The Financial System (STILL?) Lurking in the Shadows

As expected, these guys let Bush off the hook. And all his financial henchmen. I mean, he was only President. He can't be expected to do a good job in everything.

David Weidner's Writing on the Wall May 19, 2009, 12:01 a.m. EST The Financial System Lurking in the Shadows NEW YORK (MarketWatch) -- What or who exactly caused the banking crisis? Was it the banks? The bankers? The borrowers? Did the government fail? Like torture, can we blame it on former President Bush and just move on? It seems everyone had a role in the biggest financial and economic disasters since the Great Depression. Though degrees of guilt vary, it is a rare economic collapse where everyone in society doesn't have some kind of role. This time around, however, one party seems particularly culpable. It's what has come to be known as the "shadow banking" system. Loosely defined, the shadow banking system is the group of non-bank institutions that are doing a whole host of banking functions. They lend, and they take collateral. We know them as pension and hedge funds, investment banks, structured investment vehicles and various insurance companies. During the last 20 years, as the economy has hungered for more credit, the shadow banking system has provided the meat. As the nation searches for remedies and reforms, shadow banking is under new scrutiny. No one agrees on how to regulate or reform what's in the shadows, but they do agree that we can't approach it as we have before. Banks aren't just banks. Hedge and pension funds, insurance companies aren't always what they seem either. Put it this way, a couple of years ago most of us thought American International Group Inc. was an insurance company, not one of the biggest credit-default swap players on Wall Street. New research by Gary Gorton, a finance professor at the Yale School of Management, shows not only how the shadow banking system has grown but how it's truly the main culprit of the credit collapse. Gorton knows how financially deadly shadow banks can be. He advised AIG's credit default swap unit. See full story (unfortunately, subscription necessary at this moment, but it's sure to hit the tubes soon). Gorton argues that shadow banking is "at the heart" of the financial crisis in his research in a paper "Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007" last week at the Federal Reserve Bank of Atlanta's Financial Markets Conference. Gorton argues that the recent financial crisis was really a banking panic in which banks, both in the shadows and in the light, were unable to meet their obligations. A $6.2 trillion giant Judging by the numbers, the shadow banking system was big enough to trigger such a panic. Speaking last summer, then-New York Federal Reserve Bank President Timothy Geithner described the scale of what he called the non-bank financial system. He said that before the crisis hit in early 2007, non-banks had asset-backed commercial paper conduits, structured investment vehicles, auction-rate preferred securities, tender option bonds and variable rate demand notes, with a combined asset size of roughly $2.2 trillion. Assets financed overnight in so-called tri-party repurchase agreements, or repos, grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then-five major investment banks totaled $4 trillion, he said, making a total of $6.2 trillion in non-bank assets. Geithner pointed out that the top five bank holding companies, in comparison, had just over $6 trillion in assets, and total assets of the entire banking system were about $10 trillion. In short, the unregulated shadow banks became huge and powerful, amassing huge amounts of short-term Wall Street debt. Building on this, Gorton shows that as confidence in some of these securities eroded, the credit squeeze cascaded through the banking industries, both shadow and recognized, not unlike the way margin calls triggered the stock market crash of 1929. Specifically the market for repurchase agreements, which are contracts to buy financial assets such as Treasurys, got squeezed. More than $2.7 trillion in contracts failed in October, sending real banks in search of capital. Appropriate reform In a way, the collapse triggered by the non-banks was the kind of panic real banks have been inciting and fighting for centuries. Gorton believes we are at a crossroads when it comes to preventing crushing market panics caused by shadow banking. "What these reforms will be depends on who controls the narrative of the crisis," Gorton wrote me in an email. "If the narrative is that 'a reckless few gamed the system' then the focus will be on compensation - and credit derivatives only because they have been smeared." Gorton believes the government would do better to recognize that shadow banks are indeed banks because they provide credit to the system, not an easy idea to digest. Geithner, who as Treasury Secretary has moved on to greater things, was one of the first to recognize the impact of shadow banks. Along with Ben Bernanke, the Federal Reserve chairman, Geithner has talked about a systemic risk regulator that would look at any institution, regardless of how it's chartered, and assess its threat to the system. He hasn't talked about regulating shadow banks as banks. But Gorton is hopeful. He thinks regulators are well aware they need both kinds of banks in the system. "They're working on it," Gorton said. After every panic, they always do. David Weidner covers Wall Street for MarketWatch.

They're working on us all right. Suzan _______________