Let sleeping shadow banking systems lie

By J Saft
March 6, 2009

James Saft Great Debate – James Saft is a Reuters columnist. The opinions expressed are his own –

Rather than vainly trying to refloat the shadow banking system, the U.S. would be better off grappling with the inevitable ultimate solution — debt destruction and inflation.

The common denominator of policies like the Term Asset-Backed Loan Facility (TALF) that was detailed on Tuesday, is that they try to solve fundamental problems with indebtedness by attempting to float asset prices high enough that they are back in proportion with the debt.

Even more, they use the same structures that worked out so poorly — highly levered hedge fund like vehicles and securitisation — but this time substitute government funding and leaves the taxpayer as main bag-holder if the deals go bad.

With up to $1 trillion, the TALF is designed to re-start parts of the securitization market such as auto, business and student loans. This followed the plan to avoid foreclosures and further house price falls by cutting borrowers, many of whom made silly borrowing decisions, a break on their interest rates.

Next up: a public-private plan to buy up toxic legacy assets from banks, which should be detailed in the next two weeks. Again, that program will provide government money at sub-market rates to investors to entice them to pay more than the market price for assets that would otherwise sink many banks.

The higher the leverage supplied the higher the price hedge funds and other investors will pay for doubtful assets. After all, like a Florida condo flipper, if the asset declines in value they can just walk away and throw the metaphorical keys at the Federal Reserve and U.S. Treasury.

“We want to make sure that the prices of the assets that are purchased reflect true market values that are not overpaid. So the idea between the public-private partnership would be that there would be both public and private money involved and that the pricing decisions would be made by private-sector specialists, not by public bureaucrats,” Fed Chairman Ben Bernanke told Congress on Tuesday.

“If the government is willing to provide longer-term lending, or leverage, there are many investors who presumably would be willing to buy under those circumstances who are unwilling to buy without the credit, without the lending they need to finance those purchases.”

I simply cannot reconcile the first part of that statement with the second. What do we mean by “market values” in a situation where the government provides financing not otherwise available? Vary the leverage and achieve any price you like.


The TALF is slightly more defensible. There is a market failure when reasonably good credits can’t raise money under any circumstances. But before we try to re-start securitization and the shadow banking system, let’s recall what the problems were in the first place. For one thing the TALF relies upon imprimaturs from the credit ratings agencies which have been found wanting. That’s not yet changed, but government participation simply papers it over.

Even the obsession with banks almost seems beside the point.

“You won’t revive the economy through debt,” said Albert Edwards, global strategist in London at Societe Generale.

“Banks aren’t the problem, they are a symptom of the problem.”

The problem is that asset prices are out of line with their ability to generate cash flow. Falling prices do impose a risk premium but the real issue, for stocks or for houses, is that their prices are not in the proper proportion to the debts they carry and to their ability to generate cash. That happened in part because of the shadow banking system and was a mistake.

So, what’s the implication? Some debt will be repaid but a lot will just be destroyed via default. An organized write-down seems impossible. That will be a huge problem for the banking system and the country, and you can understand why the government does not wish to meet it head on.

University of Oregon economics professor Tim Duy thinks the U.S. will ultimately end its romance with financial engineering and get down to working through unsupportable debt the old-fashioned way — inflation.

“And therein lies the key to predicting when the Fed shifts gears; When Bernanke abandons the notion that proper credit market functioning is alone sufficient to restore housing values (asset values more generally) to their former glory and support acceptable growth,” Duy writes.

“At that point, the Fed will again consider the wisdom of what it has defined as quantitative easing, an expansion of the balance sheet via a deliberate expansion of liabilities.”

That is a dangerous and difficult to govern process, and the U.S. shows every sign of being willing to pay a very high price to avoid it.

