The Heart of Darkness

The following is an excellent excerpt from the book “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism” by Yves Smith from Chapter 9: “The Heart of Darkness: The Shadow Banking System Self-Destructs” on page 233 and I quote:

“Speculators may do no harm as bubbles on a steady stream of enterprise.  But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.  When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.  The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism.”                                         –John Maynard Keynes

“Sir Isaac Newton is justly famous for his wide-ranging scientific and mathematical achievements.  His tenure at Britain’s Royal Mint is less well-known.

Newton’s friends and admirers were troubled that the most accomplished scientist of the day was living on a meager academic stipend.  One of his supporters, the newly appointed Chancellor of the Exchequer, came up with the inspired idea of appointing Newton to be the Warden of the Mint, a cushy sinecure.

Newton had consulted to the Mint on England’s economic woes.  Prior to 1661, England’s coins were hand produced, making it easy to clip a little of the silver off the edge of a coin and circulate the now lighter coin without attracting attention.

To combat this pilferage, the Mint began producing milled coins, which would make it easier to see tampering.  But the clipping of the older coins continued, and by 1695, they were down to 50% of their prescribed weight.  The public started to be reluctant to use them as rumors spread that the older coins would be demonetized and thus worth only their much lower value as metal.  People bought gold on such a large scale that it reduced the London-Antwerp exchange rate 16% over several months.  The government decided to take in all the hammered coins and replace them with milled money.

Newton arrived at a crucial stage, when the Treasury was about to cease accepting older coins for tax payments.  But delivery of new coins was well behind schedule, their production in disarray.  The shortage of circulating money led to riots, and contemporaries worried that the strife might worsen.

The Mint got more than it bargained for.  Newton was an alchemist, and thus an expert in metallurgy.  He brought in new equipment, reorganized the fabrication process, and in a mere four months, increased output over sixfold, achieving a European record.  He kept meticulous accounts, giving a full report of how millions of pounds of silver moved through the Mint.

Newton pursued counterfeiters with the same vigor.  His alchemical research was again an aid, helping him detect fakes.  Now master of the Mint, Newton took to enforcing the rarely invoked punishment for counterfeiting, that of death by hanging and quartering.  The physician conducted his own investigations in London’s underworld, ultimately sending an estimated two dozen to the gallows.

Coin clipping and counterfeiting are clearly against the law now as in Newton’s day.  the government still retains control of the creation of currency and historically had significant influence over the creation of loans, through its regulation of capital and reserve requirements for financial institutions.

However, the officialdom does not have the same tight grasp of certain contraction, were driving factors in the crisis.  They involved operations and structures that were often not recorded on the balance sheets of banks.  As a result, they were not subject to capital requirements and were thus supervised minimally, if at all.  These new approaches have sometimes been called “the shadow banking system.”

But what do we mean by “shadow banking system”?  Let’s review the traditional activities of banks.  They hold funds in the form of deposits and lend a significant portion of them out.  Banks are government-chartered franchises.  They submit to the regulatory constraints; in return they receive deposit guarantees (which make it cheaper for them to raise money) and state control over market entry.  Preserving bank profitability was (and still is) considered to be desirable, since that led to sounder, better capitalized banks, which in turn produced greater stability.

Regulators supervise banks, which means supervisors inspect banks periodically, require them to make reports, and limit what they do.  These enable the authorities to understand not simply the health of individual banks, but also to see activity across the entire banking system.

Bank regulation also allows the authorities to influence the amount of loans that banks provide.  For instance, capital adequacy rules limit how much banks can lend against their equity.  Modern regulators, following rules stipulated by the Bank for International Settlements (BIS), require banks to hold more capital against loans and credit instruments that are riskier.  Thus, banks can make far more in the way of low-risk loans than high-risk ones against the same capital base.

Over the last thirty years, the combinations of deregulation, increased competition from securities firms and other nonbanks, and financial innovation put banking earnings under attack.  The banks found their best customers of various types cherry-picked by new entrants, and competition between banks became ever more aggressive.

