An article on SA called Beware the Rebirth of the Shadow Banking System requires that I explain why such warnings are hogwash that is foisted on the public by banks that want to keep the competition from competing-and by the banks' dupes or apologists. The article, without elaboration, claims, first of all, that the shadow banking system caused the Great Recession-or perhaps just the financial crisis that accompanied it: "We allowed shadow banking to throw us into the worst financial crisis since the Great Depression ... " That simply is not true unless someone wants to say that the largest nonbank lenders such as Countrywide (which did own a bank as well) and the largest investment banking/broker dealer firms, such as Merrill, Lehman, Goldman (GS). Bear Stearns, the investment banking arms of CitiGroup (C), Barclay's and other commercial banking companies are part of the shadow banking system. Far from being unregulated, those firms, which were primary players in making and packaging the mortgages that created the boom and the bust, all were regulated by the SEC or another federal agency. The regulation may well have been lax or misguided-but regulated they were. And none of them could be described as having lived in the shadows.
Money Market Mutual Funds
Money market mutual funds were a part of what has been called the shadow banking system, and money market funds did play a significant role in both creating the bubble and in making its bursting worse than it otherwise might have been. But N.B.: Money market mutual funds were and are strictly regulated by the SEC. The mistake in money fund regulation occurred all the way back in 1972, when they were first invented. The mistake-a mistake that the SEC made in order to enable consumers to circumvent the restrictions on the rates of interest that banks could pay under "Reg Q"-was to permit $1 stable pricing in order to make an investment in money fund stock look equivalent to a bank account. This fraud, perpetrated by the mutual fund industry and the SEC jointly, sort of worked out until Reserve Primary Fund broke the buck after Lehman failed in September 2008. When Reserve Primary Fund broke the buck, all hell broke loose and the Federal Reserve had to step and guarantee that other money funds would not do likewise.
The jig should have been up for money funds, but they, like banks, have their lobbyists and dupes and apologists, so initially, the SEC adopted some palliating new regulations. The jig is now, it appears, finally going to be up because the SEC is going to withdraw the permission it granted 40 years ago for money funds to use $1 pricing. The money fund will be a mutual fund like any other mutual fund, and it will cease to be dangerous. Its stockholders will understand that they can lose money if the fund loses money. The era of that fraud will be over soon.
Money Funds as Transmission Mechanism
Money funds also played a role in the creation of the bubble between 2004 and 2007, though that role is less well understood. What the money funds did was to lend to European banks. (European banks, like U.S. banks, are heavily regulated-nothing shadowy there.) The money funds felt safe in this lending in part because the European governments had an open tradition of rescuing their flagship banks if they got into trouble. Thus, the risk to the money funds was small despite the fact that many of the European banks were woefully undercapitalized.
Once the European banks had dollars, they needed to make investments in dollars. What investments might those be? Well, if you are a European bank with dollars that you got at fairly low price, you want safe AAA investments. You want AAA not only for safety but because banking regulators required little or no capital to back such safe investments. The ROE (return on equity) was practically infinite!
It should be obvious that a large European bank looking for AAA dollar-denominated securities is not going to be the most sophisticated customer an American investment bank ever had. So what did the European banks buy? They bought AAA subprime-backed CDOs. Nothing shadowy here. Complex securitizations undertaken by regulated U.S. banks and investment banks that were sold to European highly regulated banks that had got the money from U.S. highly-regulate money market funds, all facilitated by a wide variety of middle persons and rating agencies, all of whom fed at the trough of investor ignorance.
Structured Investment Vehicles
But what about those crazy SIVs-those conduits that seemed like they weren't owned by anybody and that bought something like $400 billion of subprime CDOs-surely they are part of the problem-and surely they should be denominated part of the shadow banking system, I hear someone saying.
Who invented the SIV? I am told it was Citibank. Who set up the worst of the SIVs in Ireland? Heavily regulated German Landesbanks that are owned by the German state governments. Yes, the SIVs were in the shadows. And yes, in my view the SIVs were a scam. But they were a scam perpetrated by the banks. The banks effectively lied to their auditors to get the auditors to permit them not to count the SIVs as part of their balance sheets. How do I know the banks lied? I know that because after the subprime CDOs became toxic, the banks, rather than letting the SIVs fail and the buyers of asset backed commercial paper from those entities take the loss, the banks took the CDOs onto their own balance sheets and absorbed the losses. A bank would do that only if the intermediary-the SIV-was a sham designed to fool the accountants and the regulators. Again, this was the banks that did it, not some shadowy group of entities that no one ever heard of. Accountants beware!
