Shadow banking

Alan Greenspan claims not to have known the deleterious effects of having outsourced mortgage lending from the "traditional" banking system to unregulated Wall Street firms.

In his latest commentary, Bill Gross of Pimco describes how the former Fed chairman's successors are dealing with the mess now.

The modern financial complex has morphed into something unrecognizable to many astute market veterans and academics. Bernanke’s fellow governors and Hank Paulson’s staff at the Treasury spread their roots during an era in which traditional banking activity – lending out deposits backed by a certain level of reserves – was the accepted vehicle for liquidity creation. Remember those old economics textbooks that told you how a $1 deposit at your neighborhood bank could be multiplied by five or six times in a magical act of reserve banking? It still can, but financial innovation has done an end run around the banks. Derivatives and structures with three- and four-letter abbreviations – CDOs, CLOs, ABCP, CPDOs, SIVs (the world awaits investment banking’s next creation; perhaps IOU?) – can now take a “depositor’s” dollar and multiply it ten or 20 times. Reserve banking, and the Federal Reserve that regulates the system, appear anemic in comparison.

I’m sure that Bernanke, Paulson, and their cohorts understand this, but it isn’t yet clear how much they appreciate it. Alan Greenspan admits in his newly published book that he didn’t appreciate until recently the impact adjustable-rate mortgages and their subprime character, accompanied in some cases by outright fraud, would have on the housing market. If the Fed was so slow to grasp the role that subprime mortgages played in the housing boom and bust, do the Fed and the Treasury of today totally comprehend what happens when the nonbanking private system suddenly stops flooding the market with credit? Do they recognize that such a shutdown puts spending for housing and business investment at risk, and job growth as well? The Fed will have to adapt its monetary policy, and the Bush Treasury will have to adjust its fiscal policy to this brazen new world dominated more and more by private rather than public policies and proclivities. To overcome private-market caution, the Fed may need to put on a bold face marked by even more decisive cuts in short-term rates. To prevent a housing-market slump from metastasizing into a cancerous self-feeding tumor, Treasury Secretary Paulson will have to coordinate policies that lend a helping hand to homeowners in distress.
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But if Paulson cannot prevent expected declines of 10-15% in national home prices over the next several years, it is problematic as to whether Bernanke can substantially cushion them either. First of all, the aforementioned lack of “appreciation” of a modern-day shadow banking system has put the Fed far behind the 8-ball in its reflexive duty to lower interest rates in an anticipatory fashion. Mortgage credit has been contracting on the ground level for all of 2007 with individual, small, and then national mortgage brokers and originators closing their doors.

The lingering question for the former Fed chairman is, "Was he naive and incompetent, or was he complicit and responsible?"

You can't really separate these two pairs of adjectives.

Wall Street banking and reckless hedge fund operations would not have progressed to the egregious levels that were the norm back in 2004 and 2005 had someone been thinking about the bigger picture. Like all manias - when everyone seems to be getting rich - not nearly enough questions were asked by the people who should have been asking questions.

With the bursting of each bubble, it is painfully understood once again that there are "no free lunches" and "perpetual motion machines" are fantasy.

Many times, during Congressional testimony in his last few years, the calm reassurances that the "traditional" banking system was showing "little sign of distress" were uttered by Alan Greenspan. And, when the subject turned to regulation of hedge funds, an adamant tone was heard praising the innovation that would not be possible with intrusive oversight.

Perhaps Senator Jim Bunning of Kentucky put it best when, during a series of inquiries earlier this year prior to the housing and credit market problems coming to full flower, he wondered about prior testimony at the height of the housing boom:

I'm amazed, sitting here listening to all of our colleagues on the committee and forgetting who used to come here before this committee and brag about the housing market carrying the economy. None other than our former Chairman of the Federal Reserve Alan Greenspan.

He was in charge of bank regulation at the time when all these sophisticated mortgages came into being. And I didn't hear him say a word about these when he was here. And now I hear him criticizing everybody that's in the business of lending.

And, of course the video:

There is more related video by john67elco (author of the above) at YouTube.