So to preserve profits, they adopted new business models.  They decided to take on more risk and use less equity in order to compete, as best they could, with new entrants.  That meant moving into banking areas that were largely unregulated–what we have described as the shadow banking system.  Initially, this development seemed to be benign.  Indeed, banks and other financial companies engaged in these activities for decades with only occasional mishap.  But differences in degree can become differences in kind.  Financial services firms kept pushing the envelope, using more and more “innovative,” which in this case meant more risky, approaches.  And some of the most aggressive activities were the ones that showed the most rapid growth.

These changes, accompanied by new types of trading strategies that took hold early in the new millennium, led to vastly more risk taking in these areas, and also greatly increased the demand for the most speculative securitized products.

In traditional banking, the main check on how much credit was extended had been governed by rules, such as reserve and minimum equity requirements.  Now the only bar to extending credit was the ability of members of the system to discipline each other.  In the period when these credit products evolved, business cycles were mild.  Market participants became more comfortable with the new approaches, and complacency about the dangers grew.  Seizing profits took precedence over prudence.

As we will see, this banking under another guise is just as subject to runs and panics as traditional banking.  And, again like the old-fashioned sort, shadow banking is what economists call pro-cyclical.  That means it expands in good times and contracts in bad, increasing the severity of business cycles and with it, the likelihood of busts following booms.

This largely unregulated financial sector involved three interrelated types of “innovations” that affected credit:

  • Securitization (and other off-balance-sheet vehicle)
  • Repurchase and reverse repurchase agreements (otherwise known as repos)
  • Largely unregulated insurance contracts on debt securities (credit default swaps or CDS).

We will show how in particular, complex debt instruments and credit default swaps fuelled trading strategies that in turn produced an unprecedented level of loans that were underpriced relative to their risk.  This was the “wall of liquidity” syndrome at the heart of the global credit mania.  These strategies took hold on a large scale starting in 2004 and grew rapidly in 2005 and 2006.  They involved tranched products, particularly collateralized debt obligations, that had subprime mortgages as a major building block.  The use of credit default swaps enabled bankers to create so-called synthetics which allowed speculators to gamble in much larger volumes than the underlying market of real economy borrowers had permitted.  That in turn meant subprime risk was not “contained’ but was much larger than the authorities believed.  And the firms most heavily exposed, namely European banks, investment banks, and insurers, were undercapitalized and in no position to take the losses that resulted from being on the wrong side of these bets.

Securitization takes place when an originator, a bank or another type of lender (like an auto company that also provides car loans or leases), sells its loans (“assets,” since they generate income) to a special purpose vehicle (SPV).  An SPV can be specific to one originator, or can hold assets from many sources.  Virtually every type of asset-backed loan, meaning one where the lender can seize a particular piece of property if the borrower defaults, from mortgages to recreational vehicles, motorcycles, and intellectual property, has been securitized.  Some types of unsecured consumer loans, such as student loans and credit card receivables, are also grist for this process.

Banks adopted this approach because securitization was less expensive than the traditional process of making loans and retaining them.  When banks hold loans, the interest rate needs to be high enough to recoup the cost of equity and FDIC insurance, as well as an allowance for losses.  Selling loans to a securitized vehicle can also lead to better accounting treatment.

The cash flows, which are the payments of interest and the eventual repayment of the loan balance, are frequently “structured” to create securities that appeal to different types of investors from a single original pool.    They range from AAA instruments with low interest rates through various credit grades to the “equity” layer that can earn high income but is most exposed to losses.  Consider a simple example, a pool of 100 mortgages, each with an initial balance of $1.  From that, we will create three bonds, A, B, and C, which are “backed” by these 100 mortgages, meaning the mortgages are the only form of security for the bonds.  Bond A has a balance of $80, bond B $15, and bond C $5.  The rules of the SPV state that as homeowners whose mortgages are in the pool make payments, those payments are used first to pay the balance of bond A, then bond B, then bond C.  Even if 20% of the mortgages never pay back a penny, the bond A investors will be made whole (unfortunately we can’t say the same for the bond B and C investors, as they receive none of their principal back).

This structuring approach, called “tranching,” was adopted by banks because offering products tailored to particular investors’ risk appetites enlarged the market for securitized products.  It also allowed banks to sell their loans to the SPVs for better prices, in much the same way that butchers sell pigs in parts (for instance, loin, chops, ribs, ham, bacon, knuckles), rather than whole, because they realize more income that way.

