The Shadow Banking System is an Unstable Funding System for Banks, Not Assets

There are many definitions of shadow banking. A New York Federal Reserve Bank monograph effectively equates shadow banking to securitization, or the process by which individual loans are packaged into bundles, used to issue a wide variety of collateralized assets, and sold to investors. The New York Fed monograph is often used to demonstrate how complicated and virtually incomprehensible the shadow banking system is – it includes a “map” of the shadow banking system that, for legibility, the authors recommend printing as a 36” by 48” poster.[1]

More commonly, however, the term shadow banking refers to the use of money market instruments to provide short-term finance to long-term assets,[2] and thus focuses attention on bank runs and on the fact that shadow banks can face such runs, just as traditional banks do. For this reason securitization should not be equated with shadow banking, because a significant portion of private sector securitized assets were financed on a long-term rather than on a short-term basis.[3] This post will limit its focus – as does most of the literature on shadow banking – to the role played by money markets in longer-term finance.

This post finds that our current money markets play only a very small role in the direct finance of private sector long-term assets and for the most part are used as a financing system for investment banks. In short, the “market-based” credit system that some equate with the shadow banking system,[4] is very small – and relies heavily on commercial bank guarantees. To the degree that a substantial shadow banking system continues to exist, it does not fund long-term assets directly, but instead provides wholesale funding for investment banks, and to a lesser degree commercial banks.

To be clear, the focus here is on finance of private sector banks and assets. Thus, although Fannie Mae and Freddie Mac played a very important historical role in the development of the shadow banking system, by pioneering the practice of financing long-term mortgage debt on money markets through the issue and roll over of short-term debt that was at least nominally a private-sector obligation,[5] they now officially have government support, and, for the purposes of this paper their debt is treated not as part of the shadow banking system, but as a government obligation.

This post provides a simple framework for understanding the shadow banking system that is organized around  the two instruments, commercial paper and repurchase agreements, that play an important role in money markets and that are, very roughly, comparable to deposits. Studying how these instruments are used not only allows a distinction to be drawn between the direct finance of assets and the finance of assets that sit on bank balance sheets, but also makes clear why the shadow banking system is unstable.

This analysis finds that the money market instruments have in the past played three roles: they have funded banks and non-financial firms directly, they have funded assets that lie off bank balance sheets, and in order to play these roles, they have created a need for commercial bank guarantees that induce lenders to lend off-balance-sheet or  in the case of tri-party repo to investment banks. In practice, the direct funding of assets now takes place only on a very small scale.

Because the two money market instruments, commercial paper and repurchase agreements (repos), are both short-term, it is easy for those who invest in them to “run,” or to decide that they no longer wish to invest their funds with a specific issuer or, indeed, in privately issued money market assets at all. Because these investors can always choose to put their money in Treasury bills or bank deposits, runs in the money markets are associated with unmanageably sudden shifts in investor preferences across short-term assets. In short, a fundamental attribute of the shadow banking system is that the decisions of money market investors can destabilize the money markets.

Money market mutual funds  and enhanced cash funds (that promise liquidity, but are less regulated than money market funds) are the most obvious money market investors, but the buy-side of the money market is composed of a huge array of institutional investment funds, corporations, and government bodies that have funds they wish to keep in liquid form. All of these entities can be part of a run in the shadow banking system. In addition, as will be explained in detail below, in the repo market it is possible for the recipients of funds, such as prime brokerage clients and banks in the interdealer market, to run.

Now that the basic instability of the money markets has been established, the next step in understanding the shadow banking system is to understand the different ways in which commercial paper and repo-based instruments are used; this is discussed in sub-part A. The following sub-parts evaluate what shadow banking does, and discuss why it is more unstable than traditional banking.

