Posted on 09/22/2008 3:05:45 PM PDT by hripka
Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.
Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a selffulfilling and destructive run on its liquid liabilities.
But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that prevent runs.
A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.
The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits.
The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.
The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended deposit insurance to the funds.
The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.
Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk.
We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.
The real economic side of this financial crisis will be a severe US recession. Financial contagion, the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the eurozone, the UK and most advanced economies.
European financial institutions are at risk of sharp losses because of the toxic US securitised products sold to them; the massive increase in leverage following aggressive risk-taking and domestic securitisation; a severe liquidity crunch exacerbated by a dollar shortage and a credit crunch; the bursting of domestic housing bubbles; household and corporate defaults in the recession; losses hidden by regulatory forbearance; the exposure of Swedish, Austrian and Italian banks to the Baltic states, Iceland and southern Europe where housing and credit bubbles financed in foreign currency are leading to hard landings.
Thus the financial crisis of the century will also envelop European financial institutions.
The writer, chairman of Roubini Global Economics (www.rgemonitor.com), is professor of economics at the Stern School of Business, New York University
i had to write a check to the shadow govt from my shadow bank.
No no, it was George BeewwSH!!!
The economy is great! Full speed ahead!
The old Soviet joke, “We pretend to work, but they pretend to pay us.”
New US joke, “I pretend to pay taxes, but they pretend to give benefits.”
Get this:
Commercial Banks are buying Brokerages.
Next up: Brokerage losses effectively insured by the FDIC.
Here’s how. The Bank (let’s say Bank of America) buys a Brokerage (say, Merrill Lynch). Financially sophisticated Merrill executives convince the relative rubes in the Bank that they (Merrill) have special sauce for trading. Just invest a little money over here, and we’ll make a killing!!!
Banker with a 105 IQ says, “Gee that’s a great rate of return!” And goes with it for about 5 years, making more and more money, with more and more chips on the table.
Finally, that bubble bursts, and Bank Of America finally realizes the leverage the Merrill guys put them into. Now, depositors can’t be covered due to the losses.
FDIC steps in and insures the depositors.
You and I (taxpayers) support Bank of America’s upside, privatizing any gains. And, when the losing bets get too big, B of A socializes the loss through the FDIC!
No Brainer.
Privatize Gains.
Socialize Losses.
Thanks Paulson!
Thanks Bernanke!
Thanks Bush!
Friggin’ idiots.
Moral Hazard is loose in the land, and devouring everyone and everything in sight. Nobody has their eye on the ball: Lousy Investments have to be recognized on Income Statements, and bad investors have to get in the soup line.
Not us taxpayers.
F*** the Bailout!
I believe that banking institutions are more dangerous
to our liberties than standing armies.
If the American people ever allow private banks to
control the issue of their currency, first by inflation,
then by deflation, the banks and corporations that will
grow up around [the banks] will deprive the people of
all property until their children wake-up homeless on
the continent their fathers conquered.
The issuing power should be taken from the banks and
restored to the people, to whom it properly belongs.
Thomas Jefferson, Letter to the Secretary of the
Treasury Albert Gallatin (1802)
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