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Bill Gross on the “Bank of Shadows” January 16, 2008

Posted by davidzweig in economics.

Bill Gross of the PIMCO Funds has written a typically urbane newsletter this month. It concerns the rapid rise, and current fall, of a shadow banking system that is unencumbered by the quaint reserves that so inspired the plot of the Frank Capra / Jimmy Stewart film It’s a Wonderful Life.

Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever….

…as this equity/subordination shrinks due to underlying defaults, the pyramid begins to unravel….The withdrawal of deposits from our new age shadow banking system has frightening potential consequences because a thinly capitalized banking system is always at risk relative to its more conservative counterpart.


[Ed. note: The pyramidical shape is not accidental.]

Much like casinos depend upon a constant stream of willing gamblers believing that this is their day, so too does Wall Street. But a trillion dollars of SIVs with their asset-backed commercial paper may be a dinosaur relic of yesterday’s shadow system. They will likely not be back. And the New Century mortgage originators? The Bear Stearns hedge funds? The chastened Freddie Macs and Fannie Maes, and all of the banks and investment banks requiring fresh capital through the sale of stock? They’ll be back but not in risk taking, fighting form.

And as the private shadow banks of the 21st century are found wanting, so then must public finance in the form of lower interest rates and increasing fiscal deficits fill the breach. The Fed will likely reduce Fed funds to 3% by midyear 2008. Congress and the Administration should, but likely won’t, join hands in a tax relief program that benefits low income homeowners. Market based, regulation-lite American style capitalism, seemingly so ascendant after the dot.com madness nearly a decade ago, has met its match with the subprimes and the poorly structured and supervised derivative conduits of today’s markets. Financial innovation will inevitably march forward, if not in distinctly new forms, then into new asset markets and even unexplored continents. For now, however, its current surge is spent. Investment survivors will have to learn to live in a different world, filled with new risks, lower leverage, and at some point, hopefully greater rewards.

(Reproduced with kind permission.)

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