The term “shadow banking” conveys a sense of darkness and illegality. However, that is not an accurate description of what is 21st century market-based banking. “Shadow banking” has become a popular description for credit intermediation outside the regulated banking system but, in many ways, it is highly misleading. Since the GFC, regulators are keenly watching what is going on in this sector of finance – the shadows that we know about, pretty much always on the right side of the law, have powerful spotlights pointing at them. The trick, however, is knowing where to point the spotlight and being able to figure out the significance of what is revealed.
In session 10 we shall examine the essence of market-based banking which combines both securitisation and collateral management. Conceptually, we already know how to “securitise” cash flows – we did that back in Session 4 by applying PDV/DCF techniques to, for example, regular mortgage payments. Now we look at actual examples and track the history of mortgage-backed securities (MBS) since the 1970s. Specifically, we look at the rise of Fannie Mae and Freddie Mac. Together with Ginnie Mae, these government-backed agencies dominate US housing finance and comprise at least 60% of US shadow banking.
Although Fannie and Freddie got into trouble, requiring both to be formally “adopted” by the Government (the official term is conservatorship), the main problem area in the GFC swirled around so-called private-label MBS. These were securities generated by loans that did not meet the relatively high standards of Fannie and Freddie. Such loans feeding into the private sector machine were either large, lacked key documentation or were dependent on borrowers with poor credit history (the infamous sub-prime sector). Another problem was the excess complexity of structured mortgage-backed securities. These were securities that involved slicing and dicing; apparently creating AAA credits out of mish-mashes of cash flows. Blinded by poor science and tainted by misaligned incentives, it was not long before the alchemy was caught out.
Policymakers have clearly been chastened by the GFC but the enthusiasm for securitisation and shadow banking remains intact. Rightly so, such activities have the potential to improve access to finance – encouraging growth and better living standards. But there is still an enormous amount of work to do to acquire information and understanding of what is going on in a rapidly evolving sector. Even on relatively narrow definitions, shadow banking is probably already larger than it was at the time of the GFC. Regulators are trying hard to keep pace but they are always going to be hard pressed to identify where the problem areas are. Back in the early 2000s, asset-backed commercial paper was the darling of the shadow funding sector. But that form of private sector money has long fallen out of fashion. Do we know where to look now? China’s huge shadow banking sector, Facebook, Google, Amazon, private equity, leveraged loans, maybe insurance companies, CCPs?
The problem in pinning down future financial risk arguably has parallels in international military conflicts. When former US Secretary of Defense, Donald Rumsfeld, was briefing journalists in 2002 on the flaky evidence linking Iraq to weapons of mass destruction he provided this epic quote:
“…as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones“
6 Nov 2019