What's Up With This Spooky "Shadow Banking' System?

The St. Louis Federal Reserve Bank has just issued a paper asking the question, "Is shadow banking really banking?" In the report Economist Rajdeep Sengupta and research associate Bryan J. Noeth give a clear description of what defines a bank and whether the infamous 'shadow banking' system that reportedly helped cause the financial crisis qualifies as banking. By their definition, banks are "intermediaries that obtain funds from lenders in the form of deposits and provide funds to borrowers in the form of loans." The purpose of banking, according to Sengupta and Noeth, is what they call "maturity transformation." Those who deposit funds with banks prefer to be able to access their funds in fairly short windows. Borrowers, however, need much longer maturity horizons to fit their funding needs. That's where a bank comes in. Since banks hold funds from a large swath of depositors, they are able to lend out much of that money knowing that only a small fraction of depositors will actually need to access their cash at one time.

The shadow banking system, according to the report, is a much more complicated process, but one that essentially serves the same function. The shadow banking system is the venue whereby financial insitutions securitize and sell off debt through off-balance sheet constructs called "special purpose vehicles." A bank will sell their loan to a shell company that has no other purpose other than to hold those loans. These shell companies are "bankruptcy remote," meaning their financial health can't affect the financial health of the company that sells it the loans and vice versa. From this special purpose vehicle, the securities are then sold to investors. In this model, companies or mortgagors issuing debt are the borrowers, and investors like pension, hedge or mutual funds are the lenders. Essentially this is just like our traditional banking system, just a little more complicated.

The report concludes, "The reader may question the rationale behind the development of the shadow banking system and all its components. While some analysts have asserted that the shadow banking system is redundant and inefficient, it is not difficult to see the benefits of securitized banking. Securitization allows for risk diversification across borrowers, products and geographic location. In addition, it exploits benefits of both scale and scope in segmenting the different activities of credit intermediation, thereby reducing costs. Moreover, by providing a variety of securities with varying risk and maturity, it provides financial institutions opportunities to better manage their portfolios than would be possible under traditional banking. Finally, and contrary to popular belief, this form of banking increases transparency and disclosure because banks now sell assets that would otherwise be hosted on their opaque balance sheets."

There appear to be several benefits of securitization and the use of special purpose vehicles. I addressed securitization in my first post, but let me explain why these special purpose vehicles might create value. If a financial institutions buys a bunch of loans and then chops them up and securitzes them, anyone who buys that security has to worry not only about the credit risk of the initial issuer, but also about the health of the financial institution that is securitizing these loans. Placing those securities in a bankruptcy remote special purpose vehicle, possibly one that is insured, will relieve that extra layer of risk and make it cheaper for issuers to borrow money. While this maybe a real benefit of these accounting constructs, I would have liked to have seen more attention paid to the potential abuses of these SPVs. After all, it was special purpose vehicles that aided Enron in its fraud a decade ago. Also, financial institutions used these special purpose vehicles to get loans off their balance sheets and therefore avoid regulatory requirements dictating they hold a certain amount of capital in reserve to back up loans. I would have liked to have seen these concerns addressed. All in all, however, the report is a good explanation of what the shadow banking sector is and how it mimics traditional banking.

Who Regulates Whom?

The Chicago Federal Reserve Bank's website has just posted an updated picture the US regulatory authority over payment, clearing, and settlement systems. It is a hot mess to say the least, a visual representation of why some are calling the Dodd-Frank law too complicated. Then again life and our financial plumbing are pretty complicated too.

Some definitions:

• A payment system is just what it sounds like: a way to transfer funds from one party to another.
• A clearing system, or clearinghouse, is an organization that takes on "counterparty risk" in a given transaction. If Party A sells a good to Party B through a clearinghouse, the clearinghouse vouches for Party B's ability to pay up.
• A settlement system is one whereby the actual good is transfered from one party to the next.

As you can imagine, the health of these organizations are vital to the proper functioning of the financial system as a whole.

Get Yo Links: Bankers don't like Dodd Frank, Rick Perry Thinks Pre-Crisis Regulation was Satisfactory

The November cover story of American Banker has some very unflattering things to say about the Dodd-Frank legislation. The nearly 4,000 words piece takes aim at the legislation, arguing that the law places undue burdens on smaller community banks, and that the long drawn out rule making process, that isn't even halfway complete nearly two years after the law's passage, is creating uncertainty that is hostile to the banking business. One of the more interesting complaints from bankers interviewed is that regulators are taking too much of a quantitative approach to determining the soundness of loans, as opposed to evaluating each loan on a case by case basis. With all the extra regulators on board at the FDIC, you would think this would be easier to do. American Banker doesn't press the regulators on this. Frankly it doesn't give many opportunities for regulators or law makers to respond to bankers concerns, either.