But ultimately, the price will be too great and we will have to inflate and default in some mixture.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –


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I cannot understand how the explanation about “one dollar doing the work of 30″ applies to the situation at hand. Maybe that says something about how complex business transactions have become recently – or how incompetent I am. The way I see things, in order to have a subprime mortgage crisis, one needs not only insolvent buyers who take the “subprime” mortgages and lenders who approve and finance the loans, but also sellers who sell the houses (often at overinflated prices) and all sorts of middlemen who get their (often substantial) cut from the deal. I understand how falling prices and customer insolvency create losses on the banks balance sheets, what I don’t understand is how this ended up creating a systemic problem when all the sellers and the middlemen have gotten paid. It seems reasonable to assume that for every subprime mortgage, for every insolvent borrower, a significant amount of liquidity was created on someone else’s balance sheets, somewhere in this economy. Someone had to sell them that overpriced house. If I’m wrong about this, please enlighten me! I understand very well that on the falling side of the asset price curve, capital is destroyed, but on the other hand capital was created on the rising side of the same curve, by the exact same mechanism. The way I see it, the price curve first created capital in the hands of the sellers of real estate, and is destroying it now in the hands of the buyers. The only way this transfer of capital could cause a systemic crisis, it seems to me, is if the capital that was created on the rising leg of the price curve was at least in part withdrawn, not only from the housing market, but from the economy and the financial system as a whole. We can’t all be insolvent, or our debts would cancel each other out. Again, I am open to the possibility that my take on the subject is naive so I would appreciate any comments that would shed light on these issues.

Posted by Andre | Report as abusive

I simply can understand why our ”leaders” are throwing good money after bad. Surely the banking system needs an enema, not more feeding! Wouldn’t the money be better spent rebuilding the manufacturing industries so short-sightedly ”off-shored”. To my way of thinking everybody is going to have to WORK their way out of this situation, unfortunately while being ”lead” by people in the political industry who are welded to people in the finance industry.
What’s the chance of complete and total chaos? Pretty good I’d say, especially after a couple of years of billions being given by the politicians to the banks to no effect, and in the attempt to resuscitate a banking system which has proved it’s totally out of control and is a bottomless sieve.
Where is Blair, the architect of destruction, when his cat rip’s apart it’s bag?

Posted by Peter H | Report as abusive

Mr. Saft, is right on the money!!! We should learn something from emerging markets that constantly have to deal with issues like this. We should just print our way out of this huge problem. We will have to deal with high inflation and a depreciating dollar, but the current alternative of deflation and recession is not going to work, people can not resist this too long. Stay away from fixed income investments!!! inflation is coming!!!

Posted by Fred | Report as abusive

Pick one: An ecomomy that is deflations and is dying slowly. An ecomomy that is inflationary that works a bit better.

How will inflation re-float anything? Isn’t it just as likely to send more homeowners underwater? Their mortgage payments may start looking sane again but all the other costs associated with rents and property ownership will rise and at a time when the country is gasping for ways to keep the general population paid highly enough to keep most of the housing stock in this country within reach of most of them. What’s inflation going to do with the already straining social security safety net?

Many people in these pages and previous commentaries have mentioned that the real reason the bubble burst was we aren’t creating enough high paying jobs to support the prices. How many inflated executive positions can an economy support in the long run? And there are no where near enough of them to support a country wide overprices real estate market. It’s almost pathetic that money has to be leant to the wealthy to make them even wealthier simply to stimulate the economy. And they still won’t want to risk it. The federal government expects too much from “noblesse oblige”.

Every country from the time of the Pharaohs through the Roman Empire to the present day has to make jobs. A country that is established and more or less at peace and raising babies all the time has to keep them all busy at something. The whole population can’t be the manager classes or the manager classes can’t do their jobs. WE don’t have enough work for the “workers” you could say. And there aren’t enough “managers” with executive pays to keep all the high cost real estate at the prices easy credit, leverage and speculation were driving them to.

I tend to think the country can’t hide from the billions of much lower paid and more productive people who live in the rest of the world. If they can work and live on so much less so will we have to live on so much less. Water seeks it’s own level.

For those who like historical anecdotes and to serve as an illustration of how lush a society can be and how difficult it is to spur enough real economic activity in a stable society one can look at the Kingdom of the two Sicilies in the 18th century. That rhelm had over 260 days of the year devoted to religious holidays. That meant no one made a living on those days. And few people were really starving. But few people, other than aristocrats, were getting wealthy either. And we are a society with far more automated production than the Neapolitans ever had.

