Shadow Banking
- The shadow banking system consists of lenders, brokers, and other credit intermediaries who fall outside the realm of traditional regulated banking.
- It is generally unregulated and not subject to the same kinds of risk, liquidity, and capital restrictions as traditional banks are.
- The shadow banking system played a major role in the expansion of housing credit in the run up to the 2008 financial crisis, but has grown in size and largely escaped government oversight since then.
The above from Investopedia.
Image courtesy of my friend Chris Temple.
Hey It’s Not QE, Not Even Monetary
Yesterday, I commented Fed to Increase Emergency Repos to $120 Billion, But Hey, It’s Not Monetary.
Let’s recap before reviewing excellent comments from a couple of valued sources.
The Fed keeps increasing the size and duration of “overnight” funding. It’s now up $120 billion a day, every day, extended for weeks. That is on top of new additions.
Three Fed Statements
- Emergency repos were needed for “end-of-quarter funding“.
- Balance sheet expansion is “not QE“. Rather, it’s “organic growth“.
- This is “not monetary policy“.
Three Mish Comments
- Hmm. A quick check of my calendar says the quarter ended on September 30 and today is October 23.
- Hmm. Historically “organic” growth was about $2 to $3 billion.
- Hmm. Somehow it takes an emergency (but let’s no longer call it that), $120 billion “at least” in repetitive “overnight” repos to control interest rates, but that does not constitute “monetary policy”
I made this statement: I claim these “non-emergency”, “non-QE”, “non-monetary policy” operations suggest we may already be at the effective lower bound for the Fed’s current balance sheet holding.
Shadow Banking Suggestion by David Collum
Mish: I also think that the repo spikes suggest the shadow banking system is finally breaking. These are spasmotic movements that nobody seems to understand.
— Dave Collum (@DavidBCollum) October 24, 2019
Pater Tenebrarum at the Acting Man blog pinged me with these comments on my article, emphasis mine.
While there is too much collateral and not enough reserves to fund it, we don’t know anything about the distribution [or quality] of this collateral. It could well be that some market participants do not have sufficient high quality collateral and were told to bugger off when they tried to repo it in the private markets.
Such market participants would become unable to fund their leveraged positions in CLOs or whatever else they hold.
Mind, I’m not saying that’s the case, but the entire shadow banking system is opaque and we usually only find out what’s what when someone keels over or is forced to report a huge loss.
Reader Comments
- Axiom7: Euro banks are starving for dollar funding and if there is a hard Brexit both UK and German banks are in big trouble. I wonder if this implies that the EU will crack in negotiations knowing that a DB fail is too-big-to-bail?
- Cheesie: How do you do repos with a negative interest rate?
- Harry-Ireland: [sarcastically], Of course, it’s not QE. How can it be, it’s the greatest economy ever and there’s absolutely nobody over-leveraged and the system is as healthy as can be!
- Ian: Taking bad collateral to keep banks solvent is not QE.
In regards to point number four, I commented:
This is not TARP 2009. [The Fed is not swapping money for dodgy collateral] Someone or someones is caught in some sort of borrow-short lend-long scheme and the Fed is giving them reserves for nothing in return. Where’s the collateral?
Pater Tenebrarum partially agrees.
Yes, this is not “TARP” – the Fed is not taking shoddy collateral, only treasury and agency bonds are accepted. The primary dealers hold a huge inventory of treasuries that needs to be funded every day in order to provide them with the cash needed for day-to-day operations – they are one of the main sources of the “collateral surplus”.
Guessing Game
This massive, daily Fed intervention business appears to be getting worse & worse. What is the Fed hiding? The longer this goes on & the bigger the interventions get, the more my confidence is shaken. I expect that’s true for other investors too. https://t.co/ozqdtUwuwv
— fred hickey (@htsfhickey) October 24, 2019
We are all guessing here, so I am submitting possible ideas for discussion.
Rehypothecation
I am not convinced the Fed isn’t bailing out a US major bank, foreign bank, or some other financial institution by taking rehypothecated, essentially non-existent, as collateral.
Rehypothecation is the practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients.
