Modern shadow banking system

Paul McCulley is a managing director at PIMCO. He is particularly influenced by Hyman Minsky, and coined phrases like the shadow banking system and the Minsky moment. Here is an extract from his May 2009 speech. I particularly liked reading this speech because it clearly explains how the financial crisis came about within the modern financial banking system:

"The conventional banking system is based on what is known as the fractional-reserve banking system. Customers deposit funds at a bank to store savings in the form of a demand claims on the bank. Holders of the demand deposits can withdraw all of their funds at any time. Banks use most of these short-term funds to invest in longer-term interest bearing loans and securities. This is called borrowing short to invest long. The assets being longer term (and riskier) have higher yields than the short-term liabilities. This is how the banks make their profits.

However, this also causes a cash-flow insolvency. If all the depositors showed up at the same time, it can cause a bank run and cause the bank to collapse. In the absence of crisis that cause a bank run, fractional-reserve banking functions well because only a few depositors will make cash withdrawals compared to the total amount of deposit (liabilities are sticky), and a cash reserve is maintained to meet the demands of depositors seeking withdrawals.

A key reason that the depositors can sleep well at nights not worrying about bank runs is the fact that since 1913 here in the United States, banks have access to the Federal Reserve as a lender of last resort. This is known as having access to the Federal Reserve's discount window, where banks can post assets for loans to redeem flighty depositors. A second government sleep-well safety net was introduced, post the great depression, in 1933. Taxpayer-backed deposit- insurance (FDIC), in which the federal government insures that deposits up to a limit will not lose value, no matter how foolish the bankers may have been. Obviously, deposit banks don't just get this for nothing - they have to submit to strict regulatory standards in exchange for such a government safety-net.

The financial crisis did not originate within the confines of the highly regulated fractional-reserve banking system. Instead, it originated within the shadow banking system which operated legally, yet almost completely outside the realms of the regulatory system. The rise of this system drove one of the biggest lending booms in history, and collapsed into one of the most crushing financial crisis we have ever seen.

Unlike the conventional regulated banks described above, unregulated shadow banks fund themselves with uninsured short-term funding. They do so by raising funding in the non-deposit markets, unsecured debt through commercial paper, and secured borrowing such as reverse repo and asset-backed commercial paper. Since they fly below the radar of traditional bank regulation, these leveraged financial institutions operate in the shadows without backstopping from the Fed's discount window or access to FDIC deposit insurance. Examples of such shadow banks are investment banks (Bear Stearns and Lehman Brothers), conduits, SIVs (at Citi), money market funds, monoline insurers (Ambac and MBIA) and hedge funds (Bear Stearns High-Grade Structured Credit Fund).

Structured to not have access to the government safety-nets, the shadow banks essentially avoided regulation, notably on the amount of leverage, the size of their liquidity buffers and the type of lending and investing they could do.

In the absence of the government backstopping, the shadow banks needed some seal of approval, so that the providers of short-dated funding could convince themselves that their claims were just as good as the deposits at the regulated banks. Conveniently the friendly faces at the ratings agencies, paid by the shadow bankers, stood at the ready to provide such seals of approval. Moody's and S&P would put an A-1/P-1 rating on the commercial paper, which in turn would be bought by the money market funds. Of course, its inherently an unstable structure. The ratings agencies face an in-built problem of putting ratings on new innovations, because they haven't had a chance to observe a historical track record - to see their performance over a full cycle.

Over the last three decades or so, the growth of the "banking" outside formal, regulated banking has exploded, and it was a great gig so long as the public bought the notion that such funding instruments were 'just as good' as bank deposits. Keynes provides the essential - and existential - explanation as to why the shadow banking system became so large. It was a belief in a convention, backed by the length of time that belief held: shadow bank liabilities were 'just as good' as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by the government-blessed rating agencies. Until, of course, the convention was turned on its head, starting with a run on the asset-based commercial paper market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization Fannie Mae and Freddie Mac in July 2008, and the actual death of Lehman Brothers in September 2008 (all being examples of banks runs on the shadow banking system.) Maybe, just maybe, there is something special about a real bank, as opposed to a shadow bank! And indeed that is ambiguously the case, as evidenced by the ongoing partial re-intermediation of the shadow banking system back into the government supported conventional banking system, as well as the mad scramble by the remaining shadow banks to convert themselves into conventional banks, so as to eat at the same government-subsidized capital and liquidity cafeteria as their former stody breathen."

