees this, and no one is in control of this situation yet. What have we wrought?
I believe the "withdrawal" is meant in terms of substance but not form. Look for a representation of the obligation off balance sheet. Furthermore when haircuts begin to be demanded, this is already a bank run.
The fact that, in this example, BS decides to offer more collateral in order to attract institutional money isn't a loss since repos are obligated to terminate at some point in the future (where the collateral is handed back). The only case it would be a loss is if BS were to become insolvent (in which case F now owns the collateral from the repo). Remember, these are repos (ie *RE*purchase agreements), so the collateral is *not* owned by the holder unless the originator falls into trouble. So if you're BS and credit is in crisis, institutional investors can demand more in collateral simply because they can (which heightens the pressure on the shadow banking system).
If I have any of this wrong, someone please correct me.
My take is that prices plunge into a deflationary abiss....
Why ?
Very simple....
Assets were priced largely via money made available through securitized loans ....you know....the loans that created big fees and were stamped AAA....which were lofted on AAA believers.....?
So this is just like taking away most of the money from an individual...and expecting them to pay the same price....?
Not going to happen.....
A number of things are missing from the oversimplification of blaming it all on repo.
Where in the above diagram does it show the massive amount of lending from prime broker operations to hedge funds? According to the reliable surveys of Greenwich Associates, in 2007 most categories of bond issuance were going to hedge funds on leverage. The incestual lending of funds to buy your own securitizations looks bad. And there was no regulation on the leverage used.
It wasn't just demand for repo collateral that drove securitization. I have always thought that most of the repo book growth was driven by the need to fund those securities not sold to customers-mainly hedge funds. Or to fund market making inventory. It seems to me the brokers make a lot more on issuance and transaction fees relative to capital charges than they make on large repo books. If they liked to expand their balance sheets so much, then why could you never get a bid on size near quarter end? In fact, at the height of the credit bubble the brokers were left with the highest rated tranches because they did not have enough spread for greedy customers. It was these top tranches that were the core of their repo book and the securities that caught them most off guard.
Where is there any mention of the use of CDS as bond insurance for regulatory capital forbearance by European banks?
I see no mention of the wink, wink nod, nod of taxable and tax-exempt auction rate securities. Nor the propensity of European banks to misbid all the business of standby purchase agreements in both CP and muni VRDB.
All the above are forms of securitization in the shadow banking system. These and repo grew unfettered with much more leveraged ratios than exist with on-balance sheet lending. I read nothing above about this overleveraged liquidity driving asset values above any level sustainable by project cash flows. The Fed and Treasury attempting to restart the shadow banking system to support asset values is folly. When normal asset value volatility exceeds equity capital cushions a panic deleveraging process is enevitable.
The bigger perspective is that credit cannot grow faster than some lower single digit natural economic growth rate with sustainability. How the Fed missed this is unforgiveable.
"Where in the above diagram does it show the massive amount of lending from prime broker operations to hedge funds?"
This is a question, not an answer. The PB is usually custodian of the underlying assets, right? So if they allowed a hedge fund--let's use a Bear Stearns 30x leveraged fund filled with subprime RMBS because I'm not creative--and JPM is the custodian--then JPM has physical of the actual RMBS, Bear has a 3% ownership of the RMBS, and services the 97% loan using the income from the assets. If the assets fail to generate income sufficient to cover the cost of servicing the debt, then the 3% ownership would get wiped out and JPM would assume the RMBS assets. So what's the massive amount of lending by PB to hedge funds?
With another example, say a leveraged LS equity, I would imagine a similar situation with the PB as custodian (or if not, then as an intermediary between the custodian and the hedge fund with collateralized counterparty accounts settled daily)...in either case, it seems like the leverage was just something that had to be paid for on a daily/monthly basis out of the hedge fund assets. If those went to zero, then the loan extended by the PB would be made whole by taking possession of the actual assets.
To me it appears the only funds at risk were the daily collateral used to settle counterparty accounts, in the form of repos (of some flavor of cash).