In a typical example of rehypothecation, securities that have been posted with a prime brokerage as collateral by a hedge fund are used by the brokerage to back its own transactions and trades.
Current Primary Dealers
- Amherst Pierpont Securities LLC
- Bank of Nova Scotia, New York Agency
- BMO Capital Markets Corp.
- BNP Paribas Securities Corp.
- Barclays Capital Inc.
- Cantor Fitzgerald & Co.
- Citigroup Global Markets Inc.
- Credit Suisse AG, New York Branch
- Daiwa Capital Markets America Inc.
- Deutsche Bank Securities Inc.
- Goldman Sachs & Co. LLC
- HSBC Securities (USA) Inc.
- Jefferies LLC
- J.P. Morgan Securities LLC
- Merrill Lynch, Pierce, Fenner & Smith Incorporated
- Mizuho Securities USA LLC
- Morgan Stanley & Co. LLC
- NatWest Markets Securities Inc.
- Nomura Securities International, Inc.
- RBC Capital Markets, LLC
- Societe Generale, New York Branch
- TD Securities (USA) LLC
- UBS Securities LLC.
- Wells Fargo Securities LLC.
The above Primary Dealer List from Wikipedia as of May 6, 2019.
Anyone spot any candidates?
My gosh, how many are foreign entities?
It’s important to note those are not “shadow banking” institutions, while also noting that derivative messes within those banks would be considered “shadow banking”.
Tenebrarum Reply
In this case the problem is specifically that the primary dealers are holding huge inventories of treasuries and bank reserves are apparently not sufficient to both pre-fund the daily liquidity requirements of banks and leave them with enough leeway to lend reserves to repo market participants.
The Fed itself does not accept anything except treasuries and agency MBS in its repo operations, and only organizations authorized to access the federal funds market can participate by offering collateral in exchange for Fed liquidity (mainly the primary dealers, banks, money market funds,…).
Since most of the repo lending is overnight – i.e., is reversed within a 24 hour period (except for term repos) – I don’t think re-hypothecated securities play a big role in this.
But private repo markets are broader and have far more participants, so possibly there is a problem elsewhere that is propagating into the slice of the market the Fed is connected with. Note though, since the Treasury is borrowing like crazy and is at the same time rebuilding its deposits with the Fed (which lowers bank reserves, ceteris paribus), there is a several-pronged push underway that is making short term funding of treasury collateral more difficult at the moment.
So I’m not sure a case can really be made that there is anything going on beyond what meets the eye – which is already bad enough if you ask me.
Preparation for End of LIBOR
What about all the LIBOR-based derivatives with the end of LIBOR coming up?
The Wall Street Journal reports U.S. Companies Advised to Prepare for Multiple Benchmark Rates in Transition from Libor
Libor is a scandal-plagued benchmark that is used to set the price of trillions of dollars of loans and derivatives globally. A group of banks and regulators in 2017 settled on a replacement created by the Federal Reserve known as the secured overnight financing rate, or SOFR. Companies must move away from Libor by the end of 2021, when banks will no longer be required to publish rates used to calculate it.
“We don’t expect that 100% of the Libor-based positions today will migrate 100% to SOFR,” Jeff Vitali, a partner at Ernst & Young, said this week during a panel at an Association for Financial Professionals conference in Boston. “It is going to be a scenario where entities are going to have to prepare and be flexible and build flexibility into their systems and models and processes that can handle multiple pricing environments in the same jurisdiction.”
Repro Quake
I invite readers to consider Tenebrarum’s “Repro Quake – A Primer” but caution that it is complicated.
He informs me “a credit analyst at the largest bank in my neck of the woods sent me a mail to tell me this was by far the best article on the topic he has come across”.
Note: That was supposed to be a private comment to me. I placed it in as an endorsement.
Tenebrarum live in Europe. Here are his conclusions.
What Else is the Fed Missing?
- Contrary to similar spikes in repo rates in 2008, it was probably not fear of counterparty risk that led to the recent repo quake. What’s more, the Federal Reserve without a doubt knew that something like this was coming. We say this because even we knew it – it was not a secret. A number of analysts have warned of just such a situation for months.
