Gary Gorton On The Shadow Banking System Run, And The Interplay Of Shadow And Traditional Banking

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).