So this may be a totally ignorant take on things and I would love to learn how leverage created substantial debt that was significant to the crisis.
Ok. I see what you meant: from a structural perspective, there was much more than the cash markets that lead to the crisis, even if the cash markets set off the powder keg and could be considered the 'root problem' in terms of rubber meets the road. These features, which you address, are of significance when considering the fundamental reasons for the en masse credit explosion.
> The bigger perspective is that credit cannot grow faster than some lower single digit natural economic growth rate with sustainability. How the Fed missed this is unforgiveable.
And, as others have pointed out, if one looks at the black-letter text of the Federal Reserve Act
> The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
http://www.federalreserve.gov/aboutthefed/section2a.htm
it certainly seems that not missing that is in fact the Fed's Job One, and the common notion that its mandate just says something like "juggle unemployment and CPI" is a canard.
http://www.zerohedge.com/article/jim-demints-questions-bernanke#comment-...
"I read nothing above about this overleveraged liquidity driving asset values above any level sustainable by project cash flows."
That's the POINT.
It seems to me Bernanke (till early-2009 maybe) also behaved like liquidity was the ONLY problem.
Tyler,
This is undoubtedly the low point of Zero Hedge journalism. I'd have expected Marla to catch you on this.
Gary Gorton was THE main advisor to AIG on their CDS activities. He pitched the board on the apparent safety of writing insurance of hundreds of bond/CDO issuances.
The fact that his reputation is still intact is a fucking shame. In the old days, he would have been tarred and feathered. It's amazing that he has the balls to write a fucking paper on the messes he recommended.
You can redeem yourself by doing some digging into his involvement with AIG.
Really disappointed.
This is why I threw this subtle dig in my response:
"Where is there any mention of the use of CDS as bond insurance for regulatory capital forbearance by European banks?"
The omission of this is self-serving revisionism by the author.
Now we know the motive at least. "It was a panic, it was a panic".. ha
Indeed:
"Gary Gorton's Slapped by the Invisible Hand perceptively explains how the financial crisis of 2008 was actually a crisis of 2007 and provides an essential historical context. It needs to be read by all who seek to shape our future policies."--H. Rodgin Cohen, Chairman, Sullivan & Cromwell LLP
Gary Gorton, a 57-year-old finance professor and jazz buff, is emerging as an unlikely central figure in the near-collapse of American International Group Inc.
Mr. Gorton, who teaches at Yale School of Management, is best known for his influential academic papers, which have been cited in speeches by Federal Reserve Chairman Ben Bernanke. But he also has a lucrative part-time gig: devising computer models used by the giant insurer to gauge risk in more than $400 billion of devilishly complicated deals called credit-default swaps.
http://online.wsj.com/article/SB122538449722784635.html?mod=testMod
Why would you want Tyler to source filter information? Whether or not you agree with Gorton is your decision.
Shadow banking is not something an average person like me instantly wraps his head around. I appreciate this information and love ZH for providing it to me for free, even if it is biased in favor of anything I oppose.
I do not agree with much of this paper and I am surprised ZH gave it such high marks. He completely ignores the fact that when money is created it immediately starts earning interest, we all know that money = debt. The problem is that people do not want to play by the rules (capitalism), and when they are not the first ones to purchase the securitized assets and thus get the best rate, they bitch and moan so more 'products' are produced with crappier and crappier underlying assets, but still somehow enjoy the higher repo value. So once the cracks appear the runs begin.
Too much of 'the fed is really doing the right thing, you are just not smart enough to realize that' in this paper. Securitization is NOT a necessity in any banking system. You make good loans and you do not have to worry. Sure some will fail but its a numbers game. If lenders are too tight, no one will borrow, rates will come down until they find that sweet spot where lenders meet borrowers.
This information is well-known in the financial world with some variations on specifics.
What is lacking is an arrow point explaining the AAA-AA spread's March 2009 low: AIG was utterly insolvent.
And AIG had $1tr cover for the biggest OTC market makers worldwide. And the crunch was spreading from their CDS book into the conventional insurance industry.
