It’s rare that I find fault with the the Financial Times, and even more uncommon with Gillian Tett and Paul Davies, who are two of their most seasoned and insightful journalists. Nevertheless, they have bitten off more than they can chew in “Out of the shadows: How banking’s secret system broke down.” The piece isn’t bad, but it fails to deliver on its promise. The article fails to define what the “shadow banking system” is, much the less explain why it is under stress now. And iit also mischaracterizes how we got where we are.
Before we turn to this article, we need to focus on nomenclature. One factor that may have gotten in the authors’ way is that different people may use the same expression to signify different things, which leads to imprecision and sometimes error.
Shortly after the credit crisis hit in August, there was considerable discussion at the Federal Reserve’s Jackson Hole conference of why this crisis was different. In particular, James Hamilton’s presentation did a very good job of summing up where the problem seemed to lie (and it’s troubling that his observations still aren’t getting the traction they deserve):
What has happened over the last decade is that a variety of new institutions have evolved that play a similar role to that of traditional banks, but that are outside the existing regulatory structure. Rather than acquire funds from depositors, these new financial intermediaries may get their funds by issuing commercial paper. And instead of lending directly, these institutions may be buying assets such as mortgage-backed securities, which pay the holder a certain subset of the receipts on a larger collection of mortgages that are held by the issuer. Although the names and the players have changed, it is still the same old business of financial intermediation, namely, borrowing short and lending long.
There are a variety of new players involved. The principals could be hedge funds or foreign or domestic investment banks. Others could be conduits or structured investment vehicles, artificial entities created by banks, perhaps on behalf of clients. The conduit issues commercial paper and uses the proceeds to purchase other securities. The conduit generates some profits for the bank but is technically not owned by the bank itself and therefore is off of the bank’s regular balance sheet.
This system has seen an explosion in recent years, with the Wall Street Journal reporting that conduits have issued nearly $1.5 trillion in commercial paper. Their thirst for investment assets may have been a big factor driving the recklessness in mortgage lending standards, as a result of which much of the assets backing that commercial paper have experienced significant losses.
Without an adequate cushion of net equity for these new financial intermediaries, and with tremendous uncertainty about the quality of the assets they are holding, the result is that those who formerly bought the commercial paper are now very reluctant to renew those loans, a phenomenon that PIMCO’s Paul McCulley described at the Fed Jackson Hole conference as a “run on the shadow banking system.” I heard others at the conference claim that there might be as much as $1.3 trillion in commercial paper that will be up for renewal in the next few weeks, with great nervousness about what this will entail.
In some cases, these intermediaries have lines of credit with conventional investment banks on which they will be drawing heavily, which will cause these off-balance-sheet entities to quickly become on-balance-sheet problems. Their losses may severely erode the net equity of the institution extending the line of credit. How big a mess will this be? I don’t think anybody really knows for sure.
This discussion is succinct and clear. It defines the nature of the problem (borrowing short and lending long) and gives a clear definition of what markets and players are involved (commercial paper and vehicles that use it for funding). And indeed, what has troubled regulators is the disruption resulting from the implosion of the asset backed commercial paper market. Banks are under stress because they are the other big source of short-term funding. They are hit from multiple sides: companies and entities drawing on lines of credit that no one anticipated would be used on a large scale, all at once; providing funding to affiliated entities that they thought they could cut free if they needed to but now realize they can’t; finding that funding in any form, short-term, medium term, equity, is costly and scarce.
Contrast Hamilton’s overview with the FT’s article, which never defines what the “shadow banking system” and as we’ll discuss, even lumps in a major type of instrument that doesn’t belong on the list. The story is surprisingly flabby and unfocused, although it does marshal some useful data:
Yet while investors are scrutinising some of the industry’s best-known names, a spectre will be silently haunting events: the state of the little-known, so-called “shadow” banking system.
A plethora of opaque institutions and vehicles have sprung up in American and European markets this decade, and they have come to play an important role in providing credit across the financial system. Until the summer, structured investment vehicles (SIVs) and collateralised debt obligations (CDOs) attracted little attention outside specialist financial circles. Though often affiliated to major banks, they were not always fully recognised on balance sheets. These institutions, moreover, have never been part of the “official” banking system: they are unable, for example, to participate in Monday’s Fed auction.
But as the credit crisis enters its fifth month, it has become clear that one of the key causes of the turmoil is that parts of this hidden world are imploding. This in turn is creating huge instability for “real” banks – not least because regulators and bankers alike have been badly wrong-footed by the degree to which the two are entwined.
