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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.
 
 
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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.

So what’s the problem? Why shouldn’t ordinary small investors be able to get the same rates of return available to the wealthy?

Well, for starters, the gains are illusory. While some hedge funds have done very well for their clients, most fail to deliver on their promises of superior investment returns. Hedge funds typically take a fee of 2 percent of the sums they manage, plus 20 percent of profits. Once those high fees are taken into account, the funds underperform the market. Simon Lack’s book, The Hedge Fund Mirage, lays out the story in convincing detail, and shows that if all the money ever invested in hedge funds had been placed in safer Treasury bills instead, investors would have made twice as much money. Latest figures on hedge fund performance, such as those reported last month by Goldman Sachs, only confirm that these funds still consistently fail to beat the market, despite taking (in fact, because they take) fees many times greater than ordinary mutual funds.

Hedge fund investments inspire a more insidious, delusional effect: they allow state and municipalities to promise their employees certain benefits without allocating enough money to fund their commitments. The gap between promise and reality is huge: depending on which expert you believe, only somewhere between half and three-quarters of the necessary money to fund these pension promises has been set aside.

Politicians are caught between a rock and a hard place; either they raise taxes or renege on promises. By investing in funds that promise pie-in-the sky returns, those responsible for funding pension funds can continue to over promise and under deliver.

How is this going to work out? Not very well, if past performance is any guide. 

Pension funds would, over the long haul, be better off investing in more conventional investments, without taking on the additional risks of investing hedge funds. But following this advice would mean facing up to reality: there’s no such thing as an investment free lunch.

2. Money market funds are neither safe nor stable.

Late in August 2012, Mary Shapiro, the head of the Securities Exchange Commission announced the failure of her efforts to reform the $2.6 trillion money market mutual fund business. This is a rare example of Schapiro—who’s been a weak, ineffective regulator—trying to do the right thing.

Many ordinary people put money into money market mutual funds. These vehicles were created in 1971, and allow payment of higher rates on deposits than conventional bank deposits.. 

Unlike commercial banks, the companies that run these funds aren’t subject to regulations requiring them to hold extra capital in reserve, to make sure they can pay back people who’ve put money into their funds. Since banks have to satisfy these capital rules, and fund companies don’t, they get a competitive advantage. Funds are subject to laxer rules, because they invest in short-term government and corporate debt, which isn’t considered to be very risky.

The money market mutual fund industry has gone to great lengths to convince people that investments in their funds are as safe as bank deposits, and that you’ll always be able to get as much out of your money market mutual fund as you put into it. For accounting and tax purposes, the value of a share in such a fund was fixed at $1. This makes people think that an investment in a money market mutual fund is the same as a bank deposit.

Unfortunately, it's not.

John Bogle, the father of index fund investments and founder of the Vanguard Group, one of the largest mutual fund firms, recently identified money funds as “certainly one of the major risks in the mutual fund industry."

Money market mutual funds neither pay for nor are backed by federal deposit insurance, which insures up to $250,000 of a customer’s money against the failure of the bank where deposits are held. Yet, just like banks, they lend money to large corporations including commercial and investment banks. (It’s worth mentioning that money market accounts, unlike money market mutual funds, are held at regulated banks, and function like ordinary savings accounts. Although they generally earn less interest, they’re federally insured.)

Fund sponsors, and the government, according to Schapiro, bailed out money market mutual funds more than 300 times since the 1970s. Most dramatically, a money market mutual fund that had invested heavily in Lehman Brothers debt was caught out in September 2008 when that firm collapsed. The fund took the virtually unprecedented step of “breaking the buck” -- valuing its shares at less than $1. This decision led to panic withdrawals from other similar funds, with more than $300 billion withdrawn in one week. The U.S. government was forced to guarantee all money market mutual fund investments in order to stem the panic.

The Dodd-Frank Consumer Protection and Wall Street Reform Act of 2010 bans further government support for money market mutual funds. But it fails to correct the underlying problem. Funds could be caught short again. If this happens, a run on these funds might follow.  But this time, the federal government would be prohibited from stopping the slide. And if fund sponsors decide not to bail out their funds, or lack the resources to do so, your savings and your job are at risk.

