Shadow Banking System: A Murky World of Credit, Securitisation and Derivatives

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Since we have little interest in joining the speculative party going on in the stock market at the moment – other than in the precious metals and “positive black swan” type of stocks we mentioned yesterday – the task of today’s Daily Reckoning is to prove why the coming collapse of the shadow banking system is not deflationary by inflationary and, among other things, bullish for gold.

If that’s not the sort of discussion that interests you, you might want to go take a powder or read a good book. These are murky waters we’re wading through. So we’ll do our best to clear them up for you. But it’s probably going to take two days. Today, we’ll look at the case against deflation. Tomorrow, we’ll look at what it means for Australia.

All good debates begin with a proper definition of terms. Rather than defining deflation in our own way, we’ll leave it up to one of its most consistent and articulate (and accurate) advocates, Robert Prechter. He’s written about it for years. But for a short course on what he’s predicting and why, check out this video.

In the video Prechter says, “The next big phase [in the cycle] is a credit implosion where people who are debtors are going to be scrambling for dollars to pay off their debts and the creditors are going to be dunning the debtors to pay them back….The scramble will be for dollars not for things.”

The investment outcome of Prechter’s scenario is bullish for the U.S. dollar and U.S. Treasury bills, where he says, “the chances of default are low.” Prechter’s argument is based on the idea – which we happen to believe – that the U.S. Federal Reserve is unable to prevent falling asset values. This would lead, by Prechter’s reckoning, to falling stock, commodity, and real estate values.

All of that seems right to us so far. The deflationary argument depends on the collapse of both the shadow AND the real (deposit taking) banking system. The shadow banking system is the murky world of credit, securitisation, and derivatives which currently supports and/or holds some $600 trillion in assets. Yes that’s trillion with a T.

Most of these are interest rate and credit derivatives. As we learned in the last two years, the big risk here is to institutions which owe and own these obligations amongst one another. In our view, the degree of interconnectedness among these obligations (they still aren’t unwound) still makes the entire global financial system vulnerable to a systemic shock and/or total collapse.

It nearly happened last time with Lehman and frankly not much has changed since. A good old interest rate spike that’s not in anyone’s model might be the sort of thing that precipitates the next crisis. After all, that’s the way these things generally begin.

You could make the argument that it shouldn’t really matter to the real economy if a bunch of global institutions find out they can’t settle their obligations to one another. Why not just forget the whole mess and start other? After all, most of these derivatives are just insurance policies of some sort. Can’t we just cancel the policy?

Probably not. These positions are held in conjunction with myriad leveraged bets on the direction of other asset prices. They are hedges. No one is going to walk away from them. But more importantly, the connection between the shadow banking system and the real banking system is much more substantial than you might first imagine.

So much of today’s funding, financing, and lending is done by the shadow banking system through securitisation and money markets and income and mortgage trusts. The real economy is tied to the shadow banking system in just the way that you are tied to your own shadow. And the real, deposit taking, depostior (taxpayer)-insured banking system is not much better off.

For example, my colleague Porter Stansberry reported today that in the U.S., 7.1% of commercial real estate loans are more than 90 days overdue. The FDIC reckons that over 700 U.S. regional and local banks are “danger” banks. The reason is that these banks own mostly commercial real estate. It’s their main asset. And unlike their money-centre big brothers on Wall Street, these banks aren’t going to be recapitalised or bailed out at taxpayer expense.

Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply. Banks, more than the central bank, are the engine of money and credit growth in a fiat money system. Take away several hundred banks, and you get lenders not making loans. Money supply shrinks. Cash and Treasuries gain in value.

In fact, when you couple the wounded regional banks in the U.S., who are massively exposed to one dangerous asset class, with the potential collapse of the shadow banking system from another interest rate/liquidity/solvency shock, you begin to wonder how deflation is avoidable at all in the near future.

We have a laboured three-part answer. We’re going to lay it on you now. It begins with the destruction of the shadow banking system. It accelerates with the paralysis of the regular banking system. And it concludes with deliberate devaluation of the currency via monetary and fiscal policy to make up for a completely destroyed credit system.

It’s easier than it sounds.

Granted, it probably sounds absurd that you can have a $600 trillion wipe-out in the shadow banking system and have inflation. But there are two points to make here. First, it’s hardly believable that an institutional panic and bank run in the shadow banking system (what happened last time) would actually boost confidence by individuals and consumers in the overall banking system.

True, it might increase people’s preference for liquidity and cash. Stocks, real estate, and bonds would fall. But another swift collapse in the shadow banking system would be a hammer blow to already fragile confidence in our financial system, including the value of paper money itself.