Ionically it was the Catholic Church that complained about the hardship 260 religious holidays imposed on the lower income people. Even the church thought the governemnt overdid the no work on holiday solution to social stability.

Re: Mr Rosa: I agree with a number of your points. I think, though, that the point with respect to inflation is not that it will ‘solve’ anything. There isn’t any ‘solution’ in that sense that some folks are hoping for–things will, indeed, seek their own level. The question is what method will write down the nonexistant ‘values’ people are still carrying in their heads as to what they think things are ‘worth’ and similarly for the values companies still hold on their books. These values may be written down in one form or another of bankruptcy or the real value of the debts may be written down by inflation making them worth less in real terms. Folks of intelligence and good will may differ over the ideal course, but, of course, events have a way of taking their own path rather than being chosen and no one is really in control. To a considerable extent, just as with the building of the leverage bubble, these are quasi-organic social processes removed from individual decision making–though sometimes some particular individuals may have a critical effect on the course of events.

Posted by Bob, The Atomik Weasel | Report as abusive

Thank you Bob for your polite rebuttal. But if we don’t know the actual cause how will anyone make the correct decision? All this discussion is about finding solutions or all that money that is being pumped into the supine (or is it the sub-prime) victim will be as wasted as giving transfusions to a corpse. That sort of activity is usually the job of the embalmers.

The stimulus money all seems a little like the Maginot Line. Something that worked for the last big crisis but also something that virus in the economic system has already figured out how to immunize itself from. People are so damned sophisticated today.

I’m getting too old to see inflation as any kind of friend. It’s more the kind of solution or result that makes me want to make an appointment with the embalmers myself. I hope I can afford him.

Posted by Paul Rosa | Report as abusive

I think i saw this move at the last Texas holdem tourny. I believe it’s called ” ALL IN “.

The Fed wants to make sure that if we lose this hand, we’re done.


Posted by Truefire | Report as abusive

The Fed and government are going to try to print their way out of this mess and destroy the value of the dollar in the process. When China stops accepting our dollars and debt, people will realize they aren’t worth the paper they are printed on. It is not a questions of _if_ this happens, but _when_ it happens and to what extent.

The only sane place to park your assets and grow your wealth in this environment is gold/silver and precious metals mining companies. I also like ETFs that short the market and short treasuries such as… TBT, SDS and UDN.

I have written Bloomberg, The New York Times, senator Christopher Dodd, and President Obama to attempt to trash this plan for the exact reasons you mention in this article. Giving cheap leverage to the folks who got us into this mess is just another huge taxpayer give away to wall street for which we shall pay the price. The only way I could see the program as being acceptable is to allow the american public access to these same funds to purchase mutual fund shares with the same deal. I’d actually try and exclude wall street, because it’s the american people who deserve to benefit when the improvement happens. Our government is doing everything it can in an attempt to get wall street to lever up once again, and we will end up with exactly the same results. The funny thing is that it’s so clear to so many people except the fed. Unfortunately, such behavior does not lead me to trust the markets and additionally does little to diminish in my mind that there actually exists some sort of agreement between wall street and washington that we don’t know about. I hate to sound like a nut case, but it’s hard to imagine any other reason for this absolute lunacy.

Posted by david b | Report as abusive

Mr. Saft, with all due respect, I think you are obfuscating rather than clarifying this economic crisis. Only meisters of credit-default-swaps and CDO’s could love all the technical mumbo-jumbo in your blog posting. It’s best to keep it simple.

An absolute requirement in this crisis is that all U.S. homeowners, whether they hold a mortgage or not, should be forced to contribute heavily to an economic stabilization plan. The housing bubble was a giant Ponzi scheme which was in the making for about 30 years, and long-time homeowners made out like bandits. Their homes appreciated tremendously, and today most of them face no mortgage troubles at all. Yet, they are still sitting on their big, fat, pretty profits obscenely obtained. Make them pay! Replace all property taxes with a stiff federal property tax, and tax profits on the sale of residential property at a 90 per cent clip. The money generated over 30-50 years would be more than enough to honestly finance an economic recovery plan. Housing prices would tumble even more, but that is EXACTLY what is needed in such jumbo-mortgage states such as California. The U.S. cannot compete on the world-wide economic stage when the price of a necessity like shelter is artificially inflated solely to enrich those who bought shelter first (a Ponzi scheme).

