The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.
(Emphases added.)
Which entities' failures and near-failures required TARP and other system-saving emergency programs again?
]]> I don't want to be too hard on Prof. Thoma: his second sentence is correct, assuming the definition of "shadow banking system" encompasses Subprime Mortgage-To-Go (which offers drive-thru!). But unlike Long-Term Capital Management's meltdown in 1998, the systemic breakdowns we have been experiencing over the past 18 months have been caused by problems at the major banks (even the former investment-only banks which weren't regulated by the Fed or FDIC cannot be called part of the "shadow banking system"), AIG (regulated by the state insurance commissioners, even if they'd rather you didn't remember) and let's not forget Fannie and Freddie, which had their own regulator. (And the most acute phase of the crisis was touched off by the Reserve Primary Fund's "breaking the buck," even though money market funds are among the most stringently regulated entities on earth.) Only when the products of Subprime Mortgage-To-Go were thoroughly integrated into the activities of these heavily regulated institutions (and sometimes even acquired in full by them; just ask Wachovia and Merrill) was the stage set for the financial crisis. By contrast, though numerous hedge funds have failed, some people are beginning to look longingly at the sector as one in which even major players can fail without touching off a systemic meltdown.This isn't necessarily an argument against extending regulation to the "shadow banking sector," but we should be on guard against any tendency to assume that the job has been done when a previously unregulated activity now has a regulation applied to it. In reality, that is when the work begins.
]]>Geithner:
The shadow banking system has been implicated as significantly contributing to the financial crisis of 2007–2009. In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the shadow banking system by their couterparties.
Nouriel Roubini:
Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders. ...
A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.
The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. " ...
[these are his five steps top the crisis - step on is, drum roll please, problems in the shadow banking system]
Bill Gross:
What we are witnessing is essentially the breakdown of our modern-day banking system...My Pimco colleague Paul McCulley has labeled it the "shadow banking system" because it has lain hidden for years, untouched by regulation, yet free to magically and mystically create and then package subprime loans into a host of three-letter conduits that only Wall Street wizards could explain.
Krugman:
As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible--and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank.
It goes on and on - I'm comfortable with the assertion - most analyses say the same thing, it was the shadow banking system (with only a few exceptions).
So it's the title of the post and your argument that doesn't compute.
]]>"And I would stand by the argument that it was the toppling of the heavily-regulated actors - e.g., Fannie/Freddie, Lehman, AIG - which set off the most systemically-risky phase of the crisis, as opposed to the numerous hedge funds which have gone under in the last year. Those two facts, to me, count as "problems in the traditional, regulated sector of the financial industry.""
First of all, you name three completely different types of entities. Fannie and Freddie were obviously government-sponsored and regulated by OFHEO (now HUD). Lehman was an investment bank/primary dealer falling under the consolidated supervised entity program of the SEC. And AIG was an insurance company with numerous subsidiaries performing all sorts of financial activities.
Second of all, your grouping of these 4 entities is nonsensical. Fannie and Freddie were heavily regulated. But to claim that Lehman and AIG were heavily regulated is pretty low-information, particularly for the Atlantic. No one claimed, either contemporaneously or ex post facto, that the SEC's regulation of the CSEs was "heavy". Even at the time, it was seen as "regulation light". If you had done any due diligence, you'd have known that the CSE program (under which Lehman was regulated) was voluntary, and in fact not implemented until 2004. To call this heavy regulation or "the traditional, regulated sector of the financial industry" is pretty unbelievable, particularly given that you're writing for the Atlantic. AIG was regulated by a hodgepodge of regulators, most of which were again seen as regulation-light or non-existent regulation. State insurance regulators regulated certain AIG subs, while OTS regulated one registered thrift. No regulator had jurisdiction over the whole of AIG, and in fact the primary source of losses, AIG FP, was based in London. To use AIG as an example of "heavy regulation" is just mind-boggling. AIG is a primary example of the shadow financial system, and how supposedly regulated entities created a series of unregulated entities to conduct a slew of banking-like activities which were the major cause of the financial crisis.
Finally, your citation of Fannie and Freddie betrays your partisan leanings. No credible expert claims that F/F caused this crisis-- that's for the libertarians to throw out there as a bogus talking point. F/F default rates have been exponentially better than private label MBS (the unregulated kind that drove the shadow banking system). And F/F didn't even get into the dodgier stuff until 06/07, primarily because at that point they were seeing the outstanding returns that the unregulated products were delivering, and convinced their regulators to allow them some forbearance. In other words, F/F got in trouble because they convinced their regulators to allow them to dive into the unregulated shadow financial markets!
To claim that this crisis was caused by the "most heavily-regulated actors", citing 4 actors, 2 of which are bogus, and the other 2 of which were prime examples of how lightly/un-regulated activities drove this crisis, is just incredible. Dr. Manhattan indeed.
]]>"The following is a letter sent on Tuesday by Jake DeSantis, an executive vice president of the American International Group’s financial products unit, to Edward M. Liddy, the chief executive of A.I.G.
DEAR Mr. Liddy,
It is with deep regret that I submit my notice of resignation from A.I.G. Financial Products. I hope you take the time to read this entire letter. Before describing the details of my decision, I want to offer some context:
I am proud of everything I have done for the commodity and equity divisions of A.I.G.-F.P. I was in no way involved in — or responsible for — the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.-F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage."
I think you are confusing unregulated products (CDS, for example) and new processes with ineffectual regulation (mortgage securitization,for example) with with established, old-line financial businesses and services. Unfortunate considering your visibility and branding.
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