3. Extending securitized mortgage madness to the rental market.

In 1988, the Bank of International Settlements introduced bank capital standards, a risk-based system to make banks safer. These rules encouraged banks to remove various sources of risks from their balance sheets by sending them to the shadow banking system.

In the mortgage world, the BIS rules spawned a system of loan production where those banks that made loans didn’t hold them to maturity.  One way banks protected themselves from mortgage risk – the possibility that borrowers would default on their loans—was by inventing mortgage-backed securities (MBSs). These securities are typically made by assembling a pool of mortgage loans, and then designing a security that will pay investors based on the revenue earned by collecting mortgage payments from that pool.

As was the case before the BIS changes, banks got fees from making loans. But they don’t hold onto the loans themselves, as investments. And since someone else—those who bought the mortgage-backed securities, including many state and foreign governments, charities, and pension funds—stepped in to serve as the investors, banks stopped worrying about whether borrowers could repay or not. For their part, banks just focused on volume—making as many loans as they could. Instead of making the regulated system safer, the BIS rules helped generate the factors that led to the financial crisis that began in 2007 and continues today. No one was responsible for making sure that loans made could be repaid. But plenty of people got rewarded for the number of loans they made.

Mortgage brokers, who operate largely independently, in the unregulated shadows, for example, originate mortgages and are paid based on production. The typical borrower assumes a broker represents his interests, but brokers actually had big financial incentives to place customers into what are the most profitable loans for banks, rather than the best deals for customers.

The end result of a system that paid people to make loans, whether or not they could be repaid, was lots and lots of bad loans. When conditions turned downward in local real estate markets, people found it difficult to make their mortgage payments. When mortgages weren’t paid, investors in MBSs weren’t paid either. These investors — e.g. your pension fund—suffered major losses.

In a pre-MBS world, banks would have had a big incentive to keep people away from mortgages they couldn’t  repay or once they got in trouble, to revise loan terms using common sense. But this isn’t possible in the shadowy world we live in: borrowers don’t even now who to talk to in order to get some relief. Unsurprisingly, many struggling borrowers, many of whom had been steered into bad loans, ended up being losing their homes and savings.

Did anyone learn from this past mistake?

Nope. The financial industry is lining up to make the same mistakes all over, again with the acquiescence of regulators, who show no signs of stepping in and stopping them. This time, however, they want to securitize rent rolls, by assembling a pool of rentals. The income stream from these rentals—meaning the combined rent checks of everyone in the pool-- would be packaged into securities, which would be sold onto investors.

Think about what this means. Just as banks got out of the business of administering the mortgages they made, these securitized rental investors would replace conventional landlords. To make these deals profitable, lots and lots of mortgages would have to be combined. But, the investors won’t administer these rentals. Instead, a rental servicer would be responsible for collecting your rent and distributing it to all of the investors.

Now, what will happen when your toilet backs up or there is no heat? Your concerns would be addressed at a call center, perhaps in another country, provided you stay on hold long enough and are eventually switched to the right person.

Most likely, after leaving any number of messages, your rental servicer will schedule an appointment when you have to be at work. Or, will just allow you to get on with it, and sort the problem on your own.

Suppose you decide to hold back rent until the repairs are taken care of. The servicer may report you as delinquent in paying your rent. That may make it harder for you to find a new rental later—or finance the car you need to get to work—because this negative information would be reported to credit agencies. 

Rent securitization is also a bad idea for the investor. There is no historical information on investment performance of securitized rent pools. What looks like a good deal on paper for your pension fund could lead to losses even after someone is evicted on your behalf. Do we really want to go down this road? Doesn’t the ongoing mortgage and foreclosure mess give us a good idea of how this movie ends?

4. The wild world of derivatives.

One big misconception spread by shadow banks and their enablers is that these entities performed better in the banking crisis than regulated banks and that they never get too big to fail.

This statement just isn’t true.

