Will The Record Plunge In Shadow Liabilities Impair Current Account "Shadow" Deficit Funding And Guarantee A Double Dip?
Last week's European stress test is by now, luckily, part of propaganda history. Easily the most ludicrous finding of the "test": all seven of Germany's largest Landesbanks, NordLB, WestLB , LBBW, BayernLB, HSH, Landesbank Hessen Thueringen and Landesbank Berlin, magically passed with flying colors. As the Landesbanks are at the same level (or far worse) of capital deficiency, courtesy of underwater and mismarked real estate assets accumulated over decades of lax lending practices and still marked at par, as are Spain's cajas (of which 5 were generously allowed to fail, although with laughable tier 1 capital shortfalls of a few hundred euros each), this finding alone is worth a few chuckles, for those who actually care. We won't speculate on the stress test any more - everyone knows it is a farce. Yet the role of the Landesbanks in European, and especially American markets, deserves a prominent discussion. And not just any market, but the very shadow banking system which at last check was vastly bigger than regular plain-vanilla commercial banking. As even the New York Fed acknowledges in its recent paper "Shadow Banking", by Zoltan Poszar, in which there is a whole section on the critical Landesbank function in the shadow economy, "As major investors of term structured credits “manufactured” in the U.S., European banks, and their shadow bank offshoots were an important part of the “funding infrastructure” that financed the U.S. current account deficit," the proper functioning of the Landesbanks is crucial to maintaining a stable and efficient market funding structure. This is actually extremely important, as for years most economists and pundits have considered only the non-shadow banking funding aspect of the massive US current account deficit (a topic most critical now that even the US is embarking on fiscal austerity, and the government sector will be unable to further fund the multi-trillion deleveraging ongoing in the private sector, thus pushing the topic of the current account to the forefront as Goldman did recently). Generically, everyone has always looked at China and Japan as those parties responsible for funding the US Current account deficit. Alas, that is only (less than) half the truth. As the New York Fed suggests, the shadow banking system is likely a more important economic funding factor than even China and Japan combined when it comes to the CA. Which is why the all time record decline of over $1.3 trillion in shadow banking liabilities should be a far greater warning sign than any month to month change in China's UST purchasing patterns, than whether WestLB is "really" broke or only "never never" so, and than the debate whether China will decouple, float or just continue posturing vis-a-vis the CNYUSD exchange rate. As everyone contemplates navels, a major portion of liability funding is literally evaporating as shadow banking implodes. Yet nobody bothers to discuss this most important to the future of the US economy topic.
For those who have not read the Poszar seminal and must read breakdown of the shadow banking system (an analysis we will discuss much in the coming weeks), and which he defines as: "financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees", the salient section discussing European bank importance, and especially that of the Landesbanks, in the shadow banking system is as follows:
Some parts of the “internal” shadow banking sub-system specialized in certain steps of the shadow credit intermediation process. These included primarily undiversified European banks, whose involvement in shadow credit intermediation was limited to loan warehousing, ABS warehousing and ABS intermediation, but not origination, structuring, syndication and trading.
The European banks’ involvement in shadow banking was dominated by German Landesbanks (and their off-balance sheet shadow banks—securities arbitrage conduits and SIVs), although banks from all major European economies and Japan were active investors. The prominence of European banks as high-grade structured credit investors goes to the incentives that their capital charge regime (Basel II) introduced for holding AAA ABS, and especially AAA ABS CDOs. As major investors of term structured credits “manufactured” in the U.S., European banks, and their shadow bank offshoots were an important part of the “funding infrastructure” that financed the U.S. current account deficit.
Similar to [Financial Holding Companies'] credit intermediation process, the maturity and credit transformation performed through European banks’ ABS intermediation activities were not adequately backstopped: First, while European banks had access to the ECB for funding, they only had access to euro funding, and not dollar funding. However, given that ABS intermediation involved mainly U.S. dollar-denominated assets, a euro-based lender of last resort was only a part of a solution of funding problems, as borrowed euro funds had to be swapped into dollars, which in turn needed willing counterparties and a liquid FX swap market at all times. As the crisis has shown, however, FX swap markets can become illiquid and dysfunctional in times of systemic stress. Second, similar to other shadow banks, the liabilities of European banks' shadow banking activities were not insured explicitly, only implicitly: some liabilities issued by European shadow banks— namely, German Landesbanks-affiliated SIVs and securities arbitrage conduits—benefited from the implicit guarantee of German federal states' insurance. European banks’ and other banks’ and nonbanks’ involvement in ABCP funded shadow credit intermediation activities is listed in Exhibit 12.
