Hi Dad.
I saw this article “Shadow Banking: What is it, How it Broke and How to Fix it” which features a short (1 page) concise interview with Barnard College Professorof Economics Perry Mehrling, an economist who specializes in the Economics of Money and Banking regarding the “Shadow Banking System” i.e., that part of our financial system that created a market for the securitization of bank loans and then developed the various derivative instruments, such as credit default swaps to supposedly insure against the risk of default. As I understand what he’s saying, the problem was less the issue of the sub-prime loan market which was never larger than $400 billion, but the system that was created to spread the interest risk and the default risk of traditional bank loans of all types. The interest risk was supposedly dealt with through the bundling of various types of loans that banks made (the securitized loan instruments also known as collateralized debt obligations) and the interest risk was dealt with through the sale of credit default swaps (CDS) and similar instruments provided by large insurers like AIG, but also by many of the investment banks on Wall Street as well who had their own insurance subsidiaries.
As Mehrling explains, individuals like Fischer Black of Goldman Sachs and the others who pioneered the creation and use of these instruments did so for the purpose of making the credit markets more efficient, i.e., making credit cheaper by passing on the risk of interest losses and defaults to the large institutional investors who could best calculate the risk and absorb the losses, if any that might result. After the debacle of the S&L crisis where smaller banking institutions paid for their incredibly ill informed assessment of loan risks, you can see why then use of securitzation and default risk insurance seemed like a good idea. It turned traditional banks onto loan originators, who then sold those loans and the associated risks to a larger, unregulated credit market. The idea was that these large Wall Street firms wouldn’t make the same mistakes that the smaller banks had made in assessing risks, that securitization would spread the risk, and that the Government would not have to be on the hook for so much of the risk like they were during the 80’s.
Unfortunately the big firms and Insurance companies did a poor job of risk assessment because after the Tech stock boom and crash in the 90’s they went looking for another market to provide “products” to sell to their customers. CDO’s insured by CDS’s looked like a great investment product precisely because previously it hadn’t been as volatile a market as the stock market. However, there was a reason for that. Until Wall Street moved into the business in a big way after 2000, that market increased dramatically. In addition, besides regulated banks which has previously been the being the primary loan originators, there was now a great deal of competition from the new mortgage brokerages like Countrywide, who weren’t subject to the same limitations that traditional banlks were in terms of qualifying people for loans. And lots of loans were what the “shadow banking system” needed in order to create the products it sold: CDO’s and CDS’s. So risk assessment took a back seat to originating more loans, and finding ways to make those securitized loans look safer than they were through the use of Credit Default Swaps. Here’s a more succinct explanation of what happened from Professor Mehrling:
The traditional banks became an originator of loans which they packaged, securitized, and then sold to the shadow banking system, which then raised funds in the money market from mutual funds and asset-backed commercial paper that they issued to whomever. It was avoiding the traditional banking system entirely in this regard, and also avoiding all the regulation of the traditional banking system as well as all the regulatory support of the traditional banking system.
But of course it had the same risks. You aren’t actually getting rid of liquidity risk or getting rid of solvency risk; you are just moving them into a different place.
According to Professor Mehrling, the problem arose in large part from the formulas that were devised to calculate the premiums paid for the CDS’s to insure the risk of default. Those formulas failed to take into account the liquidity risks of these derivatives:
[T]hat is, the chance that you will be not be able to trade an asset before taking a loss. (quoted from Prof. Mehrling)
The assumption was that these new markets would always be liquid. Unfortunately, as we discovered that was not the case. And because there was no lender of last resort outside the private system. Unlike banks, who use the FED as a lender of last resort, and whose depots are insured by the FDIC, there was no similar structure in place with the shadow banking system. Quoting Mehrling:
The assumption that liquidity will always be there is just an assumption. And this is my argument, that this is really what happened, and why things became so brutal: That there was no organized lender of last resort for the shadow banking system. The shadow banking system really depended on the traditional banking system as its lender of last resort, and the traditional banking system depended on the Fed, but the Fed had no direct link.
