The Scramble For US Safety, As Europe Imploded, Offset The $357 Billion Plunge In Q3 Shadow Banking
In continuing our exclusive analysis of the periodic variations in the by now all important shadow banking system, we next look at the change in third quarter (3 Months ended 9/30) shadow liabilities as disclosed by the just released Flow of Funds (Z.1) report by the Fed. As by now should have been made all too clear, if there is one threat above all to the monetary regime, primarily of the US but by extension, global, it is the ongoing collapse in shadow banking, which is simply an unregulated pass-thru funding conduit for all the non-traditional banks and bank holding company firms which perform one or all of the three banking functions: maturity, credit and liquidity transformations. As such these are critical because having peaked at $21 trillion, the shadow banking system was always substantially larger than the traditional banking system since Q4 of 1990 when it finally overtook in terms of total notional, and provided far more broad "credit-money" liquidity to the global financial system than regulated (and we emphasize this word with bold and underline) entities. And since the burst of the credit bubble, the liquidity is now evaporating on a quarterly basis. So cutting to the chase, in Q3, US shadow banking declined by $357 billion to $15.2 trillion in liabilities, a decline of $654 billion in 2011 YTD, and a drop of $5.7 trillion from the $20.9 trillion peak in March of 2008. Such an uncontrolled ongoing collapse, primarily brought by the disappearance of dumb incremental (marginal) money originating in Germany (Landesbanks) and Spain (Cajas), as well as various Asian sources of dumb money, is beyond a shadow of a doubt the biggest deleveraging threat to the global monetary system bar none. And here is where the central banks step in.
As it turns out, and as was discussed previously, Q1 ended up being the first quarter which saw a sizable increase in consolidated shadow and traditional liabilities, primarily due to the impact of QE2 which culminated in Q1 of 2011. Afterwards, we saw a quarter in which there was no net consolidated change, courtesy of a rebound in traditional banking and now we analyze Q3, in which the abovementioned plunge in shadow liabilities was once again more than offset by a $388.5 billion jump in traditional liabilities. Yet what caused this spike in offsetting liquidity? Why none other than the Fed, via its latest preferred conduit: foreign banks, a topic discussed extensively first by Zero Hedge back in June. Because of the $624 billion increase in traditional liabilities in Q2 and Q3, the bulk, or $415 billion is courtesy of "Foreign Banking Offices in U.S." aka table L.111 in the Z.1. Said otherwise, in the most ingenious scheme to date, the Fed managed to pump reserves into foreign banks (or rather their US-based offices), and hence back into the US system, as these intermediaries promptly turned around and used said reserves as source of precious liquidity even as the rest of the shadow world was collapsing around them, courtesy of lack of demand for unregulated paper out of Europe. Ironically, it turns out that a collapsing European continent does as good a job, if not better at offsetting shadow leverage as quantitative easing.
Unfortunately, for the Fed, reserve reallocation is only a stop gap measure, which in the absence of incremental liquidity will merely shuffle the chairs on the deck of the Titanic, while at the same time non-shadow European banking is caught in the "Death Spiral" discussed previously. Needless to say, should Europe collapse, the bulk if not all of shadow banking will go up in smoke with it due to the unregulated yet explicit daisy-chaining of Euro-facing transactions, and thus transatlantic counterparty risk.
At that point not even the Fed will be able to offset the momentous collapse in nearly $15 trillion in gross shadow liabilities, or $7.5 trillion excluding GSE liabilities currently held with an implicit guarantee of the US itself. Because should the Fed have to ramp up its balance sheet from the current $2.7 trillion to $$10 trillion overnight, the resulting hyperinflation will be the least of everyone's worries. Yet that is precisely what the Fed has to do each and every time there is a collapse in shadow liabilities! Forget anything else you may hear about the justification for "printing money" and remember this: the Fed's one and only directive is to offset the massively deflationary and increasingly more rapid deleveraging of shadow liabilities, which incidentally consist of money markets, GSEs, Agency Mortgage Pools, ABS Issuers, Funding Corporations, Repos and Open Market Paper: these are the various components that can be tracked via the Z.1, and which cause sleepless nights for the 10 voting members of the FOMC committee.
One key component that can not be tracked, primarily since it is domiciled in the UK due to an enabling regulatory regime, are the liabilities generated by hypo/rehypo and hyper-hypothecation, courtesy of lax UK supervision standards allowing up to infinite rehypothecation of the same asset in what could become the daisy-chain from hell of linked serial counterparty exposure. According to IMF estimates, this vehicle, which does not exist anywhere in the Z.1, accounts for an additional $4-6 trillion in shadow liabilities. Yet it is the marginal rate of change that interests us, and as such it relies almost primarily on the $9 trillion in levered hedge fund assets which subsequently are (re)hypothecated by Prime Brokers. In other words, should the hedge fund industry be decimated in 2011, as it likley will be, and if the $3 trillion or so in HF AUM collapses by a third, there goes another $3 trillion in hypo-associated shadow liabilities... with who knows how much real assets pledged as collateral. But that is a tangent to this story, which is that regardless of what is happening in the hypothecation vertical, a fascinating story in its own right, the "traditional" shadow liabilities (pardon the pun) continue to collapse and collapse. And unfortunately, in Q4 domestic offices of foreign banks will not help the US as any minute now, these same banks will be forced to commence an epic wave of deleveraging to the tune of up to €2.5 trillion... Which means that once again without halting the shadow banking collapse, it is QE (and we mean hardcore LSAP monetization - none of this sterilized amateur stuff) or bust.
So for our visual readers, here is what all of the above means graphically.
First, total Shadow liabilities on a quarterly basis, ex-rehypothecated. Note the peak and subsequent slide.
Next, we present a breakdown by key shadow components.
The sequential change shows that the attempt to arrest the decline failed in Q1 of 2011 and has since picked up speed once again.
Yet "shadow" is only half the battle. Don't forget the traditional stuff (aka U.S.-Chartered Commercial Banks, Foreign Banking Offices in U.S. and Bank Holding Companies). This area is the primary beneficiary of Fed QE largesse, typically via reserve accumulation. As can be seen while shadow liabilities collapse, it is the forced deployment of reserves into US and foreign banks that has done miracles to offset a consolidated crunch via the traditional banking pathway.
And the kicker: even without QE, the Fed has managed to sequester liquidity in the US via foreign banks (which accounted for $291 billion of the $389 billion in total traditional liability expansion) courtesy of the sovereign and financial crisis in the Europe which has peaked in 2011.
So will the Fed, and global central banks, be able to continue to offset the evaporation in shadow liquidity: certainly not, at least not without another massive large scale asset purchasing episode. Which, once Europe-based deleveraging picks up, is guaranteed. After all, there is nothing easier for the Fed than to push a button, and to add a zero to every banknote in circulation, or every checking account in the continental (and offshore) US.
But that, like every other thing, will take the market some time before it is fully processed.