An overview of shadow banking for journalists

This post is a transcript of  a 12-minute talk RepoWatch editor Mary Fricker gave at the annual conference of Investigative Reporters & Editors in Boston June 15, 2012. Click here for accompanying handout and slides.

Shadow banking was the epicenter of the financial crisis. Almost no reporters understood it then and not many understand it now. But it is important because it probably provides half the credit in this country, and we’ve seen how dangerous it can be, so we need to know how to cover it going forward.

(Slide 1)

To give you an overview, I’m going to describe five steps to shadow banking, starting with the step you already know, about home loans. As I go along, I’ll suggest some local stories you can do as soon as you get back to work.

But first let’s ask: What is banking?

“Banking” is what a bank does when it borrows short term, like from a depositor, and lends long term, like for a 30-year mortgage. That’s dangerous, because if lots of the depositors suddenly get scared and demand their money back right now – this is called a run on the bank – the bank can’t repay them because its money is tied up in 30-year mortgages. Pretty soon the depositors can force the bank into bankruptcy.

That’s why we have FDIC insurance – so depositors will feel safe and not run on their banks.

Shadow bankers make loans, too, like traditional banks do. But shadow bankers don’t get their money from depositors. They borrow it from Wall Street.

For Wall Street lenders to feel safe, they usually lend for brief periods, often just overnight, and they take securities as collateral, mainly U.S. treasuries, bonds and stocks.

For shadow banking to work, there must be securities.

If Wall Street lenders lose faith in those securities and panic, they will demand their money back. That’s a lot like a run on a bank. If the shadow bank can’t pay back the money, right now, the Wall Street lenders can force it into bankruptcy.

That’s what happened in 2007 and 2008.

Little has changed. It could happen today. It’s happening in Europe right now.

So shadow banking is banking that happens outside traditional deposit-based banking. (Its name came from economist and PIMCO executive Paul McCulley during remarks at the Fed’s annual symposium in Jackson Hole, Wyoming, in August 2007, and it has since been widely adopted by economists.)

Who are these shadow bankers and Wall Street lenders?

(Slide 2)

Here’s a list:

Asset management firms
Bank holding companies
Banks, investment
Banks, traditional
Companies, public and private
Exchange-traded funds
Hedge funds
Insurance companies
Money market funds
Mortgage servicers
Municipalities
Mutual funds
Pension plans
Private equity firms
Securities dealers
Securities lenders
Securitizing firms
Sovereign wealth funds
University endowments
Fannie Mae and Freddie Mac
Federal Home Loan Banks
Federal Reserve and other central banks

If you cover any of the institutions on this list, you need to be watching their shadow banking. Most make financial reports that are public. In our handout are several examples.

These are mostly giant institutions. Many are both borrowers and lenders on the shadow banking market. Notice that traditional banks are also shadow bankers.

Much of the action in shadow banking is driven by the institutions that have big pools of cash they need to invest – like money market funds, insurance companies, hedge funds, pension plans, municipalities, even university endowments.

The purpose of shadow banking is to get those big pools of money down to the consumers and businesses who want to borrow it. I’ll show you how that’s done, in the five steps I’m going to tell you about.

Where do these companies get their big pools of money?

From you, and from your readers and viewers. At IRE we always say Follow the Money. In shadow banking, the money comes from you and your readers – in money market funds, pension plans and so on – and it goes to you and your readers, when you buy a house or a car, or get a student loan, for example.

With that as background, here are the five steps of shadow banking that I want to tell you about:

(Slide 3)

1. Make loans.
2. Make securities (this is called securitization).
3. Sell securities.
4. Insure securities.
5. Keep securities to lend and repo.

Along the way, we’ll talk about six kinds of shadow-banking transactions*:

(Slide 4)

1. Asset-backed securities – ABS
2. Collateralized debt obligations – CDO
3. Asset-backed commercial paper – ABCP
4, Credit default swaps – CDS
5. Securities lending – SecLend
6. Repurchase agreement – Repo

(Slide 5)

Step One: Make loans.

First, a company makes a loan to a consumer or a business. Mostly what you’ve heard about was home loans, because they’re the ones that blew up. But there were also lots of other kinds of loans.

(Slide 6)

Here’s a list:**

Aircraft leases
Auto loans
Auto leases
Commercial real estate
Computer leases
Consumer loans
Credit card receivables
Equipment leases
Equipment loans
Franchise loans
Healthcare receivables
Health club receivables
Home equity loans
Insurance receivables
Intellectual property cash flows
Manufactured housing loans
Mortgages, commercial
Mortgages, residential
Motorcycle loans
Music royalties
RV loans
Small business loans
Student loans
Trade receivables
Time share loans
Tax liens
Viatical settlements

Companies making these loans are traditional banks, mortgage lenders, finance companies, credit card companies, and others.

Step Two: Make securities.

The company that makes the loan sells it to another company that I’m going to call a securitizing firm. There are many different kinds.

(Slide 7 )

Here’s a list:

Conduit
Special purpose entity – SPE
Special purpose vehicle – SPV
Structured investment vehicle – SIV
Trust
Variable interest entity – VIE

These firms have mainly one purpose: Pool a bunch of loans together and make securities backed by the loans.

