Shadow Banking System (SBS)
Since the dotcom bust of 2000, the flight to survival and profits went into real estate. As a result the real estate market soared to all time highs. Over these last 7 years, the lending industry endured growing pains. The 80/20 ‘piggy back’ went into high gear, followed by teaser adjustable rate mortgages (ARMs). The banking system under went primal and systemic changes. The mortgage lender’s model went from one of originating a mortgage with retained servicing, to one of using warehouse lines to fund a loan (often pre-sold on forward contracts) to Wall Street investment bankers waiting to deliver the ‘securitization’ of a pool of loans to third party investors. There is nothing wrong with a more profitable mortgage banking model per se, however, refinements and safeguards should be in place so less extreme asset devaluations tend to occur, and society is fairly treated, protected and participates in the success of such a model. The fact that this new model is not federally insured, nor able to use the Federal Discount Window, makes it vulnerable to market extremes, to levels not yet known or understood. Japan and China as buyers own the majority share of the USA subprime high-risk high-yield mortgages. This will now create international issues, and potentially weaker world markets or confidence. The greatest capitalists in the world should and can do better than it did this last round of historic homeownership growth.
During the years from 2000-2007, the banks took in securitization products including mortgages (worth over $1 trillion) and issued commercial paper. The banks created a great number of off balance-sheet conduits and structures. As such, these structures fail to report full liabilities on the bank’s balance sheets. This is what I call RahC (Randomly Activated Hidden Contingency) and RahD (Randomly Activated Hidden Debt). The industry created a Shadow Banking System (SBS) [phrase coined by Paul McCulley, PIMCO].
Yes, you’ve seen this movie before. Remember Enron? Enron apparently, through a series of related entities garnered a massive off-balance sheet contingency that exposed the company to risks and liabilities in untold and unknown amounts, not respected by its investors, the government or society. Well, with off-balance sheet liability and exposure related to hedge funds, commercial paper and derivatives, our formal banking system is now trying to absorb the assets burdened with unknown quantities and qualities of RahC and RahD losses and liabilities now exposed in our Shadow Banking System. Moreover, the SBS is not backed by Federal Deposit Insurance nor does this system have access to the Federal Discount Window for liquidity. Not to rub salt in this wound, but my ‘free market purists’ friends should now recognize some need for ‘refined free market industry and government regulations.’ How many times must we see this movie of ‘extremes’? Literally, untold exposure is etched in the fabric of off-balance-sheet contingencies. We must safeguard our economy from this type of market destruction but at the same time make laws and industry practices that see a steady and voracious growth across the board in new homeownership for decades to come.