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The Looming Threat That Could Initiate the Next Economic Collapse

Lurking behind the big banks is a mess of unregulated finance that could trigger the next financial blowup.

Most people now realize big banks aren’t their friends. Only in the fairy tale movie world of It’s a Wonderful Life does banker George Bailey lend a helping hand to friends and neighbors to build a prosperous Bedford Falls.  

But many people have no idea that the regulated banking system is only one part of a gigantic problem. Lurking behind regulated banks is the shadow banking system. And it’s from out of these shadows that the next big shock to the global financial system, threatening everyone’s nest egg, might come.

What is shadow banking? Different writers mean different things when they use the term. But the fact that it’s hard to explain only makes it more difficult to constrain.

For our purposes, “shadow banking” is the loosely regulated or unregulated portion of the financial system outside the boundaries of the large and well-known commercial and investment banks.  The shadow banking system includes shadow banks, such as hedge funds, and shadow practices, such as inadequately regulated derivatives. This system is vast, and grew by a factor of five between 1990 and 2011, so that it now represents more than 15 trillion dollars in liabilities, according to a staff report by the Federal Reserve Bank of New York.  Shadow banking liabilities exceed those of the formal banking sector, and are currently about equal to the entire U.S. gross national product.

Why does it matter? Because this system is too big to fail -- so you may end up footing the bill if something goes wrong.

You might not realize it, but the institutions and products that comprise the shadow banking system touch each and every one of us, in four significant ways. Your pension fund likely invests in freewheeling hedge funds. Your money market mutual fund deposits aren’t nearly as safe as you think they are. The same crazy mortgage products that created the last financial crisis are about to be rolled out for rent rolls. And derivatives continue as the Wild West of the financial system, where the latest revelations confirm: no one’s in charge. In each of these areas, regulators who are supposed to look out for all of us have punted on or are unable to fulfill their responsibilities.

1. No such thing as a free lunch.

Hedge funds are classic examples of shadow banks. Investments in these funds are limited to those with annual incomes for the last two years of at least $200,000 or a net worth of at least $1 million (without counting your primary residence). These large pools of capital are largely unregulated, because they cater to sophisticated investors our regulators have decided can look after themselves.

Is this true? Well, not really.

Many ordinary people —firefighters, the police, teachers-- now invest indirectly in hedge funds, whether they realize it or not. At one time,  the “prudent man rule” prevented your pension fund from investing in a hedge fund because it wasn’t thought to be prudent. But that sensible rule was replaced by a ”prudent investor rule” that focused upon diversification.

The result: hedge funds now get access to large pools of money coming from the pockets of ordinary working- and middle-class people, who unlike the wealthy, can’t afford to make risky investments. 

Wait a minute, how is this possible?

Hedge funds can’t solicit investments from these people directly, since most of them can’t meet the annual income or net worth qualifying requirements.

But hedge funds can take investments from institutional investors, such as pension funds, colleges and charities. These hedge funds point to past performance, and suggest they’ll deliver higher rates of return than ordinary investments.