The securities are called asset-backed securities. In a more complicated form, they’re called collateralized debt obligations or CDOs. CDOs were responsible for many of the losses in the financial crisis. A lot of these securitizing firms are offshore, but you may have one near you. I do.

Step Three: Sell securities.

Where does the securitizing firm get the money to buy the loans from the lending company? Mainly it sells three things.

First and second, it sells the asset-backed securities and the CDOs.

What few of us understood until it was too late was that a lot of the buyers are big investment banks and traditional banks. So when the crisis hit, the big banks got stuck with the losses. If real investors had been buying these things, and lost money, who cares? Investors lose billions of dollars every day. But when banks lose billions of dollars, that’s a crisis.

If you cover banks, you need to be watching their financial statements for this.

The third way the securitizing firm gets money is this: It sells asset-backed commercial paper, which is a kind of IOU that it promises to buy back real soon, probably tomorrow. Many of the buyers of this asset-backed commercial paper were money market funds. In the crisis, they panicked, and they stopped buying it. That was called a run on the asset-backed commercial paper market, and it was a big reason for the financial crisis.

If you cover money market funds or personal finance, you need to be watching for this.

Step Four: Insure securities.

By this point in our steps, a lot of companies own asset-backed securities, CDOs, and asset-backed commercial paper. The securitizing firms own some, and they’ve sold a lot to others. Companies that own securities often buy derivatives called credit default swaps to protect themselves. Credit default swaps pay off when securities default. They’re like insurance. Companies that don’t own securities also buy credit default swaps, to speculate. Often the same company both buys and sells these swaps.

That’s one reason shadow banking is so interconnected. AIG was the most famous collapse caused in part by credit default swaps.

Step Five: Keep securities to lend and repo.

Now if you’re a big company or bank sitting there holding a lot of securities, probably including U.S. Treasuries but also asset-backed securities, CDOs and asset-backed commercial paper – you’re collecting the interest payments, and you’re protected by credit default swaps – your busy mind will start trying to think of ways to use those securities to make more money.

In shadow banking there are two main ways: Securities lending and repurchase or “repo” agreements.

In securities lending, companies briefly lend securities to other shadow bankers in exchange for cash, often just for overnight. AIG lost almost as much money on its securities lending as it did on its credit default swaps.

In a repurchase agreement, companies use securities as collateral to get a loan from another shadow banker, often just for overnight.

Now, at this step in shadow banking something interesting happens. In a securities lending transaction or in a repurchase transaction, somebody gives cash and gets back securities. Whoever gets the securities can re-use them as collateral to get their own repo loan. Then the second repo lender can re-use the same securities as collateral to get a repo loan for themselves. And so on.

(Slide 8)

This is a daisy chain where the same securities become collateral for several loans. It’s called rehypothecation. It’s another reason that shadow banking is so interconnected.

Although repo loans are often made just for overnight, usually that loan gets renewed day after day. But at any time the repo lender can call the loan.

Companies that borrow on the repurchase market are often in danger, because their lenders can disappear overnight. We should be watching financial statements for repurchase loans.

In the financial crisis, repo lenders freaked out over the quality of the home loans that were in the securities that they’d taken as collateral. They called their loans. Some economists have called this a Run on Repo. Bernanke and Geithner have said this was the thing that scared them the most during the financial crisis.

(Slide 9)

And that’s the basics of shadow banking. It can get a lot more complicated than that, but that’s the basics.

Since the crisis, shadow banking has fallen by more than one-fourth. This is an important reason our economy is struggling and it’s hard to get a loan. But shadow banking will be back.

That’s the end of my 10 minutes. But I’d like to take just two more minutes to tell you a little bit about repo, which is my specialty. 

The repurchase market

Repos are the heart and soul of shadow banking, because they’re usually the cheapest way for big borrowers to get quick cash and the safest way for big lenders to lend.

Before the crisis, when shadow bankers bought asset-backed securities, CDOs, asset-backed commercial paper or credit default swaps, they often paid for them by getting a repo loan.

At the time of the crisis, at least $5 trillion was changing hands every day on the U.S. repurchase market. The main borrowers were companies like Countrywide, Bear Stearns and Lehman Brothers. The main lenders were, and still are, prime money market funds.

The Federal Reserve also has an interest in repos, because it has conducted its monetary policy transactions largely on the repurchase market, as do most central banks.

In the U.S., the securities that companies use as collateral for a repo loan are usually U.S. Treasuries and other government-backed securities. So the lender feels safe. But in the lead-up to the financial crisis, more and more of the collateral was asset-backed securities, CDOs, and asset-backed commercial paper.

Today the repo market is 40 percent smaller, in part because of the bad economy but also because there are not as many securities to use as collateral.

But bankers are out there right now looking for the next great repo collateral.

It better be safe. We need to be watching this. I hope you’ll start developing your sources right now.

*-These are securities for sale:
1. Asset-backed securities – ABS
2. Collateralized debt obligations – CDO
-This is a borrowing of cash pretending to be a security for sale:
3. Asset-backed commercial paper – ABCP
-These are derivatives:
4, Credit default swaps – CDS
-This is a loan of securities:
5. Securities lending – SecLend
-This is a borrowing of cash pretending to be a sale of securities
6. Repurchase agreement – Repo

**From “Securitization” by Yale University professors Gary Gorton and Andrew Metrick.