Curse of AAA

Chris Davis of Davis Funds sites three reasons for the collapse of AIG. (1) the financial sophistication of management, (2) the leverage of derivatives and (3) the danger of collateral requirements tied to mark-to-market accounting.

Lets talk about the third factor again. AIG was originally AAA rated. Reserve requirements to meet possible CDS losses were minimal (or possibly none) since the rating agencies thought AIG had a "strong" AAA balance sheet. When the financial system came crumbling down, the estimated losses for the swaps started going up. At this point (too late in my opinion) the rating agencies reevaluated AIG's AAA rating, and downgraded it from being AAA. They should have done this years ago when AIG's CDS exposure was going up, and not after the fact. David Einhorn at Greenlight capital calls it the Curse of AAA. Here is an extract from his May 2009 speech at IRA W. Sohn Investment Research Conference:

"Both President Obama and Chairman Bernanke have said that the problem with AIG was that greedy people put a hedge fund on top of an insurance company. As I see it, AIG failed precisely because it was not a hedge fund, but a highly regulated, AAA rated insurance company. Call it the Curse of AAA. The market incorrectly believed that regulators and rating agencies carefully monitored its risk profile and activities. As a result, AIG was able to abuse its access to unlimited cheap financing without any of its counterparties performing any additional credit analysis or demanding any collateral. Hedge funds can't abuse the system the same way, particularly in the aftermath of Long Term Capital Management, as lenders pay much more attention to hedge fund counterparty risk and collateral requirements. Had AIG been a hedge fund as President Obama and Chairman Bernanke claim, none of this could have happened.

Come to think of it, many of the spectacular failures during this crises bore AAA ratings. The Government Sponsored Enterprises (GSE), the monoline insuraners (Ambac and MBIA), AIG, and General Electric, whose slow moving train-wreck is ongoing, suffered the Curse of AAA and damaged their companies with sizable harm to the economy at large. The only AAA rated (or atleast until recently AAA) financial institution I can think of that didn't abuse its status is Berkshire Hathaway.

Investors who bought AAA rated structured products thought they were buying safety, but instead bought disaster. They can forgive themselves by blaming the rating agencies. But if the credit markets improve to the point where newly issued AAA rated bonds price with tight spreads only to later widen or ultimately fail, investors will have no one but themselves to blame. Fool me once ...

Investors have figured this out and many deny that they buy bonds based on ratings unless they are forced by law. Even Moody's largest shareholder, Warren Buffet, has said that he doesn't believe in using ratings.

We are short Moody's Investors Service. If your product is a stamp of approval where your highest rating is a curse to those who receive it, and is shunned by those who are supposed to receive it, you have problems.

Moody's says it has enormous incentive to do a good job with the ratings because the ratings are the brand. Imagine yourself the head of Moody's a decade ago. If your goal was to destroy the brand, would you have done differently?

The truth is that nobody I know buys or uses Moody's credit ratings because they believe in the brand. They use it because it is part of a government created oligopoly and, often, because they are required by the law. As a classic oligopolist, Moody's earns exceedingly high margins while paying only the needed lip service to product quality. The real value of Moody's lies in its ability to cow the authorities into preserving its status.

The ratings agencies' lobby is pushing 'reform' through modest changes to the ratings process. Why reform them when we can get rid of them? Are we waiting to blow up the Lunar economy as well? Some wonder what would happen without government sanctioned ratings. It is hard to imagine how things would be any worse.