An AIG failure would have ended the parallel banking system right there. They also held the largest portfolio of AAA corporate paper in the world and they were liquidating, and other big corp investors followed. The bailout started to reverse the situation.
Bail-outs and credit easing are only a stop-gap measure. Going forward, government policy has unsustainably distorted the information content of nearly every market price.
The shadow banking issues are hardly addressed in the pending Reg Reform bills now before Congress save the Barney Frank "10% skin in the game" on securitization.
New accounting rules recently killed off the utility of SIVs used in securitizations. The 10% skin in the game House approach will finish off any new securitizations in the cradle. Kiss that added $3-5 T in funding liquidity goodbye for the next 5 to 10 years,
Repos are not addressed at all in the House bill/ Senate draft (a state secret you know wink wink).
Derivatives will be hardly touched --save the newly created ccp's and platforms for trading and clearing basic derivatives raising at the margin the issue of a single point of failure problem. The end user exemption essentially guts the House bill.
Sooo we have a shadow banking systen that continues to generate gassy and exotic asset volumes unregulated by anyone, thereby allowing the prime banks the ability to create money growth using access to zero rate Uncle Stupid cash to prop up the whole sheebang.
Meanwhile all we hear about is the Consumer Financial Product Agency. Note the paper's conclusion that sub-prime alone did not creates the meltdown. The cynical in DC attribute this focus to a clever deflection campaign engineered by the prime banks to keep the focus off of their business structure problems, access to cheap cash and unfettered business models as well as their need to generate margins via accelerating run away growth in derivatives.
So we are back to the 1907 era.. Great job Mr. Greenspan.
A long winded way of saying that panic eventually ensued once the markets realized that the risks in securitization could not be quantified.
However, the author then broadly claims that: "No one has produced evidence of any problems in securitization generally". Hello ? Securitization allows a bank to lever up while offloading risk onto others. That model works only if all parties have confidence in their own ability to quantify the risk. And therein lies the weakness. If anyone comes to doubt valuations because they doubt the rating agencies, property values or even macro economic trends ...etc the whole scheme collapses. Such fragility would seem to be a big problem.
Let's simplify this further....
If the percentage of money available to buy goods and services via the shadow banking system was over 50%....and this source has been eliminated....it is the same as removing the same percentage of pricing power from the total funds available....
If this amount were 50%....then prices would trend towards being 50% less in price....
..............................
An individual has $40,000....and can buy a $40,000 car....
An individual has $20,000....and cannot buy a $40,000 car....
...............................
The question now is .....how can there not be severe deflation ?
Particularly ....even if the govt. were to simply print enough money to make up for this shortfall....their aim is to only distribute to the banks ...who lever the money....thinking that the monetization can be minimized by doing so....
The current issue is that although the banks have received funds....the funds have not been distributed to the buyers....
And there has been no structural change in order to bring about sustainable small businesses....
...........................................
The bottom line is that if there is not permanent and favorable tax structure change....IT WILL NOT BE POSSIBLE FOR THE US TO MOVE ITS ECONOMY UPWARD IN A MEANINGFUL WAY....
You missed the ceteris paribus part. What would happen in a shadow system failure is the Fed would shift from reliance on intangible credit to forcing of tangible money flowing thru the system to fill the void and keep a form of balance. We have seen that nothing will stop the fed from intervening when the system is at risk monetarily. Consider the inflationary impact of $70 trillion in new currency in circulation and/or reserves (currently it is less than $1 trillion). Furthermore, in order to prevent excess reserves from increasing by a factor of 70, it is likely that the zero Fed Fund rate barrier will finally be broken to the downside, as the Fed will pay people to borrow money.
The real question that nobody is asking, is how the Fed will adjust the asset side of its balance sheet when it is forced to compensate for the collapse of the shadow banking system and transferring trillions in dollars from imaginary credit constructs to tangible M1 and the Adjusted Monetary Base. And that's when real monetization comes in. In other words the collapse of shadow banking, which in a normal Fed-free world would be hyperdeflationary, would in effect become hyperinflationary as the Fed does everything it can to counteract the one most dreaded consequence of monetary policy failure.
