How Shadow Banking Turns Sewage Water into a Double Malt Whiskey

Reddit

Yesterday we floated the idea that the Fed, and central banks in general, don’t actually ‘print’ money. They just monetise previously created credit. We know that probably sounds confusing, so we’re going to delve into the topic more deeply today. We’ll also show you why the Fed is becoming just a tad concerned about the effects of its ‘monetisation’ program.

People create credit and money, not central banks. A central bank sets the price of money and credit. Individuals or businesses create money by borrowing it into existence.

Take the example of a (rare) first home buyer borrowing $250k to build a home. The money didn’t exist previously but, using their credit and good standing, the bank agrees to create the money and credit their account.

The first home buyer then pays for the various services required to build the house, and the money flows through the economy. The loan therefore increases the amount of money flowing through the economy, which winds up back in various different bank accounts, which go on to fund other loans etc.

So the person now has a house as their asset, and a $250k debt to the bank as a liability. But 6 months later they lose their job, and can’t make their loan repayments. The loan turns bad and the bank has to write down the value of it.

Imagine, for a moment, that this happens on a large scale. If the bank was to write the loan down in value it would wipe out shareholder equity and render it insolvent. It doesn’t want to do that so it turns to the central bank for help. It says the situation is just temporary. It has a liquidity problem, not a solvency problem.

The central bank buys the loans off the bank for 100 cents in the dollar, even though they might be worth only 50 cents. In doing this, the central bank is monetising previously created credit that has turned ‘bad’.

This is how central banks try to avoid deflation. If inflation is just growth in the creation of credit money, deflation is the destruction of this money via loans turning bad.

This is a very basic example of how central banks operate in the normal banking system.

But the real action happens in what is known as the ‘shadow banking‘ system. This is truly a wonder of modern finance. It’s a system that creates more ‘money’ than central banks could ever dream of.

And therein lays the problem. Shadow banking is an out of control beast. Its fuel is hope…hope provided by central banks that they won’t let speculators go under.

What is shadow banking? It’s a system of banking for very large organisations (money market funds, pension funds, insurers, hedge funds etc) that is largely unregulated.

Put simply, the shadow banking sector monetises the debt created in the traditional banking sector and uses this money to speculate in the asset and derivative markets. In other words, it transforms long dated, illiquid debt instruments into ‘money’.

If you have a 10-year US government bond, you can go to an investment bank or broker and leave it as security (collateral) for an overnight cash loan. You then have ‘money’ to play with, and can keep rolling your loan over as long as you don’t do something stupid.

Even if you don’t have good collateral in the form of treasury securities, the shadow banking system has a solution for you. Through various relationships with the players involved (brokers, clearinghouses etc) you can swap a junk bond for a treasury note and then go elsewhere with your treasury note and obtain cash.

The shadow banking system is a place where you can turn sewage water into a double malt whiskey.

This all works amazingly well when participants are ‘hopeful’ that nothing will go wrong. There is faith in even the poorest form of collateral, like junk bonds, and when sentiment is so bullish, the system turns nearly all forms of market debt into ‘money’.

But last week, a little known Fed member, Governor Jeremy Stein, gave a speech titled ‘Overheating in Credit Markets: Origins, Measurement, and Policy Responses’. It’s a bit dense, but well worth the read.

He basically shines a light on the largely unregulated shadow banking system, and ponders how the Fed should respond to the excesses that are beginning to emerge. He doubts that regulation can have a meaningful effect on curbing excesses, and wonders whether monetary policy should play a greater role.

Such a ‘solution’ may sound completely rational to a person with common sense. But coming from a Fed governor, it’s a big deal. If Bernanke had made these comments, markets would have plunged.

The Fed knows the real turmoil in the credit crisis had its origins in shadow banking. It was where the double malt whiskey went back to being sewage water.

That it will happen again is assured. It always does. That the Fed is wondering aloud how it might prevent it is also another obvious sign of the inherent fragility of the system.

So, keep one eye on the exit, because the Fed is getting nervous.

And buy some gold, which is currently on sale for the Chinese New Year.

Diggers and Drillers editor Dr Alex Cowie has found a profitable way to do so, here.

Regards,

Greg Canavan
for The Daily Reckoning Australia

Join me on Google Plus
From the Archives…

Money in the Time of Financial Cholera
8-02-13 – Satyajit Das

Dishonest Leaders and Delusional Voters
7-02-13 – Bill Bonner

Uranium: The Commodity Like Gold Ten Years Ago
6-02-13 – Byron King

How Australia-China Relations Are Caught in the Monetary Battle Space
5-02-13 – Dan Denning

The Great Rotation Into Stocks
4-02-13 – Dan Denning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
Reddit

Leave a Reply

1 Comment on "How Shadow Banking Turns Sewage Water into a Double Malt Whiskey"

Notify of
avatar
Sort by:   newest | oldest | most voted
shortchanged
Guest

Good report Greg, how about telling the boys and girls about Fractional Reserve banking where, depending on the rate at the time, for every $1000 deposited in the bank, $9000 is loaned out, with the extra interest free to the bank. Amazingly, when I asked a bank employee what the reserve rate was, she did not know what FRB was, and when explained to her she, and other colleagues said they had never heard of it. Banking employees not knowing that., what kind of people do we have working in banks these days?

wpDiscuz
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au