While Rick Perry was on CNBC unveiling his new flat tax, he took the time to say he believes financial regulation, pre-crisis, was adequate. This new line of thinking from Republicans is something I expect we'll see more of as the events of the financial meltdown fade in people's memory (even if the effects of said meltdown don't).

Time magazine has a new piece up about the much ballyhooed Volcker Rule, which in its simplest form forbids deposit taking institutions from speculative trading on their own accounts. Paul Volcker, the former Federal Reserve chairman for whom the rule is named, has turned against the iteration of the rule passed in the recent Dodd-Frank legislation. He argues it contains too many loopholes. This piece gives a nice explanation of how all those loopholes got in there.

Federal Reserve Officials have been increasingly vocal about their willingness and ability to further stimulate the economy. Many Wall Street Watchers are seeing this as a sure-fire sign that more quantitative easing is on the way. Quantitative easing is a process by which the Federal Reserve buys United States treasury bonds, bidding up the price of those bonds, and therefore bidding down the interest rate at which the U.S. government borrows. Since most interest rates are based off of what the U.S. government pays, this will theoretically lower borrowing costs for individuals and businesses, giving them extra cash to spend. Giving consumers and businesses more cash will help stimulate the economy. Others fear that this will put too much extra money into the system and lead to escalating asset prices, otherwise known as inflation.

GAO Report Tackles Conflicts of Interest at the Federal Reserve

The Government Accountability Office released a report Wednesday which studied conflicts of interest and diversity amongst Federal Reserve Officials. Though the 127 page GAO report didn't accuse the board of corruption, it does warn, "directors' affiliations with financial firms and former directors' business relationships with Reserve Banks continue to pose reputational risks to the Federal Reserve System."

The report points to the example of Stephen Friedman who was chairman of the New York Federal Reserve in 2008, when Goldman Sachs applied to become a bank holding company in order to receive cheap loans from the central bank. At the time, Friedman was a shareholder and board member of Goldman Sachs. The New York Federal Reserve sought a waiver to allow Friedman to remain president even though normal rules would have prevented this arrangement. The waiver was granted on the logic that finding and installing a replacement in the middle of a banking crisis would be difficult and potentially harmful to the economy. In January of 2009, an "automatic stock purchase program" triggered Friedman's purchase of additional stock in Goldman. The backlash from this forced his resignation.

The politics surrounding the Federal Reserve are tricky in the best of times. During crises, people get a bit more worked about about this institution, to say the least. Ironically, the Federal Reserve's main purpose is to steer the national economy through times of crisis.

Financial markets are basically a virtual crowd of people. And no matter how rational an individual human being is (and individuals' rationality is certainly up for debate), we all know that crowds are given to bouts of irrationality, especially when fear is involved. If everybody believes that credit is about to freeze up, nobody will be willing to lend any money. This becomes a self fulfilling prophecy.

English economist and journalist Walter Bagehot famously called the British central bank the "lender of last resort." This description has survived until today as a succinct description of a central banks role. When nobody else is willing to lend, The Federal Reserve, America's central bank, should continue to lend to institutions that are solvent. This, theoretically, will prevent unnecessary financial turmoil brought on by the vicissitudes of financial "crowds."

This is all well and good in theory, but in practice it can get kind of messy, as the past few years have shown. For a central bank to be effective in a democracy, it must be insulated from quickly shifting political winds. If representatives had direct control of the bank, they would be tempted to use the institution to goose the economy in the short term, sacrificing stability for gains that might help them electorally. In addition, central bank actions must be swift and decisive and avoid the gridlock of representative democracy.

However, when an institution is so insulated from popular oversight, there is plenty of room for actual or perceived corruption. The Federal Reserve is a fairly complex system made up of a board of governors and several regional banks each with its own boards. The Federal Reserve has 7 member Board of Governors appointed by the President and approved by the Senate. The regional banks have boards of governors themselves, 2/3s of which are elected by the member banks in their respective regions. There are three classes of boards of governors of the regional banks, one of which can be affiliated with financial institutions regulated by the fed, and two of which cannot. All are supposed to have knowledge of the economy and financial system, for obvious reasons.

The main issue here is that those who are most expert in financial system are those who have gained and stand to gain substantially from the financial system. The GAO report acknowledges this, and its solution is basically more transparency. Transparency can stem temptation to abuse the system by its officials, and it can assuage the fears of critics who believe the system is being abused. Reform will be a delicate process, but considering Washington isn't accomplishing much these days, it may be a while until we see any changes at all.