Other Conduits for Loan Securitization
Some of those who decry the shadow banking system include as "shadows" the conduits that are established to hold loans and whose securities actually are the ones sold to the public or institutional investors. I am not sure why these pass-through entities should be included. But let us examine what they are. They are trusts or partnerships (usually) that are organized specifically to hold a specific group of loans and to issue securities representing interests in those loans. They are registered with the SEC. Such entities have been around since the 1970s, and I fail to see how any one of them-or even group of them-could have systemic importance except to the extent that over-leveraged institutions choose their securities as the bad investments du jour. But probably more importantly, these entities are established specifically for the purpose of removing loans from banks' balance sheets, and as such, they are scrutinized by the bank's internal auditors, their external auditors, and their regulators to make certain that in fact the loans are properly not counted on the balance sheet. If there is a problem here, it is a problem caused by the regulated banking industry, abetted by rating agencies, accountants and regulatory authorities, not by any shadow banking companies.
Regulation of Lending
In the U.S., anyone can make a loan to a commercial enterprise without being regulated. It is where the lender gets the funds to make the loan that determines under what regime it will be regulated. If the money (or some of it) comes from deposits, then the lender must become and be regulated as a bank. If the money comes from the issuance of insurance policies, then it must become and be regulated as an insurance company. If the money comes from the sale of securities in the retail market, then the lender may have to be a mutual fund (but there are exceptions). If the lender comes within certain other exceptions to the mutual fund rules, then it must be a hedge fund, which brings relatively light regulation. The point is that lending is not deemed to be a dangerous or systemically important event. It is where the lender gets the funding that we focus on. We do this for good reason: A commercial borrower is assumed to be able to take care of itself. We do not worry that a hedge fund is going to overreach a commercial borrower-nor should we worry about that. And we do not worry too much about the people or entities that supply the funds to the commercial lender, so long as there is disclosure and a registration statement is filed if one is required.
But horrors: Hedge funds are barging in on banks' turf. They are competing! Even worse, they are borrowing from the banks at low rates and lending to businesses at higher rates! That's what banks are supposed to do. And even worse, they are borrowing short and lending long. Aghh! That's what banks are supposed to do. It is called "maturity transformation." We must regulate this conduct.
Nonsense. It may be dangerous conduct-to the investors in the hedge funds. But it is not dangerous to anyone else so long as the banks are lending prudently and establishing appropriate reserves for losses. And if the banks suffer losses on these loans, those losses will be no different from the losses the banks suffer on any other loans. That is their business, and they are supposed to be able to protect themselves from the wiles of insidious hedge fund managers. Besides, all the hedge funds in the world add up to about one very large banking company. Yes, their financial significance is quite small. Most of us are merely jealous of the amounts of money their managers make.
Worry About the Regulated Banks
Yes, it is the regulated banks that I worry about because it is they that have access to MY and YOUR Federal Reserve banks. It is THEIR deposit insurance system that is backed by the full faith and credit of MY and YOUR government. It is THEY who may be TBTF and therefore may be bailed out with MY and YOUR tax dollars.
Happily, we have ways to deal with those banking issues, and the Fed is starting to do so, prompted by Dodd-Frank. Yes, Dodd-Frank is a bloated piece of legislation if ever there was one, but it also is a piece of legislation that nevertheless contains some of the most important regulatory reforms in our history. One of those reforms-shared with Basel III-is higher regulatory capital requirements. Equally important is the stress tests requirement that makes capital a forward-looking rather than just a backward-looking concept. With higher capital requirements that are stress tested in a forward-looking manner, I believe the banking system will be substantially safer.
Our SA contributor whom I am excoriating worries mightily that European banks are not lending as much as they did and that European businesses are finding funding elsewhere. Does he know where they are finding funding? They are finding funding in the securities markets, where American corporations have been getting 80% of their funding for decades. Europe has funded its businesses in the reverse way-80% through banks. That was not healthy. The banks supplied that funding only because the European nations subsidized bank lending in various ways, partly because doing so gave the governments greater control over their banks and industries. Now we are seeing that the capital markets can provide funding just fine in Europe as they have in America. We should worry about the health of the banks, not the loans that the capital markets are buying.
Capital Markets Versus Banks
And, guess what? The capital markets are safer than the banks because the intermediary does not borrow short to lend long, nor does the intermediary suffer losses if the borrower defaults. The risk is held by the various purchasers of the securities. The intermediary (the underwriter/broker) takes a fee for getting the parties together. But the people with money to invest lend it directly to the business, thus allowing the banks-who are the dangerous intermediaries-to shrink and thereby to pose lesser dangers to the public.
Oho, someone is saying, but that is precisely the point. Everyone bought subprime CDOs, and that is what brought down the system. There is some truth in that. It is quite astounding that a mere $1 trillion of investment assets could bring the world's financial system to its knees. But was that really the case?
- A raft of subprime lenders failed between late 2006 and mid-2007 and nothing systemic happened.
- Countrywide, a larger subprime lender, failed but was acquired by Bank of America (BAC), which might have failed as a consequence if it had not been helped by the Treasury in 2008.
- Bear Stearns failed in April 2008 but, perhaps because of Fed assistance, nothing serious happened. But Bear did not fail because it owned subprime loans or CDOs. It failed because it had too little capital and the financial world stopped believing it could pay its debts. It had managed two hedge funds that invested in subprime big-time and failed in June 2007, but that was not what brought down Bear.
- Fannie (FNMA.OB) and Freddie (FMCC.OB) failed, in part because they relaxed their underwriting standards and in part because they were undercapitalized. But they owned no CDOs. (Are F&F part of the shadow banking system? Can U.S. government agencies be shadowy? Makes no sense to me. They should be phased out for other reasons.)
- Washington Mutual Bank (WAMUQ.PK) failed because it made bad loans-many of them subprime. It was sort of an ordinary bank failure.
- Lehman failed because it had made bad loans to commercial real estate companies and had too little capital.
- Reserve Primary Fund is discussed above.
- AIG, an insurance company, failed because its bank-like subsidiary, that was supervised by an American bank regulatory agency, made insurance-like bets on subprime loans. Was one of the largest insurance companies in the world a shadow bank? What might one mean by that?
- British banks, notably RBS, failed largely because they made bad loans-many of them in Britain.
- Icelandic banks failed because they made bad loans in Iceland.
- Irish banks failed because they made bad loans in Ireland.
- Several Continental banks did almost fail because they bought subprime-backed CDOs.
- Merrill and Citi might have failed mostly because they held too much subprime paper-but it was subprime paper that, mostly, they had underwritten themselves. Their mistake was not knowing they were defrauding others, so they defrauded themselves-perhaps a unique moment in financial history.
I would conclude that although the trillion dollars of subprime-backed securities did have a major role in precipitating the crisis, the crisis was caused by a more general malaise of over-leveraging. Probably that overleveraging was enhanced by various governmental policies, most prominently by policies in the U.S. and Europe that led markets to believe that large banks would not be allowed to fail. The current sovereign debt crisis is an extension of the same public policy mistake.
As one can see from the bullet points above, the entities that failed and caused problems all were regulated entities, most of which failed because they did what financial intermediaries usually do: They made loans. And they failed for the reason that financial intermediaries most often fail: They made bad loans. The systemic cure is not to prevent loans from being made. It is to require that large institutions that are involved with the public maintain sufficient capital that even after they have made bad loans or otherwise squandered billions of dollars, they will have the financial strength to continue to fund themselves and to recover. The capital stress tests are the most important part of the new requirements.
I should not be unfair to our SA contributor from Cyprus. The Financial Times and many of its writers suffer from the same or similar myopia, as do some of the regulators-in the U.S. as well as in Europe. I think the major problem is commentators' failure to understand the public-private interplay of the financial system. I have been around these financial beasts for 46 years now. I well remember my various stages of naivete.
Some will claim that I am still naïve about hedge funds. I am not. They are not eleemosynary institutions. They exist solely to make money for their managers (first) and their investors (second). But capitalism is about competitive markets. It is competitive markets that spur innovation and reduce prices. The good things about hedge funds are that (1) they get no subsidies from the government (there may be some tax things that provide effective subsidies that should be changed), (2) hedge funds have failed in droves and have disappeared with hardly a trace, leaving only their managers and investors poorer, and (3) hedge funds compete fiercely with each other and with other kinds of financial company. That is the best thing they do. They bring competition to markets that otherwise tend to be oligopolistic. And when they get too greedy and violate the law, their managers go to jail, as several have lately for insider trading. That is the way a competitive economy should work. Work hard and compete within the rules and you can make money. Violate the rules and bad things should happen to you.
One of our tasks as readers is to distinguish between relative truth, on the one hand, and male bovine excretion, on the other.