- It is astonishing that the Fed somehow seemed unprepared and quite surprised by the extent of the liquidity shortage. We would submit that this fact alone is a good reason for markets to be concerned. If the Fed is not even able to properly gauge such a “technical problem” in advance, what else is there it does not know?
Effective Lower Bound
Finally, Tenebrarum commented: “I agree on your effective lower bound comment, since obviously, the ‘dearth’ of excess reserves was pushing up all overnight rates, including the FF rate.”
For discussion of why the effective lower bound of interest rates may be much higher than zero, please see In Search of the Effective Lower Bound.
Mike “Mish” Shedlock
“What Else is the Fed Missing?”
What else is the FED hiding?
The overall problem is that the non-banks are largely absent from the funding market.
That is the view from 20,000 feet in the air. At 10,000 feet the problem is that reserves and withdrawal liability are unevenly distributed. On the ground the problem is collateral previously accepted is not being accepted.
Mish,
What are your thoughts on the whole WeWork situation. They have $50 billion in leases which is a huge amount. It is curious that Softbank would agree to back stop them and I was wondering if instead they were getting some money from other sources to keep WeWork from crashing commercial real estate.
I just saw a tweet saying that JPM had underwritten the WeWork valuation of 40 – 100bn. Does that mean, if true, that JPM will have had to hand over this amount of cash to those doing the float?
If so, that might explain the repo operation.
FWIW, in London in 2009, Gilts were considered better collateral than cash.
I thought someone suggested that the repo need came from Chase Bank?
I’m a very simple person, and all of this makes my head spin reading about all of the speciation and theories.
Does anyone know what the term is of the collateral is that’s used in the repo market? Is it typically short or long, or is it a mixed bag?
Normally the Fed will accept only treasury paper and Mortgage Backed Securities (MBS) and the terms are usually fairly short, or else really secure if longer. Remember the Fed is actually buying these for cash. In most cases it is overnight lending and the bank/institution buys it back the next day. Unless it is arranged to be longer than one day and that is called Term Lending, there is a term of say a week or ten days.
Some institutions get caught with their pants down on a position, like those that bought Argentine bonds that they were sort of pushed to buy with an implicit or even explicit guarantee from the IMF, because the US is by far the largest contributor to the IMF funding we also pressure institutions to keep the work of the IMF afloat by having them buy into those bailed out nations. But, now we see the old leader of Argentina imposing capital controls to stop foreign reserves from hemorrhaging away from Buenos Aires and over 55% inflation annually. Their peso has dropped from 14 to the dollar a couple years ago to now 60 to the dollar. The vastly favorite candidate to win in tomorrow’s election is promising a major haircut (at least 20%) to bond holders. Naturally US institutions holding Argentine debt are going to want to “stick” anyone else with these, and if they can get the fed to buy it they just might not show up the next day or the end of the term to buy it back, there is nothing forcing them to buy back the repo.
That is just one example and certainly some institutions did try this, the fed on some days since the repo actions began rejected over $50 billion in securities tendered for repo. I am betting that the rejected paper, at least some of it, was Argentine debt. But, no matter what the rejected debt was there has been every day some that the fed would not buy. They don’t give their reasons making the repo market a bit opaque for the average watcher like us. But, the insiders talk among themselves and there is a grapevine discussing what the fed is rejecting, they keep it on the QT because they don’t want it public, which bank is stuffed with bad debt the fed won’t touch or what insurance companies hold a butt load of Argentine garbage.
Still, the size of the repo operations and the sudden timing of them points to a far larger problem than just Argentina defaulting, even rumors of default can send the debt price into the ground and thus much higher risk/interest rates. These institutions whoever they are have already taken a giant loss on that debt and look to unload what remaining exposure they have, they are trying to do something we were taught never to do in econ class for a business degree, try to rescue funds from sunk costs. All I can do is shake my head, and be happy I was not one of the people responsible for getting any company to “invest” in Argentina. Anyone who believed the ratings on Argentine debt should have their professional status/licences pulled, that nation has a long history of defaults.