But a more technical response is that as the shadow banking system is unable to finance economic activity and speculation, either that activity goes away (a Greater Depression) or someone else tries to fill the gap. We’ll assume for the moment the regular banks won’t do it. That leaves the government.

And in fact, that is what you had in the U.S. following the last crisis. You got an alphabet soup of Fed-backed programs to provide all sorts of credit…to students, to money markets, to car companies, to corporations. This list grows longer by the day. And what it means is that the only provider of credit in a post-shadow banking world is the public sector: the Fed and the Treasury.

Whether these are loan guarantees or outright loans or the purchase of securitised mortgages (Fannie and Freddie) it amounts to the same thing: a huge transfer and burden to the public sector balance sheet. Whether it’s monetisation or guarantees that add to Federal liabilities, both are dollar bearish. The transfer to the public sector then, results both in destruction of asset values and inflation in the currency.

But wait! You can’t have inflation if there’s no one to make loans and use the money multiplier to turn growth in the monetary base into new Federal Reserve Notes. That is, if the shadow banking system collapses, won’t this lead to the same no-risk paralysis with the big banks that has led to their holding trillions of dollars in excess reserves with Central Banks?

Why yes, it will. But this also argues for inflation. Here we’re going out on a limb. But what we’re arguing is that as the private sector is less able or willing to dole out credit into the economy, we’re entering a world where the government is going to bypass the middleman and do the job itself.

This happens in three ways. First, the government can buy securitised assets to fund non-bank lenders. The AOFM does this in Australia to support housing prices and non-bank lending to first home buyers. It’s done in the State at a much more comprehensive level. In effect, the entire American mortgage market has been nationalised with the government guaranteeing and buying trillions in mortgages.

This is the future. More nationalisation of key lending institutions. If the private sector won’t do it, the Feds will. But at great cost. Each new loan guarantee weakens the public balance sheet and the currency. Thus the retreat of the banks from credit creation hastens the day where fiscal and monetary policy are forced to be more transparently absurd and redistributive.

The second way in which the government becomes a lender is through extended unemployment benefits. The dole. In some States, it’s possible to receive 99 weeks of unemployment benefits. This doesn’t mean dole bludging has become a full time job. But it does mean that the structural changes to Western labour markets wreaked by globalisation are wage deflationary.

To us, this means a larger regular expenditure on the unemployed. The U.S. is headed the way of Europe, with higher structural unemployment. Whether it can afford to pay for this while fighting two wars, spending a $1 trillion expanding health care coverage, and preparing for an increase in entitlement payments…well you do the math.

The net result of the increased burden on the public sector in supporting private incomes is a weaker currency. It always comes back to that. And it’s true for the Euro, the Yen, and the Dollar. It’s true, in fact, for all paper money. This is why we believe the end of the super cycle in paper money is bullish for precious metals (not deflationary).

The third way in which the government bypasses the traditional banking sector to get money into the hot little hands of consumers has already been suggested by Ben Bernanke: via helicopter. And this really is the greatest argument against the deflationary theory.

In one sense, Bernanke was right. The Fed can create an infinite amount of digital dollars. It can expand its balance sheet infinitely too. It can buy assets directly. It can buy gold mines. It can probably create a market that securitises future consumer wages and pays you now for them. You literally mortgage your wage-earning future (or perhaps you get an early pay out on your social security).

The only real restrictions on the Fed’s ability to create money are rising bond yields (market discipline on currency mismanagement) and political interference. On the first issue, the Fed has some covering fire. Global investors have to own something. And right now they prefer the dollar. Unless the Fed does something radical and reckless, it can expand its role in providing credit directly to the real economy without doing huge damage to the dollar…mostly because there are so few other good options.

Obviously we think gold is a good option. But for nations like China with trillions locked up in dollar-denominated assets, what options are there?

You could argue that the U.S. Congress and the President would not allow the wilful debasement of the currency via an expanded Fed role in direct lending. But we think just the opposite. Those ass-clowns will be begging for it.

When commercial real estate blows up regional banks, we predict you’ll see the President declare victory in Iraq and Afghanistan within months, bring the boys home, and cut defence spending by 30%. The money will pour into new lending and “jobs” programs to support the economy. Fiscal and monetary policy will work hand in glove to pump funny government money directly into the consumer economy. The only result there can be is hyperinflation.

So, it’s possible – likely even – that you’re going to see across the board falls in stocks, real estate, bonds, and commodities….AND inflation. Whether we got the proper sequence right, we’re not sure. But the combination of a shattered shadow banking system, a paralysed banking system, and a terrified government certainly do add up to massive inflation.

Tomorrow, is this just an American tragedy? Or is Australia at risk too? And quite obviously, what should you do?

