Friday, July 6, 2012

How Shadow Banking Affects the Economy (and you)

Few people have ever heard of Shadow Banking, let alone understand how it relates to the banking crisis we’ve been in since 2008. Here I will explain the difference between shadow banking vs. traditional banking and how it is affecting our economy and what it means for wealth preservation.

Traditional Banking
First, let’s describe traditional banking that most people are familiar with. Most people are aware that they make deposits into banks, and those banks in turn, make loans to people seeking capital for car loans, home loans or business loans. Less people understand that banks only need to hold 10% of that money in reserve to pay demand deposits (checking & savings). This is the fractional reserve system that you may have heard about. When you deposit $100 with a bank, they can make $900 of loans keeping your $100 as their 10% reserve. In this way, the amount of money is multiplied by a factor of nine. This is ordinary banking practice. When Banks are short of cash they can borrow either from other banks or from the Federal Reserve on a short term basis.

Shadow Banking
Shadow banking is, in essence, a further expansion of the money supply by making loans on other assets than deposits. This can be Treasuries held (Through Repurchase Agreements, or Repos), Money Markets Funds & assets like loans held on the bank’s books. The securitization of assets that banks once held on their books makes this easier. Those same car loans, home loans, credit card receivables, commercial loans along with commercial receivables are packaged up into a security that can be sold or lent to others. Through the 2000’s I saw these every day working on trading desks. They go by an alphabet soup of names you may have heard before but not understood like:

  • CDO’s – Collateralized Debt Obligations
  • ABS’ – Asset Backed Securities
  • MBS’ – Mortgage Backed Securities
  • CMBS’ – Commercial Mortgage Backed Securities

Some of these are ultra-safe. For example using a US Treasury, lent overnight, for one day’s interest is extremely safe as it’s unlikely the US will go bust overnight. Others, like mortgage backed securities have turned out to be much less safe than they were theoretically thought to be. The point is, that assets that banks once held on their books can be used to further expand their liquidity as well as the money supply the same way that a bank can make $900 of loans out of your $100 deposit. 

Here’s the big difference, The Federal Reserve can tell the banks they must have a 10% reserve on their deposits but they have no way of regulating shadow banking. In this way, the banks can rehypothicate (lend an asset to another) over and over again without a Federal regulator limiting the degree or number of times that an asset is rehypothicated. In this way, banks can leverage up much higher than they can of their deposits. Lehman was leveraged about 37 to 1 on their mortgages, nearly four times higher than they could under regular banking regulations. The only limitation to this leveraging by banks is the confidence between one bank and their counter-party. 

Through these methods, banks were making record profits by leveraging up outside of the normal banking regulations. This is what is often referred to as the financialization of the US economy. Once Lehman’s counter-parties lost confidence in Lehman, they refused to trade with them, even on an overnight basis. The result was a liquidity crisis and  was catastrophic for Lehman, but also for other banks who now questioned every other bank’s strength. Shadow banking had allowed the economy to expand with an artificial expansion of the money supply. When banks no longer trusted each other the liquidity the shadow banking system supplied, evaporated almost overnight. It was like taking hundreds of billions or even trillions out of the money supply in just a few days. This was the reason for the systemic failure that almost brought down all of the banks.

Of course, the entire shadow banking was curtailed but did not entirely go away. It has, however continued to decline, and with it, much of the liquidity that was once in the system. It also reduced the money supply. 

In comes Bernanke
Through a number of programs, Bernanke and the Fed have been expanding the money supply to counter act the shrinking banking system. This is part of the reason that despite pumping several trillion into the US economy we have seen only moderate levels of inflation (though still higher than what is reported). As you can see from the graph below, the shrinking shadow banking system continues to decline.

Remember, all those trillions are going to banks, not consumers. So although that money is keeping banks afloat, it is NOT stimulating the economy. Meanwhile, since the money supply has been debased by printing, the dollars are worth less resulting in higher food and gas prices. Remember in my previous post with John Williams of Shadow Stats that the “stimulus” was a bank bailout and that the banks are still impaired and not making loans. Williams believes that hyperinflation will come eventually, probably once the shadow banking finishes its decline.

So we have a situation where we simultaneously have both inflation and deflation. It’s the worst of all possible outcomes. No economic recovery. Declining home values. Higher costs for consumables.

All of this means it’s harder to get a loan, the US dollar is being devalued and wealth is being destroyed.

I only know of one asset that can protect wealth….

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