The article is hamstrung by failing to establish what this parallel banking universe is, beyond citing SIVs and collateralized debt obligations as examples and later “vehicularized finance.”
But in fact, what the FT piece does is conflate the sort of problem that Hamilton defined crisply – that of new non-bank entities acting like banks by borrowing short, in this case via commercial paper, and lending long – with another financial development, securitization. The stresses arising from CDOs are not a shadow banking system issue as defined by Hamilton, except in those cases that CDOs were structured to use commercial paper for a “super senior” tranche. As we have discussed, this was unnecessary, dopey, greedy, and could be expected to blow up, as it has. But so far, the only issuer known to have used this, ahem, innovation is Citigroup, although they did it on a grand scale.
So CDOs are part of the “shadow banking” problem only to the extent that they issued commercial paper; by every indication, this took place only to a limited degree in a very big market. Yet the FT piece would lead you to believe that CDOs are every bit as much a culprit as SIVs.
That isn’t to say that CDOs aren’t creating stress in the markets. But the “crisis in the shadow banking system” talk is all about a run on non-banks. The scrambling for a resolution of SIVs’ inability to roll maturing commercial paper is a classic manifestation.
But the CDO trouble (which by the way is primarily hitting the very large debt trading houses, not commercial banks generally) operates by the same mechanism that subprime, credit card, home equity loans and commercial real estate are, via credit losses. The financial firms are taking writedowns that are large enough that they are reducing equity. This has two effects: it reduces balance sheet capacity, and it also tends to produce new-found caution. Thus the intermediaries typically become more stringent in their credit policies, beyond what is warranted by their equity losses. In fairness, the excessive conservatism may be warranted, since it isn’t clear yet that all the dead bodies have been found (i.e., there may be further balance sheet shrinkage).
But the FT is clearly confused about where the problem lies:
By any standards, the activities of this shadow realm have become startling. Traditionally, the main source of credit in the financial world was the official banks, which typically forged business by making loans to companies or consumers. They retained this credit risk on their books, meaning that they were on the hook if loans turned sour.
However, in the past decade, this financial model has changed radically. On the one hand, banks have increasingly started to sell their credit risk to other investment groups, either via direct loan sales or by repackaging loans into bonds; at the same time, regulatory reforms have permitted the banks to reduce the amount of capital that they need to hold against the danger that borrowers default.
Huh? Where have the writers been? Banks have lost market share in the credit game to investment banks since 1980. If you are going to claim that the culprit is disintermediation, it isn’t a ten-year old phenomenon. And recall that in the last credit crisis, the LTCM workout, the Fed called on the Wall Street firms that were its creditors, evidence that the world had already changed by then.
Now there is likely a case to be made that the increase in systemic leverage makes a difference in degree into a difference in kind, that with the uses of leverage-on-leverage (hedge funds which are geared investing in CDOs which have a lot of embedded leverage) that a lot of players have been put in the position of facing large price swings (more accurately, declines) that they assumed they’d never see, and then facing unexpected demands for liquidity (think of the redemptions at quant hedge funds, which ironically were not players in the sort of structures that this article discusses; they stuck with instruments that were liquid). But hedge funds have taken to freezing withdrawals if things really get dire to assure an orderly wind-down.
Consider this comment:
Satyajit Das, an author and derivatives industry expert, cites an example where just $10m of real, unlevered hedge fund money supports an $850m mortgage-backed deal. This means $1 of real money is being used to create $85 of mortgage lending – credit creation far beyond the wildest dreams of high-street bankers.
The writers fail to frame why equity is necessary, and that omission again clouds the discussion. Banks need liquidity and hence need a buffer primarily due to their funding mis-match. Their depositors “lend” short, and so banks need a cushion both to deal with cash needs and possible losses due misjudging or mismanaging credit or term risks (presumably, they priced the credit with certain assumptions in mind). In theory, if you had a perfect asset-liability match and had priced the credit correctly for credit losses, you’d need no equity. The alleged better ability of investors to tailor their assets (the debt instruments they buy) to their liaiblity requirements is one of the drivers of bank disintermediation (the other is that investors don’t face the cost of deposit insurance, a non-trivial item).
That’s a long-winded way of saying that disintermediation and the resulting increase in overall leverage could readily be depicted as an accelerant of the shadow banking crisis, but the authors don’t make that case.
Despite this critique, I nevertheless encourage you to read the article; it has useful comments and factoids, despite the flaws in the overall argument.