If there had been a regulatory scheme in place, the FED and whoever regulated the sellers of credit default swaps would have required these institutions to set aside reserves for the risks involved, which would have required higher premiums for the CDS’s and probaly lower returns on the CDO’s (as well as a more accurate rating of the CDO’s themselves). You see, the CDO’s were being rated AAA becuase they were insured by CDS’s issued by AIG or the insurance subsidiaries of Lehman Brothers, Merill Lynch, etc. However, it was a phony rating, because the CDS sellers did not have the capital reserves to cover their potential losses, nor were they charging an appropriate premium for the “insurance” they were providing. All because the formulas used to justify these instruments made the assumption that liquidity would never be an issue.
In short, they bet that the loans being bundled into securitized debt obligations would not incur those kinds of losses from defaults because the real estate markets would continue to rise. Obviously, they failed to learn anything from economic history. Whenever you create a bubble in any commodity (and these CDO’s were essentially a commodity because they were tied to the price of real estate) you run the risk of that bubble inflating too fast because the inflation in price is being driven by excessive speculation in the market place.
They (and I mean by “they” I mean traditional economists, politicians, investors, risk assessment managers, ratings agencies, bankers and insurance company executives) assumed all along that the smart guys on Wall Street and at the big insurance mega-corporations, who understood risk so well in so many other areas of finance, would understand it in this newly created market for securitized debt obligations. But of course they had no incentive to understand that risk, and no real long term market history to rely upon since the market for collateralized debt obligations was a relatively new one. It had only rally been created in the last 30 years, a drop in the bucket in economic time. Without any trend lines from past markets to guide them, and with a market that had exploded in growth exponentially over the last ten years, they were operating in uncharted waters. The assumption they all made was that the real estate bubble would continue for the indefinite future. The Federal Reserve under Alan Greenspan was keeping its rates low, pumping money into the economy, and with real estate loans (from construction lending to end user mortgages) being the easiest place to put that money to work, real estate prices continued to rise. Until, of course, they burst like all previously artificially created financial bubbles from the Tulipmania of the late 1500’s in Holland, to the South Seas Scandal of 18th Century England, to the stock market bubbles of the Roaring 20’s, and to a lesser extent the late 90’s. Indeed, as Professor Mehrling notes, they had a hard time believing the good times would ever stop rolling even when AIG stopped issuing credit default swaps for these CDO’s:
Once AIG stopped writing insurance, the game was really over, but it continued to run for quite a while. One thing that happened, and we know this from the UBS shareholder report, is that UBS started to say if AIG isn’t going to sell us insurance at this cheap rate, we are going to make a plan to buy just 2% insurance and then make a plan to do “dynamic hedging” ourselves, which is a problem. That means when the price goes down, we sell, assuming that there would be a buyer on the other side.
Of course, in the end there were more sellers than buyers, and like all bubbles, this one burst as well. And all these securitized debt instruments, which had been sold as the “safest of safe” investments were exposed as the highest risks out there. Unfortunately by that time ot was too late. AIG, Lehmann Bros., Merrill Lynch, etc. were in too deep. Never having anticipated that the market for their products would crash because the artificial boom in real estate they had helped to create by keeping credit cheap and ignoring the risks involved regarding (1) who was recieveing all that easy credit under the relaxed standards they helped make possible, and (2) the realistic value of the assets (homes, malls, etc.) which ultimately supported those loans, they did not have the cash reserves available to make good on their obligations.
Why? Because they had no idea how to value those assets properly, had not accurately priced the CDO’s and CDS’s they sold and therefore had not set aside sufficient reserves to cover this risk. And why should they have? They were under no obligation to do so. When they’re are no rules to be broken anything goes. Unlike the traditional banking system they were free to make up the rules as they went along. The result was so cataclysmic that even President Bush and his economic advisers, including Secretary Henry Paulson, former Fed Chief Alan Greenspan and current fed Chief Ben Bernanke, understood that something had to be done in the Fall of 2008 to prevent the complete collapse of our financial system. We let Wall Street treat the market for derivatives like a casino and they gambled big, and they lost big. Bush and Obama and the Fed bailed them out not because they wanted to, but because they had no other option. One can argue about the particulars of how each of them have managed the funds distributed under the various bailout programs, but regrettably not the reason for having to have a bailout in the first place. Failure to act would have resulted in a far worse economy than the one we are struggling under now.
In any event, I hope you take a look at Mehrling’s interview. It’s one of the best explanations of how this market in collateralized debt obligations came to be, and why it crashed as it did that I’ve read anywhere from someone who has made it his career to study these matters. And it’s a lot shorter than my email.
Love,
Steve