When an auto clutch fails, it does no good to gun the engine.
The Fed says they will raise interest on reserves, of course IOR only directly effects on-balance sheet lending. I believe the Fed will never shrink their balance sheet. Yet, I also believe the Fed will never expand their assets enough to counterbalance the collapsed shadow banking system. Much as they had no clue as to the relavence of the shadow banking system's expansion, they will continue to underestimate the impact of its collapse. Eggheads operate in the fog of their own arrogance.
In the event they do decide to go all crazy in reflationism I don't believe the political climate will allow for it. The sweet spot for political feasibility is controlled deflation in IMO.
The "sweet spot" will be like hitting a very small target, in a strong political crosswind, after running more than two years with a heavy load. Plus, I think the Beard will only get one shot. Try not to think about the fact that he is an academic, and has not been trained to handle this type of pressure.
Real monetization and inflation will happen not by helicopter drops. It will be through the Fed expanding credit easing in a way that bypasses intermediation entirely... they will purchase specially originated CLOs and CBOs--if not outright purchases of corporate bonds-- just to sustain enough operating cash to keep people in jobs.
Just to be clear, this is Tyler Durden's conclusion, not Gary Gorton's conclusion, correct?
What would happen in a shadow system failure is the Fed would shift from reliance on intangible credit to forcing of tangible money flowing thru the system to fill the void and keep a form of balance.
AND HOW DO YOU SUPPOSE THE FED WOULD DO IT? EVEN IF THEY WERE TO GIVE MONEY DIRECTLY TO PEOPLE IT WOULD NOT WORK. PEOPLE WOULD PAY DOWN THEIR DEBTS AND.....SAVE(!) NOT SPEND.
1. THE FED MAY ATTEMPT TO DO IT BUT THE BOND MKT WOULD NOT ALLOW IT. IF THE BOND MKT WOULD EVEN SNIFF THAT THE FED INTENDS TO DO IT IT WOULD DAMP THE BONDS AND THE PRICES WOULD COLLAPSE. THAT WOULD BE HIGHLY DEFLATIONARY.
2. EVEN IF THE FED WOULD CREATE $70T THE MKT WOULD IMPLODE MUCH FASTER. THE DERIVATIVE MKT IS SOMEWHERE NEAR $700 QUADRILLIONS. $70T IS A DROP IN THE BUCKET.
3. THE FED WOULD BE TOO SLOW TO REACT. YOU'RE RIGHT IT TOOK FEW HOURS/DAYS FOR THE SYSTEM TO FREEZE UP. IT WOULD TAKE THE FED WEEKS IF NOT MONTHS TO RESPOND. THIS TIME AROUND THEY MAY NEED THE APPROVAL OF THE (CON)GRESS. THE LATTER MAY NOT ALLOW THEM TO PULL A FAST ONE ON THEM AGAIN.
I BELIEVE THAT THE WHOLE EPISODE WILL, INITIALLY BE hyperdeflationary (TO USE YOUR TERM). AFTER THAT IT MAY TURN, DEPENDING OF WHAT WOULD THE FED AND THE CONGRESS DO, INTO hyperinflationary.
THE QUESTIONS ON MY MIND ARE:
1. HOW LONG WOULD IT TAKE BETWEEN THE FIRST AND THE SECOND STAGE?
2. WHAT WOULD HAPPEN TO THE PRICE OF GOLD IN THE INITIAL STAGE?
WHAT'S YOUR TAKE ON THIS?
I for one would like to know more of the details of the Great Electronic Bank Run that took place on Sept. 18, 2008, and if any regulatory agency has shown any interest in investigating this incident.
Page 5.
"It does it explain the figure above."
Literacy is dead.
To be certain.....the govt. could care less about the core middle class savers in the US as well....