Originally, securitization was limited to pools of assets that had explicit or implicit U.S. government guarantees and were perceived as safe, such as mortgages insured by Ginnie Mae, Fannie Mae, and Freddie Mac, that were thus AAA rated.  But the market grew considerably as financial firms figured out how to create instruments that were higher credit quality than the underlying loans, through a combination of techniques, such as buying insurance to improve the credit quality and “overcollateralization,” which was tantamount to setting a reserve for losses up front, as banks do for loans they keep on their balance sheets.  For instance, a pool with a face value of $!,000 might be turned into securities that sold for a total of only $975.

Securitization grew rapidly from the mid-1990s onward.  For instance, the total amount of asset-backed securities minus mortgages paper sold in the United States in 1996 was $168 billion, which rose to $1.25 trillion in 2006, the last year before the storm broke.  According to Citigroup, banks around the world sold $2 trillion in non-agency (meaning non-Ginnie, Fannie, Freddie) asset-backed securities that year.  By contrast, global lending to corporations was roughly $1.5 trillion.  Banks also simply sold whole (unsecuritized) loans.  In 2006, for every $1.00 of lending, $0.25 was sold.

Some economists were puzzled by both securitizations and vending of loans, since they knew of no precedents.  Moreover, information was lost through this process.  Sales and securitization of loans meant banks had no reason to monitor borrowers once they had offloaded loans made to them.  A still less recognized problem was the fact that in practice, not all of the trances of a securitization were equally attractive to the investing public.  Deals hinged on the need to find buyers for the less popular tranches.  The efforts to deal with this problem were, as we shall see, both highly creative and, in the end, destructure.

A variant on the securitization theme was bank conduits.  Banks weren’t entirely happy to simply package up loans and sell them.  Routine asset sales provided to much profit to the underwriter and not enough to the bank sponsor.  So they began looking for new structures to increase their returns.

So conduits were born, quasi-banks, in that they capitalized themselves with short-term liabilities and held long-term, higher-yielding assets.  Conduits held specific assets, such as credit card receivables.   These conduits were not recorded on banks’ balance sheets, even though they had implicit support from the bank sponsor if the assets in the conduit proved to be worth less than the bank claimed when the conduit was created.  They were funded primarily with a short-term IOU called asset-backed commercial paper.  Asset-backed commercial paper (ABCP) refers to a loan with a specific maturity of up to 270 days, usually 90 to 180 days, that is collateralized by asset-backed securities (that is, if the loan isn’t repaid, the creditor can seize the instruments given as collateral).

This structure was a classic “borrow short, lend long” approach.  Just like banks themselves, the conduit usually earns more income than its cost of borrowing, but simultaneously runs a funding risk.  The conduit needs to replace its maturing ABCP with a new placement, but it may have trouble finding replacement lenders (“rollover risk”).  And if the short-term funding markets have become hostile, it is likely that the credit markets overall are stressed.

Assume the value of the assets in the special purpose vehicle collapses or is merely in doubt.  The conduit has a funding crisis: commercial paper investors like money market funds will be loath to buy its ABCP, yet the entity still has to pay off the ABCP coming due.  Many but not all of these had backup credit lines, so they could borrow from a bank (typically the very same one that sponsored the entity) in case they had a problem paying off the maturing ABCP funding with a new ABCP placement.  The tacit assumption was that the parent bank would merely be providing short-term support from the credit lines, that at some not-too-distant point down the road, any conduit that had needed to borrow from the bank sponsor would be able to use ABCP to fund itself again.

The banks’ theory as to why they need not record the conduits on their balance sheets was that the conduits were independent entities.  Yet contrary to this claim, banks would in fact support some of these supposedly stand-alone vehicles.  For instance, one study found that from 1991 to 2001, sponsors intervened in 17 instances on behalf of 89 credit card securitizations.  Moreover, as losses on credit card portfolios are reaching unprecedented levels, Citigroup, J.P. Morgan Chase, Bank of America, and American Express have all come to the rescue of off-balance-sheet entities.  The banks and their accountants maintained the fiction of an arms’ length relationship despite ample evidence to the contrary.  Indeed, absent bank support, the conduits could not have been created.