“All I can do is shake my head, and be happy I was not one of the people responsible for getting any company to “invest” in Argentina…”
Don’t worry, if the problem is too severe, everyone else will pay the price while the bond salesman relaxes on a Florida beach.
Yeah the responsibility for these things never rises to the corner offices, they do though find a scapegoat, some corporate trust employee, to blame it on and fire them. When I worked in corporate trust I was hired to be the assistant for a bond recruiter, a guy that recruited customers for the bank, got them to place their bond issues with us, the guy was insane. I mean, crazy as a loon, often slept in his office and did deals that were very questionable. He slept in his office because his house was over 120 miles away in another state. He was very unhappy with his former employer and had decided to steal as many of his old customers from that bank for our bank. What a wanker, if anything ever went wrong it was always somehow my fault even if I never heard of it. That guy actually thought he walked on water.
Wow, thanks for the explanation, Herkie! I think you also answered what was going to be my follow-up question: if the banks are constantly in need of cash, why don’t they sell their collateral instead of going to the repo market every day? Sounds like they may be trying to use more than Treasuries and MBS as collateral?
Some of them do try to use collateral that the Fed wants no part of, for whatever reason, and some collateral gets downgraded so cannot be sold, because as long as they hold it they can express it on their books at face value rather than market value (That was one of the accounting rules changed just for the TBTF, the rest of us still have to mark to market) and banks are required to keep a cash reserve as a percentage of their demand deposits, so that reserve changes every day. If you are a major money center bank like BofA or Citi that is not as much a problem, they generally have enough cash to handle the reserve requirements of their retail banking, but smaller regional banks like the one I worked at don’t always have the kind of buffer the bigs do.
Something like a payday Friday near the first of the month around tax return time can see a TON of money flow into checking accounts, those are demand deposit accounts. So banks can get caught short no matter how well they plan for it. They try to operate on a razor thin margin to keep all funds in use and nothing just laying around for a rainy day. They are absolutely crazy about this, they will fire employees for small errors that keep tellers and back office clerks awake at night.
There must be something I don’t get about these markets:
How can the repo rate shoot up to 10%? — in theory other intermediaries could use excess reserves, borrow unsecured money in the federal funds market or in the inter-bank lending market and swap it for Treasuries at a big profit. You never expect the rate for swapping GC/Treasuries overnight to be higher than unsecured lending rates: they’re supposed to be the most liquid risk-free collateral in existence. In addition, there are larger markets (than just repo-ing GC) for secured borrowing where you can raise cash for a better rate.
In principle somebody should be able to make money arbitraging this.
What am I missing here ???
Mish, I don’t believe that SOFR can replace LIBOR because of the basis risk between the two rates. SOFR is a rate only relevant to US banking system dollars whereas LIBOR is the rate relevant to “Eurodollar” funding which comprises all shadow banking and most bank derivatives books (which are off-balance sheet except for the mark-to-market). If derivatives were forced to reference SOFR that would add a lot of basis risk. Hence the resistance. See Jeffrey Snider @ Alhambra’s blog for details.
I don’t think it’s true that SOFR only references the US banking system, although it does refer to dollar funding.
SOFR printed 10% a few weeks ago and is trading all wacky from EFF and IOER. It has a lot of basis risk vs. shadow banking and derivative exposures. Which is why I don’t think it will replace LIBOR.
Golly gee my confidence in our monetary system is skyrocketing! What a load of horse****.
As noted, it could be anything … or multiple anythings.
BUT I still lean to (or one of) FASB 157 related. Major banks were given wide discretion to price (mark to model) illiquid assets. Think banks are reticent to lend to other banks (or just certain others) due opaque balance sheets. Came about now to business cycle ending and players know defaults Dead Ahead.
LIBOR is not likely the explanation but it could be.
There is pressure on institutions to unwind those contracts – NOW. If the new repricing or margin requirements are even slightly different, it could be a part of the problem.
There can be many parts to this problem, and probably are given how the Fed was caught totally off guard.
Lots of small problems = one big problem.
