Shadow Banking In The Headlines! The Future Is Here!

by: John M. Mason

Shadow banking has finally made the front page of the Financial Times! Lead article is "Shadow Banks Reap Fed Reward." Tracy Alloway writes "non-bank lenders have emerged as among the biggest beneficiaries of the Federal Reserve's ultra-low interest rates …"

The evidence presented: "Assets held by U.S. business development companies, specialist finance companies and real estate investment trusts have jumped from $779 billion in 2008 to $1.22 trillion in the second quarter of 2013 …"

This is an increase of almost sixty percent! These organizations don't take deposits. Hence, they are not highly regulated. These organizations borrow from others… and, in today's environment, they borrow at very low rates. Some of these alternative finance companies lend at rates that are close to credit card rates.

Some of these alternative finance organizations borrow short to lend long. Some of these alternative finance groups are creating new financial instruments. And, in all cases financial leverage is increasing.

Glad to see that credit inflation is working its wonders again. Thank you Mr. Bernanke!

But, the commercial banks are so tied up in a predatory regulatory environment, are still facing solvency issues, and are scared silly of the "new world order" that they are doing very little traditional bank lending.

An example: In the areas of Pennsylvania, Ohio, and West Virginia that are going through the natural gas boom, lots of things are happening and lots of wealth is being created. Are the "regular" financial institutions lending in these areas?

No! People and small- to medium-sized businesses are having a devil of a time getting money. For one thing, commercial banks don't lend to many of these people under these circumstances. They don't know or understand the kind of lending that is needed. For another thing, there is great fear that regulators will come down on them very hard if they do make loans in these areas.

What about real estate lending? Residential real estate loans in the United States are not increasing. But, real estate is being bought. Seems as if hedge funds, private equity funds, and individual groups are borrowing money… commercial loans… and are buying residential properties to rent.

And, there are many other examples of merchant lenders, merchant banks, and asset managers making their mark in this environment.

Readers of this post know that I have discussed these trends for the past year or two and suggested that this is an area in which an investor can make a lot of money. I will continue to write about these things in the future.

The crucial point I want to make today is that I am in total agreement with Tracy Alloway. The Federal Reserve is underwriting this behavior and it is making a lot of money for some people but it is doing very little good in terms of promoting economic growth.

The four things I mentioned above, taking greater risk, engaging in financial innovation, increasing financial leverage, and mis-matching the maturities of assets and liabilities, are how people respond to credit inflation. And, credit inflation has been going on for more than 50 years in the United States and savvy investors have learned their lessons well. They move "with" the Fed and take advantage of what the Fed gives them. And, they rake in a lot of money.

The world we are now living in is built for the top 10 percent, not the bottom 90 percent. An article in the New York Times on Sunday, November 10, 2013 is about how some of the top 0.01 percent have made money in this environment: "Treasure Hunters of the Financial Crisis."

The fear that seems to be growing is that this sector is becoming so large and is so un-regulated that something must be done about it. But, the regulators don't know quite what to do with it.

Here is the dilemma… the government has created this environment… and, now the government is faced with the consequences of the environment it has created. It raises the policy question: How do you continually stimulate the economy, through monetary and fiscal policies, to keep unemployment low and NOT create expectations that you will continually stimulate the economy to keep unemployment low?

We have seen that over the past fifty years that this continuous credit stimulation has created expectations that lead to increased risk taking, increases in financial leverage, increased mismatching of maturities, and increased financial innovation. And, these things do not lead to increasing economic growth but they do lead to plenty of action in the financial world.

And, we are doing it all over again!

Let me reiterate what I have been saying for the past three or four years: shadow banking is on the upswing... commercial banking is going the way of the thrift industry. Consider this in your investments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.