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Posted by jeflin on September 22, 2008, 1:35 am
> http://www.ft.com/cms/s/0/622acc9e-87f1-11dd-b114-0000779fd18c.html
>
> The shadow banking system is unravelling
>
> By Nouriel Roubini
>
> Published: September 21 2008 17:57 | Last updated: September 21 2008
> 17:57
>
> Last week saw the demise of the shadow banking system that has been
> created over the past 20 years. Because of a greater regulation of
> banks, most financial intermediation in the past two decades has grown
> within this shadow system whose members are broker-dealers, hedge
> funds, private equity groups, structured investment vehicles and
> conduits, money market funds and non-bank mortgage lenders.
>
> Like banks, most members of this system borrow very short-term and in
> liquid ways, are more highly leveraged than banks (the exception being
> money market funds) and lend and invest into more illiquid and long-
> term instruments. Like banks, they carry the risk that an otherwise
> solvent but liquid institution may be subject to a self=ADfulfilling and
> destructive run on its =ADliquid liabilities.
>
> But unlike banks, which are sheltered from the risk of a run =96 via
> deposit insurance and central banks=92 lender-of-last-resort liquidity =
=96
> most members of the shadow system did not have access to these
> firewalls that =ADprevent runs.
>
> A generalised run on these shadow banks started when the deleveraging
> after the asset bubble bust led to uncertainty about which
> institutions were solvent. The first stage was the collapse of the
> entire SIVs/conduits system once investors realised the toxicity of
> its investments and its very short-term funding seized up.
>
> The next step was the run on the big US broker-dealers: first Bear
> Stearns lost its liquidity in days. The Federal Reserve then extended
> its lender-of-last-resort support to systemically important broker-
> dealers. But even this did not prevent a run on the other broker-
> dealers given concerns about solvency: it was the turn of Lehman
> Brothers to collapse. Merrill Lynch would have faced the same fate had
> it not been sold. The pressure moved to Morgan Stanley and Goldman
> Sachs: both would be well advised to merge =96 like Merrill =96 with a
> large bank that has a stable base of insured deposits.
>
> The third stage was the collapse of other leveraged institutions that
> were both illiquid and most likely insolvent given their reckless
> lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage
> lenders.
>
> The fourth stage was panic in the money markets. Funds were competing
> aggressively for assets and, in order to provide higher returns to
> attract investors, some of them invested in illiquid instruments. Once
> these investments went bust, panic ensued among investors, leading to
> a massive run on such funds. This would have been disastrous; so, in
> another radical departure, the US extended deposit insurance to the
> funds.
>
> The next stage will be a run on thousands of highly leveraged hedge
> funds. After a brief lock-up period, investors in such funds can
> redeem their investments on a quarterly basis; thus a bank-like run on
> hedge funds is highly possible. Hundreds of smaller, younger funds
> that have taken excessive risks with high leverage and are poorly
> managed may collapse. A massive shake-out of the bloated hedge fund
> industry is likely in the next two years.
>
> Even private equity firms and their reckless, highly leveraged buy-
> outs will not be spared. The private equity bubble led to more than
> $1,000bn of LBOs that should never have occurred. The run on these
> LBOs is slowed by the existence of =93convenant-lite=94 clauses, which do
> not include traditional default triggers, and =93payment-in-kind
> toggles=94, which allow borrowers to defer cash interest payments and
> accrue more debt, but these only delay the eventual refinancing crisis
> and will make uglier the bankruptcy that will follow. Even the largest
> LBOs, such as GMAC and Chrysler, are now at risk.
>
> We are observing an accelerated run on the shadow banking system that
> is leading to its unravelling. If lender-of-last-resort support and
> deposit insurance are extended to more of its members, these
> institutions will have to be regulated like banks, to avoid moral
> hazard. Of course this severe financial crisis is also taking its toll
> on traditional banks: hundreds are insolvent and will have to close.
>
> The real economic side of this financial crisis will be a severe US
> recession. Financial contagion, the strong euro, falling US imports,
> the bursting of European housing bubbles, high oil prices and a
> hawkish European Central Bank will lead to a recession in the
> eurozone, the UK and most advanced economies.
>
> European financial institutions are at risk of sharp losses because of
> the toxic US securitised products sold to them; the massive increase
> in leverage following aggressive risk-taking and domestic
> securitisation; a severe liquidity crunch exacerbated by a dollar
> shortage and a credit crunch; the bursting of domestic housing
> bubbles; household and corporate defaults in the recession; losses
> hidden by regulatory forbearance; the exposure of Swedish, Austrian
> and Italian banks to the Baltic states, Iceland and southern Europe
> where housing and credit bubbles financed in foreign currency are
> leading to hard landings.
>
> Thus the financial crisis of the century will also envelop European
> financial institutions.
That was a good article. A lot of these problems stem from lax
regulation and abuse of free-market principles. Let the shake-out
begin.
http://jeflin.net
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