Speaking of collapse, so the USA is heading FAST towards negative interestrates, the EU is already there and it’s probably not hiking for the next few years with the arrival of Princess Lagarde and Japan…well, need I really comment on that…
How exactly is the bankingsector going to survive? It’s already proving to be lethal for German banks and others. And what about pensionfunds? What about depositor withdrawals when negative rates get passed on to savers? Or will the banks divert those costs by simply making transactions and accountfees higher, just as I’ve noticed in Holland and Ireland?
So many questions and not a single politician who’s willing to fight against this insanity.
I second Douche Bank as the likely culprit.
I believe that I expounded on the probability of a “re-hypothecation” problem in a comment several days ago. We are apparently in an era of “Fractional Reserve of Everything” Banking.
And this also speaks, yet again, to the Fed’s horrific record as regulator of the largest Nationally Chartered Commercial Banks – otherwise known as “TBTF”.
Axiom7’s hypothesis is a likely scenario. Foreign investors of every ilk, but especially EU and Japanese banks are starved of yield in their own currency. They have no source of dollar funding to buy higher yield USD assets. This has been a very meaningful investment flow. I can see why the US banks would need help with USD funding for this pool of investments at reasonable levels and why accommodating these investors is in the national interest. If the collateral is treasuries and agencies, overnight repo is not especially risky. US Treasury would also not want to see repo discounts blowing out as this creates market nervousness.
Either there are excessive reserves of ~$1.5T or there are not. If they are there, why is nobody willing to get the pickup over IOER to fund the GC repo? And if they are a fiction, why is the reporting sham allowed to continue?
My thoughts exactly. Somehow there are not enough reserves with 1.5T floating around, and somehow banks have trouble unloading UST when demand is an all time high, signified by rates near all time lows.
What likely happened is that a bunch of repo lenders repudiated all those CLO’s and refused to take them as collateral.
They do know where the problem is but they can never say as it would cause an immediate run on that bank or institution.
So yes, this is a stealth bailout IMO.
As Tenebrarum pointed out however, the Fed was completely caught off guard by the sizer of the problem.
It would be a real sham[e] if the Fed was in fact bailing out a foreign bank.
Hey, by the way, I wonder how Deutsche Bank is getting along with its mountain of derivitives?
And it’s Russian mafia loans and laundromat. Hey, they can’t collect a third of a billion Trump owes them so how will they collect who knows how many billions the russians have borrowed using worthless collateral.
The Fed’s Repo Operation looks like an old-fashion ‘run on the bank’ to me – a Run On The Fed. Where will it end? Doc
I have a hard time believing that the Fed can’t pinpoint where the problem lies. They are entering into Repo contracts daily, so they should understand or at least be investigating who is having problems, starting with those looking for a free handout.
Moreover, why is the Fed having to bail out the party or parties. With Long Term Capital, Greenspan brokered a deal with the large investment banks and basically said, this is a problem that you facilitated, everybody pitch in.
In the back of my head, I’m wondering if this isn’t a ruse to create an excuse to reload the QE program and stoke the equity market – notice the rally since the Oct. 8th announcement of NOT QE. I know, I must be getting paranoid in my old age, but really nothing would surprise me anymore.
I have mentioned this explanation in an earlier comment, the cartel trying to force the Fed into QE by holding back on cash in the repo markets, b/c they have a truckload of bonds and crap they need to sell back to the Fed.
Not to mention when it comes to free handouts they are ALL in line for that. We have seen the data daily about how much was offered ($75 billion) how much the banks tendered for cash, and how much was accepted. The Fed knows who tendered what and what the Fed rejected. Some days that has been in the tens of billions of dollars, one day a couple weeks ago I saw there was over $80 billion in securities tendered but only $30 billion accepted by the Fed, so the Fed rejected more than $50 billion in securities that day.
Mish is right, they don’t publish the data because of the incendiary nature, not just a run on the equities of the firm(s) in question but their debt as well.