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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14 Comments on "Shadow Banking System: A Murky World of Credit, Securitisation and Derivatives"

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Coffee Addict
Guest
Excellent article Dan! A political impetus of all governments will be to maintain employment AND for this they require lower wages. Governments can’t reduce nominal wages (Greek style) without voter / law and order troubles so Governments will embrace inflationary monetarisation as their friend. The bottom line is that real wages must drop to maintain employment. As for the banks it is beyond me as to why anyone would deposit funds in a 2nd or 3rd tier institution here there or anywhere (said Sam I am). Green eggs and ham will indeed be offered to superannuants, they will take up… Read more »
Matto
Guest

the shock may well lead to helicopter drop debasement of currencies but i worry as much abou the inital shock as the resultant policy. I get the feeling it could be much less a short freeze as one that could be up to a year or two in length, before hyperinflation were to take hold. either way a hyperinflation depression here we come!!

Ross
Guest
I don’t entirely disagree, but for me it is a matter of sequencing and timing. The envisaged Fed balance sheet growth is mind boggling and that will need hard proof by way of deflationary pain before the US govt could move. The EU core won’t move at all and this hasn’t been factored. If any major fiat currency won’t join the race to the bottom it will hit the fan big time. Imagine the effect of new Euro or other dissenter’s hot money buying up the same US assets that US domestic borrowers had just paid off at a massive… Read more »
GB
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Dan,
you said at the start that the next phase will be bullish for USD and treasuries as debtors scramble for dollars. This will lead to a fall in stocks, property and commodities

If so, then wouldn’t it be wise to invest in USD now, wait for the next phase to hit and once USD hits a high then sell the USD and buy gold

Gold fell when the USD spiked in 2008

SV
Guest
This is a rather complex scenario. Is this the only possible one, the most likely one or simply one of the many? Why would not Bernanke bail out regional banks? I understand they are not like his chums from Wall st, but still… colleagues. Why would not he prop up real estate, like Japanese did? This can drag on for years. Economists routinely underestimate politicians’ ingenuity. How about selling Alaska back to Russians? And Russians could sell the Kuril islands to Japanese. Even in the “express” scenario, how all this – from “recovery” to “hyper-inflation” phase would fit into months… Read more »
Smack MacDougal
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Dan writes, “Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply… Take away several hundred banks, and you get lenders not making loans. Money supply shrinks.” Yet, what Dan writes is not quite right. Dan makes the mistake most make because most do not quite get money, credit and banking. On the Great Depression ——————————– The number of extant dollars and minted coins did not disappear during the Great Depression. Thus no “contraction in the money supply” happened. This is true, especially, after FDR confiscated gold and gold coins, forcing… Read more »
Stillgotshoeson
Guest
@SV “This is a rather complex scenario” About somes it all up.. no one has definitive answers.. not governments.. certainly not economists and federal bankers… One can only read all the information, hope it is true, and make decisions based on how they feel is the best way to go.. Some think the worst of the GFC is over, some think we are in the eye of the hurricane and more to follow and some think that it has only been the entree with the main to come. All I know is the world economy has had trillions thrown at… Read more »
Ned S
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Mr Denning’s finest work that I’ve read I think. Ta DRA.

SV
Guest

I would like to ask a simplified question – why would there be a shock and blow-up of the financial system, rather than continuous patching by Bernanke? and why would this occur within months?

Stillgotshoeson
Guest

a simplified answer.. it would be like trying to build a wall below the water line at the beach to stop the tide coming in. The sea is the global economy, the bricks are the patches.. the tide is going to come in faster than he can patch.

Biker Pete
Guest

“And quite obviously, what should you do?”

Decouple. Time to unshackle ourselves from the USS Titanic… .

Dan
Guest

The shadow banking system is the metaphoric gun to the head of the world’s governments.

prozak
Guest

…and this is what you get when you have a writer extrapolate their own bias and speculative ideas on a few comments from a psychologist who occassionally gets the odd thing right.

Great read mind… I was reaching for my popcorn.

Can’t wait till version 2.. maybe throw in a godzilla to spice things up though.

Ross
Guest
Dare I say I enjoyed that Smack? Below is a link that reveals some impending consequences of the exposure of the naked counterparties (I am bracketing the monolines with swap parties with the latter the more extreme end of Rubinomics creationists work from vapor) those that pretend to wash bankster risk for sucker investors. http://www.smh.com.au/business/train-project-goes-off-the-rails-20100310-pz8l.html So DD’s “Shadow Banking System: A Murky World of Credit, Securitisation and Derivatives” has entrails of consequence into public infrastructure stimulus spending as well as major private project finance. The next Hoover Dam is no certainty, it took the Korean War boom to build our… Read more »
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