Within the universe of conduits, the dodgiest were SIV’s or structured investment vehicles.  They were riskier on just about every axis: lower credit quality of their assets, higher levels of borrowing, and no formal support from their sponsor.  But as we will discuss later, when they ran into trouble, investors demanded that their sponsors intervene, so again, the “off-balance-sheet” designation was misleading.

Repos are another type of collateralized lending that played an important role in the credit crisis.

Repo is short for “sale with agreement to repurchase.”  In a repo, a party that owns a high-quality bond borrows against it in a pawn shop-like procedure, by selling it to another party with an agreement to buy it back it at a specified future date, including interest.  Repos are typically overnight, and funds can thus be readily redeemed if the repo lender decides not to renew the repo.

Repos are thus another way to lend against an asset.  The high-quality bond that is sold plays the role of the collateral guaranteeing the loan. The interest paid corresponds to the cost of funding the loan.

Securities firms and banks hold a lot of assets.  They also have to settle a tremendous amount of money going in and out on a daily basis.  Repos give them an easy way to raise cash or deploy funds on short notice.

A repo can also produce an effect similar to banking, by providing an alternative to making a deposit.  Say you are a very big broker-dealer (BBD) and you have some extra cash on hand.  BBD is loath to park $!00 million for a few days at his friendly bank because the amount is so large that the funds would not be insured.  But BBD can “deposit” it with another dealer and get top-quality, highly salable securities, plus interest.  This arrangement serves the same function as a deposit and is more secure.

Borrowers and securities for repo are to treated equally.  A lender may require a “haircut” or margin, say lending only $95 against $100 of current market value.  That is, he may not lend the full market values of the instrument sold to secure the loan, based on his view of the risk of the borrower and of the odds of unfavorable price changes in the instrument repoed.  A small haircut implies that the repo borrower will have correspondingly greater leverage.

Repos have been around for a very long time.  But even in the mid-1980s, the repo market consisted solely of Treasury securities, which are safe and highly liquid.  Repos only began to become dangerous when, in response to increased demand for paper that could be repoed, more and more dodgy paper became widely accepted as collateral for repos.

Some have argued that the parabolic increase in demand for repos was due in large measure to borrowing by hedge funds.  Indeed, Alan Greenspan reportedly used repos as a poxy for the leverage used by hedge funds.  Others believe that the greater need for repos resulted from the growth in derivatives.  But since hedge funds are also significant derivatives counterparties, the two uses are related.

Brokers and traders often need to post collateral for derivatives as a way of assuring performance on derivatives contracts.  Hedge funds must typically put up an amount equal to the current market value of the contract, while large dealers generally have to post collateral only above a threshold level. Contracts may also call for extra collateral to be provided if specified events occur, like a downgrade to their own ratings.  (Recall that it was ratings downgrades that led AIG to have to post collateral, which was the proximate cause of its bailout.)  Cash is the most important form of collateral.  Repos can be used to raise cash.  Many counterparties also allow securities eligible for repo to serve as collateral.

Due to the strength of this demand, as early as 2001, there was evidence of a shortage of collateral.  The Bank for International Settlements warned that the scarcity was likely to result in “appreciable substitution into collateral having relatively higher issuer and liquidity risk.”

That is code for “dealers will probably start accepting lower-quality collateral for repos.”  And they did, with that collateral including complex securitized products that banks were obligingly creating.

As time went on, repos grew much faster than the economy overall.  While there are no official figures on the size of the market, repos by primary dealers, the banks and securities firms that can bid for Treasury securities at auctions, rose from roughly $1.8 trillion in 1996 to $7 trillion in 2008.  Experts estimate that adding in repos by other financial firms would increase the total to $10 trillion, although that somewhat exaggerates the amount of credit extended through this mechanism, since repos and reverse repos may be double counted.  The assets of the traditional regulated deposit-taking U.S. banks are also roughly $10 trillion, and there is also double counting in that total (financial firms lend to each other).

In other words, this largely unregulated credit market was becoming nearly as important a funding source as traditional banking.  By 2004, it had become the largest market in the world, surpassing the bond, equity, and foreign exchange markets.

The third major component of the shadow banking system, credit default swaps (CDS), also grew rapidly early in the new millennium and now enjoys a well-deserved notoriety, thanks to the role of CDS in the collapse of American International Group (AIG), the world’s largest insurance company.”


LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog ( and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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