Shadow Banking System Unravels: Explains Bailout Timing

No, this is not a conspiracy hypothesis.  There really is a
href="http://money.cnn.com/2007/11/27/news/newsmakers/gross_banking.fortune/index.htm?postversion=2007112810">shadow
banking system
.  There is even a
href="https://www.aei.org/research/projectID.15/project.asp">Shadow
Financial Regulatory Committee
(although the Committee is
really a study group, not a regulatory body of any sort).  



The System is said to be falling apart.  This might explain
why the Fed and the Treasury decided to
href="http://www.washingtonpost.com/wp-dyn/content/article/2008/09/21/AR2008092102060.html">act


href="http://www.usatoday.com/news/washington/2008-09-21-financial-rescue_N.htm?csp=34">now
,
and why Morgan Stanley and Goldman Sachs are doing
href="http://afp.google.com/article/ALeqM5iFGdtoAuyvp9iTa14DJLPENmfzHg">what
they are doing
.  As reported in the Financial
Times
:



href="http://www.ft.com/cms/s/0/622acc9e-87f1-11dd-b114-0000779fd18c.html?nclick_check=1">The
shadow banking system is unravelling


By Nouriel
Roubini


September 21 2008


Last
week saw the demise of the
shadow banking system that has been created over the past 20 years.
Because of a greater regulation of banks, most financial intermediation
in the past two decades has grown within this shadow system whose
members are broker-dealers, hedge funds, private equity groups,
structured investment vehicles and conduits, money market funds and
non-bank mortgage lenders.

Like banks, most members of this
system borrow very short-term and in liquid ways, are more highly
leveraged than banks (the exception being money market funds) and lend
and invest into more illiquid and long-term instruments. Like banks,
they carry the risk that an otherwise solvent but liquid institution
may be subject to a self­fulfilling and destructive run on its
­liquid
liabilities.

But unlike banks, which are sheltered from the risk
of a run – via deposit insurance and central banks’
lender-of-last-resort liquidity – most members of the shadow
system did
not have access to these firewalls that ­prevent runs.

A
generalised run on these shadow banks started when the deleveraging
after the asset bubble bust led to uncertainty about which institutions
were solvent. The first stage was the collapse of the entire
SIVs/conduits system once investors realised the toxicity of its
investments and its very short-term funding seized up...



The whole article explains it, step by step.  What is
particularly interesting is what Dr. Roubini posted on his
href="http://www.rgemonitor.com/index.php">website
,
but which is not in the FT article.  The design of the site
makes it difficult to link to this particular blurb, but here it is:


Run on off-balance sheet shadow financial system
forces Fed to step in as lender of last resort to non depository
institutions it does not supervise or regulate. Fed takes on unknown
credit and market risk if collateral-providing dealer defaults.

--> it is not the job of the Fed to bail out insolvent non bank
financial institutions. If a bail out should occur this is a fiscal
policy action that should be decided by Congress after the relevant
equity holders have been wiped out and senior management fired without
golden parachutes and huge severance packages.



Nobody minded, too much, as long as the shadow system was making money.
 But now that it is unraveling, it is creating problems for
all of us.  Based upon the timing, Roubini implies that the
bailout has nothing to do with problems on Main Street.  It
isn't even the problems on Wall Street.  Rather, it is the
problems on whatever street the shadow banking system is on: call it
Elm Street, I guess, as in Nightmare on...



Having Goldman Sachs and Morgan Stanley enter the world of depository
banking will expose them to more regulation.  However, that
will do nothing to bring the off-balance-sheet transactions into the
sunshine.  For that, we need new, stronger regulations, regulations that extend to
all types of financial dealings.
 That will not stop the crisis, but it might prevent the next
one.



By the way, the staff of the now-defunct Lehman Brothers brokerage are
set to
href="http://www.independent.co.uk/news/business/news/fury-at-25bn-bonus-for-lehmans-new-york-staff-937560.html">share
a $2.5 billion bonus
.  That's fine with me.
 As long as the proceeds are taxed an the appropriate rate.
 Say, 100%.



It just wouldn't be right, for them to make more than
href="http://en.wikipedia.org/wiki/Freddy_Krueger">Freddie
Krueger
.  


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