I am thinking the $100 billion Argentine foreign debt now in question has to have something to do with it. Macri instituted capital controls a couple months ago (July?) and the repo market started to derail, coincidence? Now Fernandez says he want to use the Uruguayan form of default to give the creditors about a 20% haircut, the way that works is they still guarantee the principal but push the maturity dates out x number of years. Oh by all means, I am way more than comfortable letting you repay me years later Pablo. Fernandez claims this represents about a 20% haircut. So here these bond investors thought they were getting some 5% or so and now will get -20% maybe some year.
All I know is I just read a story about how a bottle of whiskey was just sold for $1.9 million, a single shot of this booze costs more than a new Porche 911. I say if that is the case then we have to scrap our entire financial system, all cash, all credit, just start over from scratch, and if we do it deliberately we can have some control over it, if we just allow it to happen by itself we are going to see a lot of people die needlessly.
Paul Krugman and other mainstream trade experts are now admitting that they were wrong about globalization: It hurt American workers far more than they thought it would. Did America’s free market economists help put a protectionist demagogue in the White House? link to foreignpolicy.com
I’ve found Krugman to be a political hack more often than an economist..
Does America have any “free market economists?”
Anyone remember the events as described in the movie ‘Too Big To Fail’? I re-watched that recently and it comes to mind.
Remember how the US taxpayer got forced into accepting the 700 billion (and then some) bailout? Well, in todays political climate, they can’t get away with that. Or if they could, it would be political suicide. Especially with Trump 2020 in mind. Maybe the Democratic socialists could be persuaded, since they’re planning on giving money away to any swinging dick out there anyway. (no offence)
As for the list of banks, my guess is Deutsche Bank and of course some unmentioned Spanish and Italian banks.
And isn’t it a total coincidence that the Bundesbank has recently purchased additional gold and repatriated substantial goldreserves which was stored outside Germany, back into the country.
Russia, China, India are all stockpiling gold.
And then the Dutch DNB talking about gold being necessary to rebuild after ‘a collapse’….nah, total coincidence.
I’d better follow suit and stack some extra bars.
Could it be JPM and RICO? Why would the end of LIBOR in 2021 cause problems now? Surely if a bank receives its money at 0% and is still illiquid what does that say about the management?
I really wish I knew. I’d be making some money on shorts.
I’ve seen a lot of articles and graphs and I don’t know about you, but I’ve never seen this before. Is it out of control greed, lack of regulations, a result of excess liquidity at zero percent interest (or lower)?
My problem is that I now only trust things that I physically own. The past really is no guide is it?
I couldn’t agree more. Trust is a fragile thing and it’s eroding with every passing day and every printed out-of-thin-air-currency without real value. I’m trying very hard to purchase some property too, despite the overcooked market here in Ireland. Stay safe man…
Same to you. I watched Max Keiser the other day and in his own inimitable way summed the situation perfectly. He said that the dollar in your pocket is worth less than the paper it is printed on. Priceless.
Good old Max. One of my old favorites is Jamie the Tapeworm 😉
🙂
I may have to come knocking, find a place with a nice tent site near fresh water, not some old bog water either, I think that is what made me sick when I lived there.
I’m afraid, in the 2 years you’ve moved away, things have only gotten worse. Propertymarket is still overpriced, lack of supply, rentseeker supreme and alltime-high rents. I’m currently renting because of the above and unfortunately, it’s not exactly where I should be in life. But hey, I’m debtfree and I’ve got some cash to burn. If the whole thing doesn’t come crashing down Weimar-style, I’ll be ok.
” When Money Dies ” far more horrific than anything Stephen King has written.
Absolutely true, it will be like the zombie apocalypse with millions of people trying to find a meal or some water for their kids. But the zombies who do manage to come will have AR-15’s.
That is one side of it, the other is that human beings evolved to be social and cooperative, there are horror stories of the Great Depression, I even have my own, but in fact the depression was far larger and deeper than any living person has ever experienced, so you hear the horror stories and read Steinbeck’s The Grapes of Wrath and decide to be a prepper. The reality was that people did help each other out and really nobody died from starvation or neglect. Ruined yes, died no.
The next depression will be no different. Well, maybe a little, younger people will only help after they paid their bogus student loans and tattoo bills.