Even if ratings were free of conflict, the unfixable issue is that the rating system is inherently pro-cyclical and economically destabilizing. When times are good, rating upgrades reduce borrowing costs and contribute to credit bubbltes. The more debt they rate, the more profit they earn. When times are bad, rating downgrades accelerate a negative feedback loop and can be catastophic for entities that rely so much on their credit rating that a rating downgrade jeopardizes their existence. The monoline insureres (Ambac and MBIA) and AIG suffered this fate. This empowers the rating agencies to decide whether a company lives or dies. The rating agencies are sensitive to this responsibility. As a result, they fail to use the downgrade as a warning signal to investors, and when they finally do act, it is often coup de grace.

Regulators can improve the stability of the financial system by eleminating the formal credit rating system.

Credit analysts don't believe in credit ratins; equity analysts do. Moody's share trade at 19x estimated earnings that, wink-wink, they are supposed to beat. Ironically, for a firm that evaluates credit, its balance sheet is upside down, with a negative net worth of $900 million.

That is a lot to pay for a franchise with a socially undesirable product and a shattered brand that exists at a time when the government is considering broad reform in its mission to fix some of the systemic regulatory issues that got our economy into trouble in the first place."

Collapse of AIG

The Selected American Funds (SLADX) took a big hit when their investment in AIG blew up. Despite this mistake, in my opinion, Chris Davis and Ken Feinberg who run the Selected American Fund are very capable and honest managers. They eat their own cooking. The Davis Family, employees, and the directors have over 1.5 billion dollars invested side by side with the shareholders in the funds that their firm manages. They have very low fees for a actively managed funds. They are honest in their communication, and share very candidly their investment successes and more importantly their investment errors. In general, they set a great example for the rest of the mutual fund industry on how to live by their fudiciary responsibilities. So when their investment in AIG blew up, they shared what happened at AIG and why they continued to hang onto AIG as the situation got worse (which in hindsight was a bad idea). Here is an extract from 2009 Q1 manager's commentary:

"By far our largest mistake over the last five years was our investment in American International Group (AIG), which cumulatively detracted roughly 6% from our returns, almost three times as much as any other mistake. In essence, this mistake resulted from our incorrectly assessing three factors: the financial sophistication of management, the leverage of derivatives and the danger of collateral requirements tied to mark-to-market accounting.

Starting with management, the chief executive officer of a complex financial institution also serves as the de facto chief risk officer. He or she must understand the nature and extent of the risks being taken and must have the courage to forgo profits if the risks, however remote, could prove catastrophic. At AIG, the need for a highly capable CEO was accentuated by the diverse business models and risk profiles of its semiautonomous divisions. Unfortunately, the abrupt ouster of its longtime CEO and the promotion of a far less able successor came at the worst possible time. Although this successor had deep experience in the field of property and casualty insurance, the company’s financial operations and risks went far beyond this sector into areas in which new management had virtually no expertise.

The second factor that we–and this new management team–grossly underestimated lay in a relatively small division of AIG called AIG Financial Products. This unit contributed about 5% of total profits, only a small portion of which came from selling a type of highly complex and highly leveraged derivative known as a credit default swap, or CDS. At its heart, a CDS is a type of financial insurance in which a buyer would pay AIG a tiny premium in exchange for coverage against a highly unlikely financial event, such as the default of a triple-A security. In some cases, the premium could be as low as $1 for $1,000 worth of coverage. Unfortunately, many of the triple-A securities that AIG insured were tied to mortgages and presumed that residential real estate prices would never go down substantially. To make matters worse, unlike normal insurance contracts, credit default swaps are marked tomarket, meaning that they are priced not for what the actual losses are today but for what the market estimates the losses will be in the future. This mark-to-market accounting brings us to the third aspect of our mistake.