Posted by Darth Baghead | Report as abusive

Andre, the way I see it is this: The crisis
was engineered… I remember thinking about the ever increasing housing market as an oddity simply because most of us not having six figure incomes could not affort their ever increasing value!

I failed to sell and bank my cash under the matress, would I done that I would have been able to buy two deflated properties today.

To those that capitalized (selling high) and now awaite to capitalize further (buying low)
I take off my hat (that’s the nature of the beast) but PLEASE, keep the profit circulating in America!!!

Posted by RenTacus | Report as abusive

Quoting Darth Baghead: “The housing bubble was a giant Ponzi scheme which was in the making for about 30 years, and long-time homeowners made out like bandits. Their homes appreciated tremendously, and today most of them face no mortgage troubles at all”

…. Others than followed wanting to jump on the wagon in fact are the ones now crying fool… thats the nature of the beast, is it not?

Posted by RenTacus | Report as abusive

What a surprise the thompson reuters analyist want to use our money to leverage and reinflate the stock market. Thus paying off hedge funds and private equity which are the same people who got us into this mess by selling toxic assets to the world. they make money selling the junk, and now the government helps them to make money buying it back from all of us who have lost our shirt buying it. Is there something about working in the financial industry that removes all the moral fiber of your being that you’d actually think this is a good idea. Oh wait, the masters who pay your bills will make a fortune. You people are the scum of the earth, and unfortunately our legal system doesn’t allow for what should happen to you, your family, and the families of all the wall street scum who caused this mess in the first place. Since we actually have to work for a living, don’t have enough to invest in the markets, and are just getting by, we don’t care too much about wall street. People like you, out of touch with reality, interested in your own welfare above everyone’s is what got us into this mess. You are advocating a policy that is best for you and your friends, not America as a whole. You make me sick to my stomach!!! Get ready for the big spring rally!!! wow, maybe I’ll put the 200 bucks I’ve got into the market and make a fortune. Clueless!!!! How much money do you make, how much spare money do you have to put in the market? You are going to make a killing from the policy, and I’ll still be stuck attempting to figure out how to make my paycheck stretch to pay the rent. PIG

Posted by db | Report as abusive

A system that depends on debt will not forgive its life’s blood. it would seem that as long as we are stuck in this system, many will pay, few will truly benefit, it is literally designed that way.

The solution is complete change, hampered by battles with words like “socialism” and “debt slavery” being thrown everywhere, a literal quagmire of ideas that is, in my opinion, a perfect smoke screen to keep the train on track.

just shut up and pay, don’t you have to work soon?

Posted by jeremy | Report as abusive

The smoke screen to keep the train on track will burry generations to come, watch and share

http://www.youtube.com/watch?v=lNS8IY_Td 14

Posted by RenTacus | Report as abusive

All what is going on now in the US concerning the Dollar and it’s markets, is now fully manipulated to fail on purpose, they are all just buying time for foreign investors to realize that all US debt-buying is wasted wealth.

Obama & the Fed know it’s all gonna crash, but are trying to position the US into a better position than the rest of the Globe.

The moment Asia stops buying debt, is the moment the US will stop paying it’s debt.

What will happen then is basically a “global economic blackmail” as in ” MAKE US PAY”. The G20 meeting might give us all the general direction of what will unfold.

If your local leaders comes back in a total PANIK, you will know the US as blackmailed the world into a 1 currency system. I think they might just evaluate all currencies to reset the debt values and just Continue this Giant Fiat based counterfeit ring & protection-racket.

Posted by LastReplay | Report as abusive

Great read, espcially liked “So, what’s the implication? Some debt will be repaid but a lot will just be destroyed via default. An organized write-down seems impossible. That will be a huge problem for the banking system and the country, and you can understand why the government does not wish to meet it head on.”

Joseph Stiglitz discussed this recently on Charlie Rose:
http://expattitude.blogspot.com/2009/05/ charlie-rose-joseph-stiglitz-on-future.h tml