In an article for the Washington Post,
Mark Thoma offers us a peek into a financial system shrouded in
mystery, a "shadow banking system," full of complex financial wizardry,
designed to sap the world of its precious bodily fluids
liquidity. In his view, our current financial malaise is the product
of this shadow banking system, which is itself a financial
Frankenstein perpetuated by secrecy, deregulation, and complexity:
What happened? Deregulation beginning with the Reagan administration combined with financial innovation and digital technology led to the emergence of what is known as the shadow banking system. These are financial institutions that, for all intents and purposes, function just like banks but are not subject to the same rules and regulations and, in some cases, are hardly regulated at all.
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.
In response to these and other unfounded statements, the Atlantic's own Dr. Manhattan pointed out that the most serious threats to the financial system came from actual banks and broker dealers, which were and still are subject to all kinds of regulatory bells and whistles. The good Dr. also pointed out that the bulk of the banks' problems stem from Mortgage Backed Securities collateralized by sub prime mortgages. While MBS are touted as complex financial doodads in the popular press, in reality, these instruments are regulated all the way down the assembly line, from loan origination to issuance.
So what's the take away? The biggest threats to the world's financial system didn't come from the straw man "shadow banking system." Rather, this crisis was the product of heavily regulated institutions buying heavily regulated products. And how did Thoma respond to these allegations? Like a trial lawyer: he ignored the substantive points, and quoted a lot of really famous people who agree with him.
I disagree with your assessment, in part.
The Mortgage Backed Securities (MBS), are regulated when originated at actual banks. Yet, the problems that have been created are as a direct result of unregulated, unmonitored mortgage originators outside the banking system.
A fly-by-night mortgage broker would originate a NINJA loan, sell it to a bank (which arguably, did not do due diligence) and that bank sold it to the Goldman Sachs, Bear Stearns, and Merrill Lynch's of Wall Street. These firms (under no regulation to scrutinize the loans for capacity or collateral) then bundled the mortgages, securitized the bundled mortgages and sold "parts" of the mortgages to investors (including banks). This process, combined with the added pressure of "Wall Street" for banks to increase earnings also led to traditional banks making risky loans.
The reason for the current economic downturn does not rest solely with traditional banks, unregulated mortgage brokers, the investment firms or the rating agencies. Each of these actors played a role in generating the MBS and the CDO (collateralized debt obligations) that would lead to the corruption of so many balance sheets.
At no point could one of the aforementioned actors perpetuate this process alone, but combined, the unconstrained (read: unregulated) excess of all of these actors have proven to be equally responsible.
Dan,
I'm tempted to quote the Principal from "Billy Madison," but I'm not feeling quite that sophomoric today (yet). Your rant is virtually devoid of any fact until your final point, that all actors together contributed to our malaise. Until that last paragraph, you've overgeneralized and blatantly stated things which simply are not true.
Also, I think the overreaching point - and I'm shooting in the dark here - is that Regulated firms were participating in these activities, but due to regulatory ineptitude/indifference and legislative prodding, they were allowed to fall outside the realm of existing regulatory mandates.
Precisely. It's the difference between having authority on the books and actually promulgating and enforcing regulation. Simply because regulators failed to act does not imply that there was inadequate authority.
Dan,
No matter who issues them, MBS, CDOs, et all are securities governed by the securities laws and subject to anti fraud provisions. Mortgages, no matter who issues them, are mortgages, governed by the Truth in Lending Act. The firms themselves are subject to an alphabet soup of regulators, all of which are very much aware of what goes on. I would hardly call that type of system unregulated.
What you state at the end is misleading. That was simply a comment I left quickly when I saw the post so that the false statement made by your colleague would at least have some rebuttal while I worked on a more substantive response.
It is here:
http://economistsview.typepad.com/economistsview/2009/06/blog-posts-that-dont-compute.html
And it explains why the original post by your colleague is wrong. Feel free to update your post so that it is correct. As it stands, it is not.