GET YOUR LINKS! Bernanke, Tarullo, and the Volker Rule

The Washington Post is reporting that Fed Chair Ben Bernanke met with Senate Democrats. He spoke about the European debt crisis as well as the housing market here in the US. Virginia Senator Mark Warner was quoted as saying that much of the conversation entailed "the growing recognition from everyone -- economists across the board -- that there needs to be some more dramatic action in housing."

The AP is reporting that Daniel Tarullo, a fed governor is calling for the Fed to buy more Mortgage Back Securities to help lower interest rates.

Bloomberg News Editorial Board takes on bankers arguments against the Volker Rule. The Volker rule essentially stops federally insured banks from speculating on assets using their own money. The Federal Reserve recently proposed a version of the rule as part of the implementation of the Dodd-Frank financial reform legislation, which was passed in December of 2009. The rule has come under heavy criticism from the financial services industry.

Securitization and the Financial Crisis

One of the first narratives to emerge in the wake of the financial crisis was that the collapse of the global financial system centered around mortgage securitization. Banks handed out mortgages to homeowners and then sold those mortgages to large financial institutions like Fannie Mae and Freddie Mac, who then pooled these mortgages into "mortgage backed securities" (MBS), and sold them to investors. But the with the loans completely off the banks' books, those institutions didn't care whether the loans were any good. If there was a default, it wasn't any skin off their back. Their business was originating mortgages and collecting fees from subsequent sales.

Lets pause first to explain why securitizers like Fannie Mae and Freddie Mac wanted to purchase these loans and what the appeal of MBS was and is to investors. A single mortgage is a fairly risky investment. It's difficult to know whether a person will be able to make regular interest and principle payments. Even if a local bank diversifies this risk by issuing many mortgages in the local community, that bank is still betting that the local economy will hold up. The factory in town closing could cause a large number of the mortgages to go bust. However, if a national organization can buy up mortgages from all across the country, and then chop those mortgages up into bits and paste them together, so that one security represents cash flows from many mortgages, then geographical risk is neutralized. With this new mortgage backed security, the number of investors willing to back home loans increases greatly. This lowers borrowing costs from consumers.

However, even these mortgage backed securities have unique types of risks that other investments like a corporate bond don't have. For instance, when corporations borrow money by issuing bonds, there are often restrictions on paying back that money. This is so an investor can have some amount of certainty as to the returns from an investment. If an investor lends money by buying a 20 year bond, they want to be able to expect interest payments from 20 years and to get back the principle at the end. If the borrower pays back the money early because interest rates have fallen, now the investor didn't get the return or yield they expected to get, and they also have to reinvest their money at a lower interest rate. This uncertainty isn't acceptable for investors who have certain liabilities they have to meet on a regular basis (think pension funds). But as we all know, when you take out a mortgage, you have a great degree of flexibility as to when you can pay it back. If you move, or interest rates drop, you can pay back your mortgage. To help create more certainty for investors in mortgages, securitizers will create what is called "collateralized debt obligations," which is basically a further chopping up of these mortgage backed securities so that the cash received from these investments pays out more certainly. For instance, one "tranche," or portion, of this CDO, will receive all of the principle payments (any unexpected prepayments) before the second tranche, and so on.

These processes are very complex and to the average reader of news post-crisis, they seemed unnecessarily complicated. It's logical to the average man on the street that if a bank doesn't suffer if a mortgage they issue fails, then they have no incentive to vet those mortgages properly. One of the more memorable journalistic explanations of this phenomenon was an NPR production called The Giant Pool of Money. And there was academic research that backed up the claims of reports like this. A 2008 paper called "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans" by Benjamin Keys, Tanmoy Mukherjee, Amit Seru, and Vikrant Vig, argued that this processes explained above led to less vigilance on the part of issuers. But it seems that the academic debate on this subject isn't quite settled. (Are the academic debates ever settled?) In a new post on the Harvard Law Blog, Ryan Bubb, Assistant Professor of Law at NYU and Alex Kaufman, economist at the Board of Governors at the Federal Reserve, take aim at the narrative of securitization causing the crisis.

I'm certainly not qualified to arbitrate this discussion, but I do think its important that journalists and other observers of the regulatory system stay abreast. Its very easy to fall under the sway of a convincing narrative and then to stop considering its validity. I am convinced, however, that journalists did a poor job of explaining the benefits of securitization. Many chalked it up as simply a fee manufacturing machine for big financial institutions. No doubt, Wall Street made truckloads of money of this process, but its important to understand why sophisticated investors wanted these securities and how it helped them manage their liabilities. Only then can we properly critique the system and aid in the process creating a good regulatory structure.