(Article changed on September 18, 2013 at 21:20)
Derivative Armageddon by Barnaby Is Right
Increased regulation and low interest rates are driving lending from the regulated commercial banking system into the unregulated shadow banking system. The shadow banks, although free of government regulation, are propped up by a hidden government guarantee in the form of safe harbor status under the 2005 Bankruptcy Reform Act pushed through by Wall Street. The result is to create perverse incentives for the financial system to self-destruct.
Five years after the financial collapse precipitated by the Lehman Brothers bankruptcy on September 15, 2008, the risk of another full-blown financial panic is still looming large, despite the Dodd Frank legislation designed to contain it. As noted in a recent Reuters article, the risk has just moved into the shadows:
"[B]anks are pulling back their balance sheets from the fringes of the credit markets, with more and more risk being driven to unregulated lenders that comprise the $60 trillion "shadow-banking" sector."
Increased regulation and low interest rates have made lending to homeowners and small businesses less attractive than before 2008. The easy subprime scams of yesteryear are no more. The void is being filled by the shadow banking system. Shadow banking comes in many forms, but the big money today is in repos and derivatives. The notional (or hypothetical) value of the derivatives market has been estimated to be as high as $1.2 quadrillion, or twenty times the GDP of all the countries of the world combined.
According to Herve Hannoun, Deputy General Manager of the Bank for International Settlements, investment banks as well as commercial banks may conduct much of their business in the shadow banking system (SBS), although most are not generally classed as SBS institutions themselves. At least one financial regulatory expert has said that regulated banking organizations are the largest shadow banks.
The Hidden Government Guarantee that Props Up the Shadow Banking System
According to Dutch economist Enrico Perotti, banks are able to fund their loans much more cheaply than any other industry because they offer "liquidity on demand." The promise that the depositor can get his money out at any time is made credible by government-backed deposit insurance and access to central bank funding. But what guarantee underwrites the shadow banks? Why would financial institutions feel confident lending cheaply in the shadow market, when it is not protected by deposit insurance or government bailouts?
Perotti says that liquidity-on-demand is guaranteed in the SBS through another, lesser-known form of government guarantee: "safe harbor" status in bankruptcy. Repos and derivatives, the stock in trade of shadow banks, have "superpriority" over all other claims. Perotti writes:
"Security pledging grants access to cheap funding thanks to the steady expansion in the EU and US of "safe harbor status". Also called bankruptcy privileges, this ensures lenders secured on financial collateral immediate access to their pledged securities. . . .
"Safe harbor status grants the privilege of being excluded from mandatory stay, and basically all other restrictions. Safe harbor lenders, which at present include repos and derivative margins, can immediately repossess and resell pledged collateral.
"This gives repos and derivatives extraordinary super-priority over all other claims, including tax and wage claims, deposits, real secured credit and insurance claims. Critically, it ensures immediacy (liquidity) for their holders. Unfortunately, it does so by undermining orderly liquidation."
"This amendment which was touted as necessary to reduce systemic risk in financial bankruptcies . . . allowed a whole range of far riskier assets to be used . . . . The size of the repo market hugely increased and riskier assets were gladly accepted as collateral because traders saw that if the person they had lent to went down they could get [their] money back before anyone else and no one could stop them."
Burning Down the Barn to Get the Insurance
Safe harbor status creates the sort of perverse incentives that make derivatives "financial weapons of mass destruction," as Warren Buffett famously branded them. It is the equivalent of burning down the barn to collect the insurance. Says Malone: