Shadow Banking For Dummies

Lets for arguments sake, just state the following:

"Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the risk of default. The last two would not have to put up any capital for the bond, though they might have to post some sort of collateral."

- Fischer Black, "Fundamentals of Liquidity" (1970)

Who would have thought that nearly 40 years later this would be so true.

Basically Black is talking about corporate bonds, and splitting off interest rate risk and selling it separately and splitting off the credit risk and selling it separately. The instruments he is imagining back then are what we know today as interest rate swaps and credit default swaps. The two primary objects of the shadow banking system. These derivatives were created so that risk can be spread across the spectrum, making credit more easily available.

The whole idea of free flowing credit for credit addicted Americans was born form the shadow banking system. The shadow banking system was built alongside the traditional banking system, using interest rate swaps and credit default swaps. The idea was to make credit cheaper for the ultimate borrower and more available, but also to separate the credit system from the payment system. A lot of the regulation we have on the traditional banking system is there to protect the payment system, to make sure that when you write a check on your deposit account, that money actually gets transferred to the ones who you are paying.

The shadow banking system was not only tolerated by the regulators, but encouraged by them. The whole point of it was to get some of these risks off the balance sheet of the traditional banking system. Get interest rate risk off the balance sheet of the traditional banking system. Get credit risk off the balance sheet of the traditional banking system. And on and on. The regulators thought at the time this was a good thing. So from this, traditional banks became an originator of loans which they packaged, securitized, and then sold to the shadow banking system, which then raised funds in the money market from mutual funds and asset-backed commercial paper that they issued to whomever. All of this was done to avoid the traditional banking system entirely in this regard, and also avoiding all the regulation of the traditional banking system as well as all the regulatory support of the traditional banking system, but the shadow banking system had the same risks, just less regulation. What was happening was you weren't actually getting rid of liquidity risk or getting rid of solvency risk, you are just moving them into a different area of the system.

How The Game Is Played.

A shadow bank has AAA rated CDO tranche, because they are rated AAA by the bogus ratings agency, they are able to borrow almost 100% of the value of the CDO tranche in the overnight repo market at low overnight rates and were able to make money on the difference. The banks were trying to do the funding piece of Fischer Blacks idea, and get rid of all the other risks by selling them off. They were taking advantage of what they understood to be their access to low-cost funds and leveraging them up.

What Happened?


The collateral that was used for repo purposes above really were not AAA rated. I can't make the statement that housing blew up. If that was truly the case, all of the pain would have already happened, but it was all of the side derivative bets that were made on the state of housing and sub prime that cratered the system. Remember there was only, say, $400 billion of sub prime out there, it is not big enough to undermine the entire financial system, the fact that the crisis continues to this day puts the entire securitization structure into question. Simply anything and everything was packaged and resold with sparkling AAA ratings.

How Did It Play Out?

Like this-

Once there is any concern about the value of the collateral you are putting up in an overnight borrowing situation, the first thing the counter party does is to alter the deal, I will still work with you, but just to be on the safe side, instead of giving you 100 cents on the dollar we'll give you 95 cents on the dollar. This immediately creates a problem for the shadow bank that is doing the borrowing. Where are they going to get that other 5%? There is simply too much leverage. The way that plays out is that there is a downward spiral of the collateral because no one knew what these assets were really worth, so they looked to where these assets were traded. Where can we find a market price? And there was no market price what so ever. They needed a Proxy for the market.

So what they used as a proxy for a market price was the Asset Backed Securities ABX index, which was an index of 20 CDO tranches. This was a traded index. They looked at the price on this index as an indication of the value of the underlying. As that index fell the collateral value was marked down. You couldn't borrow as much as you used to in order to carry the underlying security. This became a self-fulfilling prophesy on the way down, something that is refereed to as a "liquidity-solvency downward spiral."

Just lo let you know...Goldman was shorting the stuffing's out of this index after they sold out their sub prime inventory. Many others were doing similar things like selling CDS insurance on sub prime. Lehman Brothers was selling protection, but it was also buying protection. They were net buyers of protection in fact. The net sellers of protection were insurance companies like AIG. They were thinking of this as an extension of their regular line of business into a new profitable area.

The Math Geeks had supposedly built a iron clad formula based on historical data. These were the models that AIG used. One problem, these models never properly gauged solvency and or liquidity risk in the underlying security. These models assumed that the markets were continuous. That liquidity is a free good, its always there in abundance. The assumption that liquidity will always be there is just an assumption. That there was no organized lender of last resort for the shadow banking system. The shadow banking system really depended on the traditional banking system as its lender of last resort, and the traditional banking system depended on the Fed, but the Fed had no direct link.

Similar to LTCM, it was the lack of liquidity in the complex derivatives that were traded that destroyed the fund.

What To Do Now?

Massive Credit contraction is going to kill the economy and system, that's the best way to ultimately fix the system, but its politically infeasible.

Another way and more feasible is to unwind complex derivatives like CDS. What basically AIG was doing when they were writing insurance on AAA CDO tranches was writing systematic risk insurance. This is insurance that they could never pay, and they knew it. Most absurdly, not only did they not reserve against it, which they didn't, they couldn't have reserved against it, because it was so complex in nature, the hedges would be more expensive then the actual premiums. What they could have done was like Goldman, short the ABX Index, but there position was so out of control, I dont even think this would have saved them.

Once AIG stopped writing insurance in 2006 the game was really over, but it continued to run for quite a while even after that.

One interesting thing I came across to read was this:

From reading UBS regulatory filings, we know that UBS started to say if AIG isn't going to sell us insurance at this cheap rate, we are going to make a plan to buy just 2% insurance and then make a plan to do "dynamic hedging" ourselves, which is a catastrophic problem. That means when the price goes down, we sell, assuming that there would be a buyer on the other side.


tradersutra.blogspot.com/2009/07/requim-for-aig-props-for-goldman.html

What Can Be Done?

There is not much the Fed, FDIC, and or the Treasury can do other then flood the market with liquidity or Quantitative Easing.

Floating the system with money market liquidity, which is what the Fed did, didn't solve the problem, because it wasn't getting to the capital markets fast enough or in time. That's why we need a credit insurer of last resort, to put a floor on the value of the best collateral in the system. Something like the Bagehot Rule that was instituted in 19th Century England.

The Bagehot Rule basically is lend freely, but at a high rate. This was good enough rule for the 19th century British Economy, an economy that ran on short term commercial bills of exchange, 90-day paper.

But our problem in now is that we have 30-year mortgages that are the underlying asset that are being turned into 90-day paper through asset backed commercial paper, or a repurchasing agreement, or repo, but the underlying asset is still a 30-year mortgage. That is where the system broke, because those mortgages serve as collateral for the short term borrowing.

So the Bagehot rule needs to be tweaked. Instead of lending, we insure. Instead of paying a rate, we demand more higher premiums.

Why are higher premiums needed?

If you insure an earthquake, you are not making earthquakes more likely. The insurance contract is a purely derivative contract, it isn't influencing earthquakes. That is not true of insurance of financial risk. When AIG is selling you systemic risk insurance for 15 basis points, that price is way too low. People were saying "If I can get rid of the whole tail risk principle that cheaply, I should load up. I should take more systemic risk." So the prices were all wrong. AIG in essence priced their CDS contracts too cheaply that all other counter parties loaded up on them, waiting for a meltdown.

So the important thing for government intervention here is to get that price closer to a reasonable rate to prevent people from creating earthquakes.