The rest of the post is just as poorly researched. Do you really believe that "this crisis was the product of heavily regulated institutions buying heavily regulated products"? That's just silly.
I believe my comment captures what The Atlantic contributors are trying to say. The largest screwups/blowups/whatever involved highly regulated entities, and while their un/lightly-regulated subsidiaries may have been a large part of the problem, its a non-sequitur to say the shadow banking system was the source of the problem.
I think you (and Delong) are actually presenting a similar argument as the Atlantic contributors, but everyone is getting all tied up in semantics and technicalities.
The fact of the matter is that, using AIG as an example, their existing regulatory burden incentivized the firm to seek other, less restrictive profits. To claim their existing regulators didn't see this coming or didn't have the power to do anything about it is a cop out, at best. Sure, the Financial Products division severely screwed the pooch, but that's another story (if they had taken appropriate risk management approaches we might not be having this conversation).
You, Prof. Delong, and The Atlantic contributors seem to be suffering from tunnel-vision, arguing whether or not the "shadow banking" system was the straw that broke the camel's back, when that's not even the salient question we should be discussing! I think we can all agree (most?) that the whole system was/is broken, across the spectrum, no? Is it really important that we assign blame like this whole argument seeks to do?
"While MBS are touted as complex financial doodads in the popular press, in reality, these instruments are regulated all the way down the assembly line, from loan origination to issuance."
This really needs to be clarified. How were MBS regulated? CDO's consisting of MBS? CDO's consisting of synthetic MBS? Is "anti-fraud" your only example? Yes people could not lie. But where was the regulation?
As a financial engineer I find all the embedded options in these contracts maddeningly complex to model, however I might just have the sophistication level of the 'popular press.' I'd be very open to hearing an expert explain this to me.
Sorry to double comment, but I think a lot depends if you think the financial crisis began in Summer 2007, or Fall 2008. If you think it is Fall 2008 then this argument definitely makes more sense. I'm the Summer 2007 camp.
Mortgages indeed have the Truth in Lending Act assigned to them, but pretending that the subprime mortgage lenders were indistinguishable from depository institutions on the regulation side is really confusing me.
Mr. Dribble and Mr. Anal,
In response to your comments, if you read my post, what I attempted to do was to describe the process of MBS from origination.
There were two points to be made (and my apologies if they weren't clear) but here:
1) Traditional banks are regulated, but they funded the bulk of the loans used in CDOs and MBS the originations were from outside traditional banking; and
2) There is no regulatory framework for MBS or CDOs as products. They are creations that are traded without regulation or a clearinghouse.
And Mr. Dribble:
The Truth in Lending Act has nothing to do with collateral standards or the repayment capacity of a borrower, those are underwriting guidelines. TILA does not address underwriting.
Thanks for clarifying, let me offer my quick response (quick note: this'll likely be incompletely as I'm in the middle of something).
1. Regulators were in-place, and knew what was going on, they just didn't do crap about it (the "not my problem" sort of mentality).
2. While MBS/CDO/etc trading may not be subject to e.g. exchange rules, there are a number of rules/regulations/etc that apply to them, their valuation, creation, sales, etc.
The point is indifference, blissful ignorance, and gravy-train lovin' on behalf of originators, regulators, enforcers, bankers, traders, investors, EVERYONE, lead to the malaise we're in now. I don't understand all the semantic and irrelevant arguments this whole debate has centered-upon.
Rortybomb, I don't think that the view that the financial crisis started in 2008 is defensible. Here's what I was writing up. (Crossposted at http://syntheticassets.wordpress.com, where links to supporting documents are available.)
I apologize for the length of the post, but we can't fix something until we understand what parts of it are broken.
A timeline of events will help:
March to July 2007: deteriorating subprime culminates in Bear Stearns hedge fund blowups
August 2007 to December 2007: The financial crisis starts with the collapse of asset backed commercial paper (ABCP) markets (which had some exposure to subprime, but mostly relied on companies like Bear Stearns to do quality underwriting). The Fed then released banks to discount issues that they guarantee themselves and within months the market stabilized after falling by $0.4 Trillion. The Fed's Term Auction Facility may have contributed to the stabilization (i.e. banks can now dump their ABCP at the Fed).
NOTE: Asset backed commercial paper is a cornerstone of the shadow banking system. ABCP is how securitizations get financed by money market funds which play the same role as bank deposits in the traditional sector.
March 2008: Bear Stearns collapses largely because 50% of its balance sheet (see page 25 in link) was financed on an ultrashort term basis in repo markets. Bear experienced a banker's bank run that took it down in a matter of days.
NOTE: Whether repo markets are technically a part of the shadow banking system depends on your definitions. They are, however, unquestionably part of the unregulated financial sector that two years ago our regulators were claiming banks could manage on their own. They supported the process by which securitized assets got financed by money market funds, because they allowed investment banks to treat assets in the process of being securitized (i.e. warehoused product) as liquid assets.
Summer 2008: Fannie Mae and Freddie Mac stabilized only after government takeover.
NOTE: This is definitely a case of failure in the regulated sector.
September 2008: Lehman failure disrupts money markets. AIG bailed out. Goldman Sachs, Morgan Stanley rescued by Fed granting them special treatment due to emergency conditions (see p.3 in both docs). Merrill Lynch, Washington Mutual and Wachovia sold to commercial banks.
NOTE: Lehman was a barely regulated investment bank. It demonstrated that banks had so mismanaged the shadow banking system that the banks themselves could fail because of it -- resulting in a generalized flight from commercial paper. Every single one of the lightly regulated investment banks had to be rescued. Highly regulated commercial banks (JP Morgan, Wells Fargo, Bank of America) assisted the regulators in the rescues. Some of largest commercial banks (e.g. JPM, WFC) had spent the last few years foregoing bubble driven profits in order to profit from the coming collapse. None of the investment banks were able to do so without an extraordinary assist from the Fed, which in theory had no business helping them (since the SEC was their primary regulator).
So Charles Davi, I have a question for you: In the absence of the $1.2 Trillion asset backed commercial paper market that made it possible for money market fund investors to finance securitization and in the absence of the multi-trillion dollar repo market, do you honestly believe that we would have had a financial panic in August 2007 and seen the failure of Bear Stearns in 2008 -- in other words, do you honestly believe that this crisis would have taken place anyhow?
The above is bad because of the comma. Try this: http://syntheticassets.wordpress.com/
ACC,
I think we're getting distracted here.
"In the absence of the $1.2 Trillion asset backed commercial paper market that made it possible for money market fund investors to finance securitization and in the absence of the multi-trillion dollar repo market, do you honestly believe that we would have had a financial panic in August 2007 and seen the failure of Bear Stearns in 2008 -- in other words, do you honestly believe that this crisis would have taken place anyhow?"
My point is that this system of SIVs and off balance sheet finance DID NOT TAKE PLACE IN THE SHADOWS OF ANYTHING. Regulators were fully aware of it, had the power to do something about it, and DID NOTHING. How is that a shadow system? It took place in broad day light.
Mr. Dribble,
I defy you to name the regulating agency that oversees, directly, CDOs, MBS, etc. and their valuation, creation, and sales.
The aforementioned products are genuinely unregulated as the contracts, from origination to sales, have no direct have no oversight but by the parties involved.
Acc, the question is your to answer as well.
You DEFY me? BTW, I'm the author of this article. But feel free to call me Mr. Dribble.
It's called the SEC -
here's some on MBS: http://www.sec.gov/news/studies/mortgagebacked.htm
Here's some on CDOs: http://www.sec.gov/rules/sro/finra/2009/34-59733.pdf
My apologies, Mr. Davi.
The second link only shows new (as in April 2009) rules proposed for regulation. So, ummm, what agency was regulating CDOs before this propsed regulation?