Of course, none of this should come as a surprise to anyone who has followed the Goldman Abacus scandal in depth: the primary dumb money recepticle of all toxic ABS and CDO exposure was long ago decided to be the German banks, which due to a regulatory arbitrage deriving from Basel II exemptions, and for other various reasons, discussed in the Fed paper, and on which we as well will touch upon in the future, were eager to gobble up any and every piece of structured debt biohazard to be kept on their "shadow" SIVs. After all they are off balance sheet - why worry? Speaking of, we wonder if Europe tested the tens of trillions in underwater assets held by Landesbanks on off-balance sheet vehicles - actually that is rhetorical.
But the issue here is much more nuanced. In essence, the Landesbanks, due to their very explosive holdings, are the German equivalent of our own bankrupt multi-trillion shadow bank extraordinaire: the GSEs - Fannie and Freddie, which served as the very basis for the creation of the entire US shadow banking system which at last count was $15 trillion - around $3 trillion larger than the non-shadow system (it is also likely hundreds of trillions globally, although nobody will stick out their neck with a near or even rough estimate). Just like our own GSEs warehouse around $7 trillion in "shadow" loans - implicitly guaranteed, but not "really" debt - just ask Larry Summers and Ben Bernanke, with an implicit but not explicit guarantee from the government, so the Landesbanks are in precisely the same position. Yet some could argue that the Landesbanks potentially have a far greater impact on the US economy due to their marginal impact as provider of current account deficit funding, than the GSEs, whose recent function has been merely to house hundreds of billions in securitized delinquent mortgage loans, and thus keep mortgage rates low, preventing an all out collapse of the US economy.
All of this must be kept in mind when considering that according to the most recent Z.1, the collapse in the US shadow economy in the quarter ended March 31, was unprecedented. The decline in shadow banking liabilities (defined as the total shares outstanding in money market mutual funds, the total liabilities of GSEs, total pool securities in the GSE mortgage pool, the total liabilities of ABS issuers, the total amount of securities loaned by funding corporations, the total liabilities of Repo markets, and total outstanding Open Market Paper: all of these can be found in the Z.1) between December 2009 and March 2010 amounted to $1.33 trillion! This was nowhere near even remotely offset by the $250 billion increase in liabilities of Commercial Banks. The full detail of the collapse in the shadow banking system is presented in the charts below.
The real question one should be asking, instead of the asinine debate over whether the Landesbanks are solvent or not (for the immediate answer, look no further than our own GSEs), is just how much of an impact on US current account funding will the massive deleveraging that is occurring in Germany have? And furthermore, if indeed German bank exposure via the shadow banking system is comparable, if not much larger, at least on the margin, to that of China and Japan, whose role in deficit funding via the non-shadow economy is well understood and extensively discussed, then what will the consequences of the continuing collapse in shadow banking liabilities be for America in the coming quarters and years? Because while the Fed may pretend to reliquify the market one day at a time using money that is stored at bank vaults, and never makes it into broad circulation aside from being used to purchase Treasuries, barrels of crude, and occasionally 3x+ beta stocks, the unwind that is occurring in the shadow system is, paradoxically contrary to its name, all too real, and orders of magnitude greater than the reverse reliquification process. Case in point: from its peak of $20.9 trillion in liabilities in Q1 2008, shadow banking has lost $3.8 trillion in liabilities in just the past two years. Indeed, over the same time period, liabilities of commercial banks have increased by $2 trillion. Which means that the Fed has been responsible for plugging the hole: curiously enough, the amount of securities purchased as part of the non-Treasury portion of QE amounts to roughly $1.7ish trillion. Merely a coincidence? In other words, with commercial banks unwilling to ramp up lending activity, and the shadow system vomiting risk each quarter, with a stunning $1.3 trillion flowing out in Q1 alone, should Q2 demonstrate a continued collapse in shadow banking lending, then the Fed will have no option but to get involved yet again, even if that means to merely plug the differential between the shadow and non-shadow system, as the inability to keep this necessary equality balanced would result in a collapse in the US current account funding, which in turn would kill the economy, absent yet another fiscal stimulus. In other words, the Fed's monetary stimuli do to the shadow economy what Obama's fiscal stimuli do to the plain vanilla backstopped deposit lending. And the scary conclusion is both reflation attempts are not only failing, but doing so at an accelerating pace.
Should the Q2 Flow of Funds report confirm another $1.3 trillion (or near) decline in shadow liabilities, it is pretty much game over, for both the US economy, and, when one factors the Fed's only logical response, for the US dollar.
1. Comparison of total Traditional and Shadow Banking Liabilities since the 1960s. The inflection point was Q1 2008, since which we have seen a whopping $3.8 trillion in liability reduction.
2. A detailed overview of the components comprising the $17 trillion US shadow banking lending market (the recent reclassification between GSE liabilities and GSE mortgage pool securities has been netted out).
3. And the shocker: the sequential quarterly change in shadow banking liabilities. The outlier is prominently noted.
Source: Z.1, Federal Flow of Funds Report