As the estimated losses on the contracts went up, AIG was required to post cash collateral for the buyers of the swaps. Worse still, the amount of cash collateral was also tied to AIG’s own credit rating. As is now apparent, all the factors were in place for a spiral. Because these contracts assumed virtually no losses, small increases in loss estimates led to huge losses. As these losses mounted, rating agencies became concerned and downgraded the company. Thus, AIG was required to post more collateral for both higher estimated losses and its lower credit rating. Adding to these liquidity demands, the company engaged in a massive securities lending program in which it lent out many of its investments. These loans were themselves collateralized with cash. Unfortunately, rather than simply hold this cash in short-term liquid instruments, the company invested much of it in illiquid, often mortgage-related securities. As nervous customers returned borrowed securities and immediately demanded their cash back, AIG was forced to try to sell these illiquid securities at a time when there were no buyers. In just a matter of months, these liquidity demands exceeded AIG’s available resources. Facing default, AIG asked for government intervention. In exchange for providing the necessary liquidity and guaranteeing or assuming responsibility for a number of assets and liabilities, the government took equity warrants for approximately 80% of the company.

All of the above analysis begs the question: “Why did we continue to hold the shares even as the situation got worse and worse?” The answer is twofold. First, we remained focused on the fact that the company had close to $100 billion of tangible equity, more than $1 trillion in investments and more than $20 billion of pretax earnings from global insurance, leasing and asset management operations. Furthermore, in contrast to a bank, it is difficult to have a run on an insurance company, as policyholders, unlike depositors, generally cannot suddenly take back their premiums. Thus, we thought the company’s powerful diversified earnings, tangible equity and assets would more than cover the losses over time. This thinking ignored three important facts. First, because of the collateral requirements discussed above, the company did not have the luxury of time but needed to come up with the cash immediately. Second, because there had been inadequate disclosure about the massive securities lending operation, the scale and immediacy of the cash requirements were far greater than anyone imagined. Finally, although the company’s financial statements showed a huge amount of liquid assets, most were held in the company’s insurance subsidiaries. As regulated entities, these subsidiaries were not permitted to release the assets to the parent company in order for AIG to meet these collateral calls. As a result, even if these mark-to-market losses proved temporary rather than permanent (as they still could), even if the company’s net worth remained substantial, or even if the company could have earned enough in the next five years to pay the losses as they came due, it still faced bankruptcy as a result of defaulting on the collateral calls.

We will end this discussion with an example of the dangers of this sort of collateral posting requirement. Imagine a homeowner has a $400,000 home with a $300,000 mortgage. Now imagine he earns $100,000 per year of which he uses $50,000 for living expenses, leaving $50,000 to service the mortgage. If we add to this example as a given that this person will never move and will never lose his job, it would seem that the mortgage is virtually risk free. But if we change one feature that on its face seems minor, we completely alter the risk profile. Specifically, imagine that the mortgage requires that if the estimated price at which the house could be sold on any given day falls below $300,000, the homeowner must put the shortfall in an escrow account or face eviction. Now, even if the homeowner could service this mortgage forever and even pay it down completely over time with no risk to the bank, he could still be bankrupted by having to mark his house to market and post collateral. It was this type of liquidity risk that, in a matter of months, brought down what had been the most profitable and highly valued insurance company in the world."

Why is your checking account "free"?

I am currently reading an amazing book on behaviorial finance "Predictably Irrational" by a Duke professor Dan Ariely. Harper published a revised and updated version of the book in 2009. It includes a new chapter on the financial meltdown from a behaviorial finance perspective. He uses an interesting illustration to point out how insurance and banks operate in a way to take advantage of those who are already at financial risk.

"Think, for example, about the 'perk' of free checking that the banks so generously provide us. You might think that banks lose money by offering free checking, because it costs them something to manage the accounts. Actually, they make huge amounts of money on mistakes: charging very high penalties for bounced checks, overdrafts, and debit card charges that exceed the amount in our checking accounts. In essense, the banks use these penalties to subsidize the 'free checking' for the people who have sufficient amounts of cash in their checking accounts and who are not as likely to bounce a check or overdraw with their debit cards. In other words, those living from paycheck to paycheck end up subsidizing the system for everyone else: the poor pay for the wealthy, and the banks make billions in the process.

