Wednesday, August 18, 2010

Causes of the Crisis: Financing of the Shadow Banks

And so we return to the old question, how does the shadow banking system finance its operations? One way, obv iously, is by selling its financial products to investors. But since ultimately the finance system is a system of making loans, it has to raise the funds to make loans somehow. There appear to be two main answers. One way is by "selling commercial paper," that is by taking out a series of short-term loans (known as commercial paper). Securitizers, in particular, used this method, using their securitizations as collateral.

These short-term loans came mostly from money market mutual funds, the most user-frienly portion of the shadow banking system. Money market funds accept"deposits" by selling shares for exactly $1, no more and no less. Shares are kept at $1 so that investors can cash out at any time for the same amount they paid in, like closing out a bank account. They pay interest and dividends to investors, usually at a higher rate than a certificate of deposit at a conventional bank. Some even offer checks like conventional bank accounts. But they are not insured. To avoid losing value, money market mutual funds limit their "commercial paper" loans to municipal governments, blue chip companies, and the like. Unlike in conventional banking, ordinary customers do not make direct deposits, but have intermediaries make their investments. Direct deposits generally come from local governments, corporations, investment institutions, and high net worth individuals. However, the Federal Reserve comments that even the most sophisticated investors in money market mutual funds have no tolerance for risk and are prone to "herd-like" behavior.

The other main source of funding are "repurchase agreements" or "repo" for short. As everyone knows, the FDIC insured conventional bank deposits for up to $100,000 before the 2008 crisis and up to $250,000 since. For ordinary depositors this is not a problem. Anyone with more money than that will probably not want to keep in in cash anyhow, but to invest it in something that offers better returns. But large corporations, banks, and so forth, may have large blocks of cash between investments, much greater than anything the FDIC would insure. (Nor are conventional banks equipped to handle such large deposits and withdrawals). But they still want somewhere short-term and risk-free to park it. Typically, the owner makes a one-day loan to an investment bank or other shadow bank and takes some safe financial instrument, such as a senior tranch security, as collateral. The short-term nature of these loans keeps them safe and liquid. Each day, the lender has the option of rolling over the loan or withdrawing it (allowing the bank to "repurchase" the collateral). Like ordinary depositors, repo lenders often close out all or part of their loan. So long as new lenders are opening new accounts and an equal rate, this is not a problem for the bank. Unlike ordinary depositors, repo lenders are powerful enough to change the terms of their loans as a condition of rollover.

All these funding sources -- investment in money market mutual funds, the short-terms loans known as commercial paper, and repo agreements -- have in common with bank deposits that they are risk-adverse and can be closed at will. A leading argument, therefore, is that when securities started looking shaky, these lenders did just that, setting off a run on the shadow banking system. Most ordinary people did not recognize the run because their own bank deposits were insured, and because it had none of the traditional features of a bank run -- long lines outside the bank, panicked mobs in the street and so forth.

The run began (so far as I can tell) in mid-2007 on banks' structured investment vehicles (SIV's). These were subsidiaries of banks, established off their balance sheets so as to evade capital requirements, that invested in securitized loans, purchases with "commercial paper" loans from money market mutual funds. As these investments came more and more into doubt, money markets stopped making loans. SIV's were experiencing a run. The Treasury Department tried to pool all the SIV's into a single SIV, but banks were not interested. Instead, they took the SIV's back onto their own balance sheet. A portion of the shadow banking system had vanished.

It was about this time that repo lenders started getting nervous. Up until then, repo lenders accepted the bank's collateral at face value. That is to say, they would deposit one dollar of repo for every dollar in collateral. Around August, 2007, repo lenders stopped taking collateral at face value. Instead, they would loan only 90 cents for every dollar of collateral. This is called a 10% "haircut." As the crisis escalated, haircuts kept rising, to over 45% when Lehman Brothers failed.

Nor was this haircut limited to sub-prime mortgages. All housing securities were suspect because they were based on grossly inflated prices. But the problems were not limited to real estate. All securitized loans became suspect. Lenders demanding more and more collateral effectively means that the system is getting less and less funding. If not a full-scale run, it is suffering a severe pinch.

But the most devastating part of the crisis, the part truly threatening a run that would threaten the entire system, occurred in the aftermath of the Lehman Brothers failure. When Lehman Brothers failed, Reserve Primary Fund, a money market mutual fund, was forced to write off Lehman debts that "broke the buck," i.e., caused its shares to fall below $1 (for only the second time in the history of money market mutual funds). This set off a panic by depositors, who had always assumed a money market was as safe as a bank account, and the beginning of a run. And, as everyone knows, the greatest danger of banks runs is that they are highly contagious. A run on money market mutual funds threatened to put an end to major corporations' normal system of financing day-to-day operations, and also threatened day-to-day funding of municipal governments, to say nothing of funding shadow banks. It drove interest rates on commercial paper from 2% to 8%. Desparate, the Treasure Department moved to insure all existing money markets. So far as I can tell, it was the prospect of a run on money markets more than anything else that convinced Chairman Ben Bernanke and Treasury Secretary Hank Paulson to request, and Congress to pass, the TARP.

So just how bad was the withdrawal of funding from the shadow banking industry?

This graph gives a good estimate. Most striking is the explosive growth of the finance industry, particularly since the mid-90's. (Unfortunately, the graph does not give these figures as a percent of GDP). Equally striking is the shadow banking industry's growth, overtaking conventional banking, and then its rapid decline. Its funding has fallen from $20 trillion to about $16 trillion, a 20% drop. Conventional banking, by contrast, has suffered a minimal dip, but definitely an interruption of growth. It should be noted that at their peak conventional banking had total funding of $13 trillion and shadow banking $20 trillion for a total of $33 trillion. Total GDP, by contrast, was approximately $14 trillion, or about half the total.

Around the time of the Savings and Loan Crisis, uncomfortable questions began to be raised about the health of the banking system in general. There was a rise in gallows humor on the subject. "Safe as money in the bank" suddenly didn't seem so reassuring. Cartoons showed depositors opening a bank account telling the bank, "But first I need two forms of ID and a major credit card." Such has not been the case in this financial crisis. "Safe as money in the bank" has, indeed, been a comforting mantra, compared to other things we thought were safe as money in the bank, but weren't.



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