Shadow Banking, and Volker

I read a few interesting articles on how we got into this mess, why they didn't follow former financial models, and what the future can bring. The first link is one from a speech by Paul Volker, one of the great minds of our generation in terms of banking. He was chairman of the Fed under Carter and Reagan prior to Alan Greenspan, and he adds some great insight into our banking institution, what some of the problems are, and how to fix them. He is also on Barak Obama's financial team which is currently dealing with the crisis, and this gives me all the confidence in the world that they will do the right thing in terms of how to handle this c

Here is the speech in full:


Some excerpts from it with my comments below. . .

I really feel a sense of profound disappointment coming up here. We are having a great financial problem around the world. And finance doesn’t work without some sense of trust and confidence and people meaning what they say. You take their oral word and their written word as a sign that their intentions will be carried out.

The letter of invitation I had to this affair indicated that there would be about 40 people here, people with whom I could have an intimate conversation. So I feel a bit betrayed this evening. Forty has swelled to I don’t know how many, and I don’t know how intimate our conversation can be. But I will, at the very least, be informal.

There is a certain interest in what’s going on in the financial world. And I will disappoint you by saying I don’t know all the answers. But I know something about the problem. Let me just sketch it out a little bit and suggest where we may be going. There is a lot of talk about how we get out of this, but I think it’s worth remembering, or analyzing, how this all started.

This is not an ordinary recession. I have never, in my lifetime, seen a financial problem of this sort. It has the makings of something much more serious than an ordinary recession where you go down for a while and then you bounce up and it’s partly a monetary – but a self-correcting – phenomenon. The ordinary recession does not bring into question the stability and the solidity of the whole financial system. Why is it that this is so much more profound a crisis? I’m not saying it’s going to get anywhere as serious as the Great Depression, but that was not an ordinary business cycle either.

This phenomenon can be traced back at least five or six years. We had, at that time, a major underlying imbalance in the world economy. The American proclivity to consume was in full force. Our consumption rate was about 5% higher, relative to our GNP or what our production normally is. Our spending – consumption, investment, government -- was running about 5% or more above our production, even though we were more or less at full employment.

You had the opposite in China and Asia, generally, where the Chinese were consuming maybe 40% of their GNP – we consumed 70% of our GNP. They had a lot of surplus dollars because they had a lot of exports. Their exports were feeding our consumption and they were financing it very nicely with very cheap money. That was a very convenient but unsustainable situation. The money was so easy, funds were so easily available that there was, in effect, a kind of incentive to finding ways to spend it.

When we finished with the ordinary ways of spending it – with the help of our new profession of financial engineering – we developed ways of making weaker and weaker mortgages. The biggest investment in the economy was residential housing. And we developed a technique of manufacturing class D mortgages but putting them in packages which the financial engineers said were class A.

So there was an enormous incentive to take advantage of this bit of arbitrage – cheap money, poor mortgages but saleable mortgages. A lot of people made money through this process. I won’t go over all the details, but you had then a normal business cycle on top of it. It was a period of enthusiasm. Everybody was feeling exuberant. They wanted to invest and spend.

You had a bubble first in the stock market and then in the housing market. You had a big increase in housing prices in the United States, held up by these new mortgages. It was true in other countries as well, but particularly in the United States. It was all fine for a while, but of course, eventually, the house prices levelled off and began going down. At some point people began getting nervous and the whole process stopped because they realized these mortgages were no good.

You might ask how it went on as long as it did. The grading agencies didn’t do their job and the banks didn’t do their job and the accountants went haywire. I have my own take on this. There were two things that were particularly contributory and very simple. Compensation practices had gotten totally out of hand and spurred financial people to aim for a lot of short-term money without worrying about the eventual consequences. And then there was this obscure financial engineering that none of them understood, but all their mathematical experts were telling them to trust. These two things carried us over the brink.

This is a quick synopsis of what happened in the financial institutions, the problems with shadow banking, and the reasons for this. As he mentions, compensation practices were completely out of whack. The leading wall street firms were spending 10's of billions on bonus' to their employees which gave a VERY LARGE incentive to increase productivity no matter what. It was a short term solution to make very few people more money than they had ever dreamed of, and hell be damned with the consequences. This shadow banking system *note this is what Volker is talking about when he says "obscure financial engineering"* (also the reason it is called shadow banking is because it operates outside of federal regulation, a lovely gift given to the banking industry by the Gramm-Leach-Bliley Act) operates outside the federal limits because they are not a deposited institution, and instead operate on credit derivatives. They are a collection of Specialized Investment Vehicles, money funds, monolines, investment banks and hedge funds. To top matters off, these banks were creating the financial overseers in bond rating institutions whom they had under their control. They rating institutions were issuing D-rated mortgages and instead giving them an A or better rating in the fund. Because they operated completely outside of government regulations, there was no oversight on what they were doing and they destroyed our financial system and tore a whole through Wall Street.

Well, Volker talks about these institutions, and the lack of regulation. He also talks about how Canada was pretty much insulated from any of the financial mess we are in because their banking system is very regulated. It is one of the reasons there are swings in the beliefs in this country every 4 decades or so. You start out with a very highly regulated system which guarantees a small profit, but little risk. You then get people complaining that they should be allowed to be more risky, remove some of the regulation, allow them to leverage more and profits increase. This begets less regulation until the regulation is completely removed. Once the regulation is removed, the few people in charge care only about themselves, and the rest of the country be damned, as long as they have their 5th house and 12th Ferrari. The system collapses due to greed and stupidity, and we start out by regulation again. Wash rinse and repeat every 80 or so years.

Finally, I would like to post a link to one of the leaders of PIMCO, and managing director, Paul McCulley. He writes about the shadow banking system, what the future brings in terms of monetary policy, and where the future is heading. You can read what he wrote here. . . but I will post his last paragraph which is quite telling.

At least for now. Capitalism, and especially financial market capitalism, brought this outcome upon itself through greed and hubris. Capitalism is now re-grouping and learning how to play by new rules, which are still being written. And ultimately, I’m sure, capitalistic bankers will once again bend those rules in the pursuit of higher profitability. And that’s okay, I think. In the end, we really don’t want to turn our banking system into the DMV. At the same time, we also don’t want our banking system to be nothing more than a betting parlor.

Or, in the famous words of Keynes again:

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”


Great stuff from some great minds!