Now does the usary of the banks end there. Imagine that it is the last day of the month and you have $20 in your checking account. Your $2,000 salary will be automatically deposited into your bank today. You walk down the street and buy yourself a $2.95 ice cream cone. Later you also yourself a copy of the book Predictably Irrational for $27.99, and an hour later you treat yourself to $2.50 caffe latte. You pay for everything with a debit card, and you feel good about the day - it is payday, after all.

That night, sometime after midnight, the bank settles your account for the day. Instead of depositing your salary and then charging you for the three purchases, the bank does the opposite and you are hit with overdraft fees. You would think this would be enough punishment, but the banks are more nefarious. They use an algorithm that charges the most expensive item (the book) first. Boom - you are over your available cash and are charged a $35 overdraft fee. The ice cream and the latte come next, each with its own $35 overdraft fee. A split second later, your salary is deposited and you are back in the black - but $105 poorer."

What is a credit default swap (CDS) ?

A credit default swap (CDS) is a financial instrument originally invented to insure the owner of a bond against default. They exploded in popularity and were the cause of one of the greatest bubbles. The 50 employees at AIG's Financial Product division creating and trading CDS brought the insurance giant (120,000 employees) to its knees in 2008. Frank Martin at MCM Advisors in his 2008 annual report explains this exotic financial instrument through the 'HDS Fable':

Flash back to 2006 and engage your imagination regarding a particular house. Suppose, if you will, that 50 neighbors have become infected by the speculative virus. The ingenious neighbors concoct what becomes an active market in HDS (home destruction swaps), buying and selling contracts, essentially taking both sides of the bet that the house will go up in flames. Those who think an accident is likely pay insurance-like annual premiums to those willing to hold the opposite view. For a contract to come into existence there must be both a buyer of risk insurance and a seller who is willing to underwrite the risk. Although there is only one house at risk, the number of contracts outstanding is limited only by the number of parties willing to enter into a swap agreement related to that particular house. Unlike a conventional homeowner’s insurance policy with a limit of one per house, these synthetic policies have no such limits. When the speculative appetite is well nigh insatiable, they multiply like rabbits (but it’s hare today, gone tomorrow). Always thinking of new ways to make their money work harder, the swap sellers, those willing to underwrite the risk that the house will be destroyed, put their proceeds to work in the rising stock market. Likewise disposed, buyers pay their premiums with money borrowed at the local bank. Everyone knows that financial leverage amplifies returns (although they conveniently forget that it has the same effect on risk). Suddenly circumstances change. The house is sold and immediately a rumor spreads that the new owner is building a potentially explosive meth lab in the basement. As the perception of risk of fire rises sharply, the protection sellers are taking huge paper losses, while the buyers are racking up big gains. The buyers naturally want to cash in their gains and reduce their debt. But the sellers can’t close out their positions at the new price. And since this is a small and transparent market, other potential buyers have no interest, because the sellers are too weak a “counterparty.” And bankers are making collateral calls on their loans. Thus the buyers of the HDS contracts discover to their dismay the meaning of “counterparty risk.” Now, suppose there’s a modest stock market downturn, just as the HDS buyers’ banks are haircutting the nominal paper gains on their HDS. The bankers will start calling for more collateral for their margin loans, which many buyers can’t meet. The sellers, of course, are in even worse shape; they’re taking paper losses, and their stockbrokers have adopted much more aggressive tones. Both buyers and sellers may end up bankrupt. And so the fable ends with the meth lab madman in jail, the innocuous little house, the object of so much reckless risk taking, still standing. Though the structure didn’t collapse as expected, it was in a very real sense a house of cards—as the 50 speculators discovered to their chagrin. Left in the wake of the massive speculative episode where risk was created out of thin air are 50 financially and otherwise devastated families. The inebriate who insisted on smoking in bed, source of the comparatively insignificant original “risk” upon which the mania took root, never had a hint of what was going on in the neighborhood around him.