The key from the first link:
"In conducting the study, the Task Force reviewed the history and development of the MBS markets, the current disclosure requirements for these securities, and **market-driven industry disclosure practices and standards**." Again I ask, who was the regulating agency prior to this task force?
The other key quote from the SEC study:
"Almost all private-label MBS that are not sold pursuant to a registration statement are sold in the 144A market. Rule 144A, a non-exclusive safe harbor from the registration requirements of the Securities Act, permits resales to institutional investors that meet the criteria for "qualified institutional buyer" ("QIB") of certain privately placed securities. Rule 144A also contains an information disclosure requirement if the issuer of the securities is not a reporting entity under the Exchange Act. Market participants have indicated that the vast majority of private-label MBS, over **98%** in 2001, are sold in registered transactions with the remainder being sold in Rule 144A transactions."
You refer to the SEC as the regulator of this products, and in regulating the language of the disclosures for the products you are correct.
However, I again reiterate my position that the SALES of these products were not regulated by any agency prior to this current economic downturn.
We can certainly agree that regulators were aware of the shadow banking system and, like the banks they regulated, failed to understand its dangers. My objection is to this view: Rather, this crisis was the product of heavily regulated institutions buying heavily regulated products.
(i) the investment banks were not heavily regulated
(ii) the shadow banks themselves (i.e. the SIVs, CP conduits, CDOs, etc.) were not regulated
(iii) repos, swaps and other over the counter derivatives crucial to the operation of the shadow banking system were not regulated
In the absence of unregulated shadow banks financed by ABCP and in the absence of unregulated repos and over the counter derivatives, I am pretty sure that any crisis would not have required extraordinary action by the Fed and Treasury.
Charles Davi:
You are ABSOLUTELY right, there is no such thing as a "shadow banking system." The regulators approved the use every single new vehicle such as SIV, CDO, BCP, Conduits, as well as the creation of the ABX indices (and forced the use of the prices to mark-to-market) and even Super Senior Swaps which received special risk-weight treatment in order to effect "regulatory arbitrage" again condoned by regulators. What passes for the "shadow banking system" exists solely as a consequence of the inept regulation framework known as basel I and II.
Regulators do not "approve" any financial products. Regulators only assess the risk of the products. In that capacity, if a product is deemed to have the potential for adversely affecting a balance sheet, the regulators duty is to note that fact and (when authority is granted) require the institution to account for the risk via capital. No federal regulator can "approve" or "deny" any financial product.
Businesses run themselves, regulator try to assess/stem risk.
They do not "condone" any financial product either.
Just as one example, "regulatory arbitrage" is condoned by regulators, it could not happen otherwise, the one involving super senior swaps exist only a) because the original risk-weighting of assets under basel 1 was too high and b)regulators "assessing risk" required capital for new instrument like super senior swap was too low, repeat: it could not have happened otherwise: full knowledge, cooperation, complicity whatever-you-want-to-call-it of the regulators. What causes credit crisis is people borrowing too much money they can't pay back, this has explanatory power accross the ages unlike the "shadow banking system" narrative fallacy.
jck
If by arbitrage you mean trading the senior swaps, then that's done in the market via actual traders. That type of trading would be reconciled daily as income, not assets.
If by arbitrage you mean the actual balance sheet selling of securities, that market doesn't exist in traditional banks because of the liquidity risk to the balance sheet.
No traditional bank actively (as in daily) trades securities.
Commercial banks, those that actively trade, never trade balance sheet securities either, they hedge a trading pool with either insurance or credit default swaps.
If you would, please clarify your last statement.
super senior swaps are used to reduce regulatory capital requirement (this is known as regulatory arbitrage and is balance sheet related), risk-weighting (decided by the regulators) for super senior swaps is as low as 6% that means capital required to carry the swap is 0.06*0.08 = 48 basis points, instead of the standard 800 basis points required by basel I for all investment grade credits.