Why would I put my cash in any bank .....what is the incentive versus putting it in my safe at home....etc....
ie normally when there are bank events usually this means restricting cash out flows of one´s own money....while not getting paid any interest....
Which means the only money that should be in the bank ....are those that are also debtors of the bank....otherwise it does not make any sense ....
...................................
In terms of the Fed being super-reactive to hyperdefaltion....this is the same as not allowing sensible middleclass savers who did things right....to buy discounted assets which would only be natural....and savers should be rewarded....instead the Fed wants to reward those who lost....rather than those who were intelligent and prudent....
I am a saver....so I know....
And I will leave it to your imaginations as to the words I have for the current set of populist ice cream blabbing comotose polys....
In any case....the US ¨paper standard¨has been broken....
There is no incentive to save....
And the incentives for small business are becoming more and more unattractive....
I thank TD for this awesome post, but disagree with the incompleteness (although I do appreciate it) with Gorton's diagram.
Also, I disagree with TD's remark:
"..which is second only to the credit and interest rate derivative market.."
The credit and interest rate derivative market are indeed intricately woven into the shadow banking system: any securitized debt instruments figure heavily into speculation of all kinds, and hedge funds and leveraged buyout pump-and-dumps.
De-linking is a no-no.
Thanks, TD.
Gordon shows over 12 Trillion in Mortgage securities issued in the 6 years 2003 through 2008. Yet US total residential mortgages outstanding are less than 12 Trillion, and not all of them are securitized but are held directly by banks and GSEs. How much of the securitization was synthetic or squared securitization of existing securities?
At some point in all bubbles the buyers refuse to buy.
The point at which you can no longer find the greater fool.
Thanks again Tyler. Two simple questions: 1) How do we protect our savings and investments going forward, and 2) Some sure fire money making opportunities must be there in all this carnage. What are they?
As far as I am concerned....
Trading successfully is one of the very few possibilities left in order to increase one's wealth....
Everything is a hot potato...and must be passed on to the next fool....
Professor Gorton’s ending comments are the most revealing under:
‘How could this have happened?’
But bank regulators and academics were not aware of these developments.Regulators did not measure or understand this development. As we have seen, the government does not measure the relevant markets. Academics were not aware of these markets; they did not study these markets. The incentives of regulators and academics did not lead them to look hard and ask questions. (Or as they say in the real world – asleep at the wheel).
Does the Professor not remember LTCM? It was the first shot across the bow, exposing the unhinged leverage in the shadow banking sector. But, lets sweep that under the rug and forget there may be a problem, as per Chairman Greenspan’s instructions.
Another interesting aside is the Professor’s omission of the word ‘leverage’. I can’t find it in the entire article. While 1.2 trillion in sub-prime may not be a lot if you’re levered 5:1, at 50:1, well, Houston, we have a problem.
Quoting the Professor again:
‘In 2007 subprime stood at about $1.2 trillion outstanding, of which roughly 82 percent was rated AAA and to date has very small amounts of realized losses.’
And this is on planet earth?
TD-
Stop treating apparatchik academics of the establishment with so much respect. This guy is smart and all, but's he's an apologist for the fed and a lapdog of the bankstaz. The "modern" fiat economists are all hacks because the ignore the unsustainability of the actual monetary system itself. Goldbug, bitches!
Dear Tyler & Marla:
Whereas, as the author pointed out that the previous banking crises was a run by individual investors and the 2007 banking crisis was a run by institutions, the next crisis could/should/would be a run by both institutions and individuals and at the same time. Actually, institutions front running, then informed individuals following closely behind.
Also a couple of political side notes, the tea that the current Tea Party is steeping is hemlock and being an “independent” relative to republican or democrat is useless while being a revolutionary is far better.
Its one of the good platform for awareness of people. Keep sharing such stuff in the future too. xbox 360 slim
I found
lots of interesting information here. The post was professionally written and
I feel like the author has extensive knowledge in the subject. Keep it that
way
sportsadministration degree
This is very good blog and I also show you some imformation through this .
Minneapolis Bankruptcy http://www.twincityattorneys.net