This post is a transcript of an 11-minute talk RepoWatch editor Mary Fricker gave to college journalism professors, students and others at the 11th Annual Convergence and Society Conference, Advancing Business Journalism and Convergence, at the University of South Carolina School of Journalism and Mass Communications September 28, 2012. Click here for accompanying handouts “In plain English,” “Resources,” and “Story ideas.”
Sometime on the weekend of September 19, 2008, I got one of the shocks of my life, when I heard on the car radio that Treasury Secretary Paulson was asking Congress for $700 billion to keep the financial markets from collapsing after the downturn in real estate.
Maybe I was in a better position than some to understand what this told us about how big our problem must be, because I’d been a reporter during the last major financial crisis 20 years earlier.
I’d like to take you back to 1986, when I was a newspaper reporter in Northern California and shareholders of a tiny savings and loan (which was supposed to be making home loans) started coming into the newsroom with stories that the CEO and others working at the thrift were throwing money around, making crazy loans, and basically looting the place. Even the mob showed up at the loan window.
Following those tips, we spent four years digging through what became the nation’s S&L crisis.
In the end, regulators had to close 1,043 savings and loans, which was one-third of the industry. It was a stunning financial collapse. Almost every town in America was affected.
Yet in the end it only cost taxpayers $150 billion, which in 2008 dollars would have been $247 billion.
Paulson was asking for almost three times that much.
That day it really hit me, how badly I had failed my readers.
Oh, sure, I’d written housing bubble stories and I’d warned about derivatives and conflicts of interest at credit rating agencies. Who hadn’t? But I’d never written that the financial markets could collapse … because I didn’t know it. It was my job to know it. But I didn’t.
We’d had plenty of real estate bubbles before. I’d reported on at least three in my years as a reporter. They caused recessions, but they didn’t cause financial markets to collapse.
And besides, weren’t those home loans being pooled and packaged into securities that were sold to investors? And if investors lost money, who cares? Don’t investors make and lose money in the financial markets all the time?
Something didn’t add up. There had to be something I didn’t know.
It turned out that I didn’t know it because I hadn’t asked this obvious question: Where’s the money coming from to fuel the housing bubble and make all these home loans?
I hadn’t followed the money, as we are all taught to do.
The answer turned out to be: Shadow banking, which by 2008 had grown to provide about half the credit in this country for houses, cars, college educations, businesses, and much more. Yet I knew very little about it.
Shadow banking is banking that happens on Wall Street instead of in a bank. In my 10 minutes today, I don’t have time to explain much about how shadow banking works. You have a handout today that does that, and honestly it’s not hard to understand.
Also in the handout is a list of the kinds of companies that do shadow banking, including mortgage companies like Countrywide, all the investment banks like Bear Stears and Lehman Brothers, large corporations like GE, insurance companies like AIG, large money market funds, in fact, all big financial institutions including traditional banks.
But about shadow banking, I do want to just briefly say that it has five basic steps. Remember that traditional banking essentially has two steps: A bank makes loans with money it got from depositors. Well, shadow banking has five steps, and you already know some of them.
Step one: A company like Countrywide or a bank makes a loan. We know that step.
Step two: That company sells the loan to a different firm, which is often offshore. This second firm pools the loans and makes securities backed by the loans. We already know about the pooling and the securities, right? But we don’t know much about these odd securitizing firms, which often don’t have employees and may be owned by charities.
Step three: Then this securitizing firm sells some of the securities to investors. We knew that. But it also sells securities to giant financial institutions. We didn’t really know that part. And it keeps many of the securities itself to use as collateral to get overnight loans for itself from those same giant financial institutions. We didn’t really know about that part either.
Step four: The giant financial institutions, which now own some of these securities or have made loans secured by them, try to protect themselves from losing money on these securities by buying derivatives called credit default swaps. You probably know about this step because our reporters have done a great job of covering it.
(And, by the way, we’ve done a great job of covering derivatives in this crisis because years ago – and I remember this – some reporters did the terribly difficult early reporting to help us understand them, which is what we need to do now for shadow banking.)
Step five: These same giant financial institutions, which now own these securities or have made loans secured by them, also use them as collateral to get overnight loans for themselves, from each other.
With this new money, these new overnight loans, the steps begin again. The giant financial institutions recycle the new money down to step one, to make more loans, to use the loans to make more securities, to use the securities as collateral, to get more overnight loans, and so on.
This repeating cycle of five steps is shadow banking. (My web site, by the way, is mostly about step five. And just to prove there’s nothing new under the sun, a key reason for the largest collapse during the S&L crisis, American Savings, was … step five.)
What makes shadow banking so dangerous? It’s the same thing that makes traditional banking dangerous, it’s banks and other financial institutions borrowing money for short periods, like from depositors, and then turning around and lending it for long periods, like for a mortgage.
It’s borrowing short and lending long.
But shadow bankers don’t get their money from depositors like traditional bankers do, so they don’t have the safety net of FDIC insurance. Shadow bankers get their money by borrowing it on Wall Street from money market funds, pension plans, insurance companies, university endowments, municipalities, other big banks – from anybody with big pools of money to lend.
In fact, the purpose of shadow banking is to get those big pools of money down to the people who need to borrow it, to buy a house or car, for example.
These lenders, these big pools of money, are like depositors at traditional banks in that they can demand their money back at any time because they usually lend for very brief periods, like overnight.
If they lose faith in the securities they’ve taken as collateral, like they lost faith in mortgage securities in 2007 and 2008, they can panic and demand their money back.
That’s like in the years before FDIC insurance, when depositors panicked and ran on their neighborhood bank, lining up outside the door to get their money out, and quickly made their bank insolvent because it didn’t have the money any more, it had lent it long on things like home loans.
That’s really what happened in 2007 and 2008. We had the 21st Century version of a run on many shadow banks by shadow lenders, and it quickly threatened to bankrupt nearly all of our largest financial institutions.
Here’s what Bernanke said:
“As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression …Out of maybe the 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.”
Since these shadow bankers, these giant financial institutions, made many kinds of loans, not just mortgages, the flow of all credit was quickly grinding to a halt.
That, the broad freezing of credit, was what almost turned a real estate bubble into a collapse of the financial markets and sent Paulson to Congress begging for $700 billion … on top of the more than a trillion dollars the Fed was pouring into the financial markets.
It worries me deeply that shadow banking is nearly as vulnerable today as it was in 2008. Little has been done to fix it. I’m afraid that might be our fault, at least in part, because we journalists haven’t covered it very much. We’ve focused on mortgages and CDOs and derivatives and Fannie Mae and Freddie Mac and Glass-Steagall, and those are very important. I’m proud of the work we did in those areas. But we can fix mortgages and CDOs and derivatives and Fannie and Freddie and Glass-Steagall until we’re blue in the face, and we’ll still be vulnerable to runs on shadow banking … which is quiet now, but it won’t stay that way because it’s so profitable for shadow bankers.
When I’ve asked reporters why they don’t write more about shadow banking, they often say it’s hard to explain and readers aren’t interested.
Here’s where convergence and multimedia can save the day. My handout has some examples of this. We business reporters, who have such tough things to write about, can be the most enthusiastic embracers of graphics and video and audio and anything else the new media can give us to help us make shadow banking easy to understand and interesting. This conference has so much to offer us.
One last thing to keep in mind, as you try to make shadow banking relevant to your audience: Shadow banking is done with our money. Our money, in money market funds, pension plans, insurance companies, university endowments and so on, gets loaned to banks and other financial institutions, who in turn lend it back to us to buy houses and cars, get student loans, and anything else we need to borrow money for.
This is not esoteric stuff.
This is everyday life.