Long-Term Capital Management, a shadow bank, was managed by trading rock stars that included two Nobel Prize winners for their work on derivatives. It was rescued in 1998 — four  years after it was founded— to protect the regulated banking system when its derivatives bets backfired. Bad bets by AIG Financial Products on unregulated credit default swaps threatened to push regulated firms, such as Goldman Sachs and Deutsche Bank, into bankruptcy in 2008. The federal government stepped in to bail out  AIG, to make sure its mistakes didn’t destroy the other firms. At the same time, the feds also ponied up massive cash infusions and tax breaks to bail out America’s biggest banks, and provided guarantees to investors.

The Commodity Futures Modernization Act of 2000 explicitly exempted over-the- counter derivatives, such as the ones that caused so much trouble for AIG, from regulation. Yet now, nearly four years after the AIG fiasco, regulations have yet to be implemented to prevent a repeat of the daisy chain of derivative counterparty failures requiring a bail out.

The financial crisis caused many derivatives to blow up in highly unpredictable ways, which had serious consequences for those that bought them. The U.K. has forced financial firms to make good on mis-sold swaps—those sold to customers that didn’t understand the products they’d been led to purchase. The U.S. has yet to adopt rules to protect customers from abusive practices, including excessive hidden fees and lack of suitability for intended purpose, that caused major hardships to small businesses, charitable institutions and state and municipal governments.

The financial world has been rocked this summer by allegations that the big banks that set the London Interbank Offered Rate (LIBOR) colluded in fixing the rate, in ways that suited the interests of these banks. LIBOR is used to set the interest rates used in calculating trillions of dollars worth of derivatives contracts.

Amazingly, banks themselves have been left alone in setting these rates, supervised only by a private organization, the British Bankers Association (BBA). The Wall Street Journal reported recently on how throughout the financial crisis, major banking regulators in the U.K. and the U.S. went out of their way not to confront the LIBOR problem. 

They recognized the banks were manipulating the rate. Such shenanigans affected the value of derivatives contracts—the amount charities, government, and companies paid for various types of protection against financial risk that they’d purchased. These rate manipulations benefitted banks, not the entities on the other side of the contract.  But the regulators refused to get involved. After all, the BBA was part of the shadow banking system, so no one was in charge.

Home alone

Despite huge public investment in regulation, there is no single U.S. government agency responsible for the stability of the financial system. Dodd-Frank established a new Financial Stability Oversight Council (FSOC) to coordinate regulation. But this committee formed of all the regulators who were unable to prevent the last crisis—plus some new ones-- is clearly an unwieldy structure for addressing the challenges the U.S. now faces. The FSOC retains all those regulatory fiefdoms that refused to surrender their independence, and be folded  into an overarching organization that could regulate effectively. Europe’s done a better job at addressing these problems, with some countries adopting a “twin peaks” model—where one regulator worries about the stability of the financial system, and the other regulates the market activities the banks get involved in.

Today, the FSOC faces a crucial test. Shapiro has asked this group to step in where her agency failed. Money market funds have proven to be banks without capital that in 2008 caused a run that required a government bailout to arrest. Dodd-Frank prohibits future bailouts. The SEC is unable to regulate a set of major savings institutions that savers and corporations depend upon. Will the FSOC step into the breach? Or will shadow banks continue to be home alone without any supervision?

Caution, here be monsters!

Regulators have largely passed the buck to the shadow banking system. Rather than making regulations that ensure the safety and soundness of financial institutions, and safeguard the stability of the financial system, the riskiest activities are pushed away, out of sight, into the shadows.

But shooing these monsters off into the shadows doesn’t kill them. The shadow banking system rivals the regulated banking system in size and overwhelms it with risk. The regulatory net has big holes in it and enough has already slipped through. We already have a  great recession. We are reminded that it could have been worse. So why are waiting for shadow banking monsters to devour the economy— and your job, your savings, your community — again?

Alexander Arapoglou, professor of finance at the University of North Carolina's Kenan-Flagler Business School, has been a derivatives trader and head of risk management worldwide for various global financial institutions.

Jerri-Lynn Scofield has worked as a securities lawyer and a derivatives trader.