Friday, January 23, 2009

On the Demise of Banking in the Shadows

In his new book, The Return of Depression Economics and the Crisis of 2008, Paul Krugman, recent recipient of the Nobel Prize in economics, explains how the sub-prime mortgage crisis put the world on the brink of depression:

As the severity of the housing bust sank in, it became clear that lenders would lose a lot of money, and so would the investors who bought mortgage-backed securities. But why should we cry for these people, as opposed to the homeowners themselves? After all, the end of the housing bubble will probably, when the final reckoning is made, have wiped out about $8 trillion of wealth. Of that, around $7 trillion will have been losses to homeowners, and only about $1 trillion losses to investors. Why obsess about that $1 trillion?

The answer is, because it has triggered the collapse of the shadow banking system. (p. 169)
I didn't know about this shadow banking system. Did you? Here's what Krugman says about the banking system that operated in the shadows:
An arrangement known as an auction-rate security, which was invented at Lehman Brothers in 1984 . . . became a preferred source of funding for many institutions . . . The arrangement worked like this: Individuals would lend money to the borrowing institution on a long-term basis; legally, the money might be tied up for thirty years. At frequent intervals, however, often once a week, the institution would hold a small auction in which potential new investors would bid for the right to replace investors who wanted to get out. The interest rate determined by this bidding process would apply to all funds invested in the security until the next auction was held, and so on. If the auction failed -– if there weren’t enough bidders to let everyone who wanted out to leave -– the interest rate would rise to a penalty rate, say 15 percent; but that wasn’t expected to happen. The idea of an auction-rate security was that it would reconcile the desire of borrowers for secure long-term funding with the desire of lenders for ready access to their money.

But that's exactly what a bank does.

Yet auction-rate securities seemed to offer everyone a better deal than conventional banking. Investors in auction-rate securities were paid higher interest rates than they would have received on bank deposits, while the issuers of these securities paid lower rates than they would have on long-term bank loans. . . .

Banks are highly regulated; they are required to hold liquid reserves, maintain substantial capital, and pay into the deposit insurance system. By raising funds via auction-rate securities, borrowers could bypass these regulations and their attendant expense. But that also meant that auction-rate securities weren't protected by the banking safety net. (pp. 158-159)
By now, everyone knows about the "shadow bank" run at Lehman Brothers and the other "investment banks" last fall. Krugman quotes Timothy Geithner, president of the New York Federal Reserve Bank and currently Obama's nominee for Treasury Secretary, about the size of this unregulated "shadow banking system" in relation to the regulated banking system that operates in the open:

In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable demand notes, had a combined asset size of roughly $2.2 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks [the shadow banking system] totaled $4 trillion.

In comparison, the total assets of the top five bank holding companies in the United States [the banking system that operates in the open] at that point were just over $6 trillion. (p. 161)
Krugman then explains why the tools the Federal Reserve and the Treasury have to handle economic crises are proving inadequate to handle our current financial situation. Those tools were designed for the banking system that operates in the open. The sizeable part of the economy that was sustained by the assets of the shadow banking system has been decimated.

I highly recommend this book. I read it through in one sitting. It is the most accessible explanation of economics that I have ever read.

1 comment:

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