A.  Shadow Banking Instruments

1.  Commercial Paper

a.  Unsecured

Commercial paper is traditionally an unsecured obligation to make a payment that has a maturity of one year or less. It is analogous to the commercial bills that were used to finance economic activity in 19th c. Britain, and indeed has existed in one form or another for centuries.

i.  Issued by financial institutions

A little over half the commercial paper issued in the United States, or approximately $550 billion, is issued directly by financial institutions.[6] Because this market-based funding source is much less stable as a funding source than retail deposits, it is categorized along with other bank funding sources that are prone to runs as wholesale funding. The case of Lehman Bros. illustrates the instability of this form of funding. When Lehman declared bankruptcy, its commercial paper went into default, and set off a run by investors who feared money market mutual fund losses on money funds that invested in commercial paper; as a result the commercial paper market itself faced a run.

ii.  Issued by non-financial corporations

Approximately one quarter of commercial paper is unsecured and issued by non-financial corporations. Because non-financial corporations have less access to liquidity than banks, there is a risk that when their commercial paper is due they will be unable to roll it over into a new issue and will be unable to honor their commercial paper obligations due to this liquidity risk. For this reason, almost all non-financial commercial paper is protected by a liquidity facility provided by a bank, which promises to retire the commercial paper if the issuer is unable to do so. Observe that when Lehman failed, the run on commercial paper was not carefully targeted to financial commercial paper, and as a result non-financial commercial paper was subject to a run as well.

b.  Collateralized: Asset Backed Commercial Paper

In recent decades, sponsoring banks have moved assets that they originated into financing vehicles that are “bankruptcy-remote,” or not available to the sponsor’s creditors in the event that the sponsor declares bankruptcy. In addition, in theory any support that would be provided by the sponsor to the vehicle was defined in a contract, so the sponsor had contractually limited exposure to the vehicle’s liabilities.[7] Thus, these vehicles were designed as a means of removing assets from the sponsoring bank’s balance sheet.

The ABCP market was one of the key markets that collapsed in the early days of the financial crisis – from $1.2 trillion outstanding in early August 2007 to $905 billion three months later. Since then the market has continued to decline slowly, and it now hovers around $250 billion.

Because these vehicles finance long-term assets they face the same liquidity risk as non-financial issuers when issuing commercial paper. In addition these vehicles face credit risk in the event that the value of the assets falls below the value of the commercial paper, and the vehicle is no longer fully collateralized. Both liquidity and credit risk must be addressed before the vehicle can receive a credit rating that is high enough for it to issue asset-backed commercial paper (ABCP) that is secured by the assets in the vehicle. The three principal means by which liquidity and credit risk were resolved are discussed below.

i.  Bank supported ABCP:  Conduits

Prior to the financial crisis most ABCP was issued by ABCP conduits that were sponsored by banks. The banks typically provided both a liquidity facility, which guaranteed that the commercial paper would be retired even if it could not be rolled over, and a credit facility, which promised to honor some fraction of the commercial paper in the event that the value of the collateral fell too low to cover the costs of repaying the commercial paper.

In August 2007 when the crisis started there was a sudden loss in confidence in the ABCP market and many conduits could not roll over their commercial paper. The banks had to step in and honor the liquidity guarantees that had been made – and in order to do so they had to seek regulatory exemptions that are documented by the Federal Reserve.[8]

ii.  Liability structure supported ABCP: SIVs, LPFCs, etc.

Some ABCP-issuing vehicles guaranteed the payment of ABCP by funding the assets with a combination of bonds, medium-term notes and ABCP. These vehicles took many forms; the most common were called  structured investment vehicles (SIVs).

The concept behind these vehicles was that, in the event that the commercial paper could not be rolled over or the value of the assets fell below a trigger point, assets would have to be sold to pay off the ABCP and any losses would fall to the longer term debt holders. In 2007 most SIVs hit their triggers and were unwound. Because of the losses that were incurred by both longer-term and commercial paper investors (after lawsuits determined the allocation of proceeds), they are no longer a popular investment product.

iii.  Repo Conduits – discussed below

2.  Repurchase Agreements

A repurchase agreement (repo) is a simultaneous agreement to sell an asset today and to repurchase it a specific date and time in the future. It has the same economic effect as a collateralized loan. Typically the amount lent is less than the value of the collateral;[9] the percentage difference is called a haircut.

There are two repo markets: the bilateral repo market and the tri-party repo market. In the bilateral repo market the lender must have the capacity to receive and manage the collateral, whereas in the tri-party repo market the tri-party clearing banks, JP Morgan Chase and Bank of New York Mellon, provide collateral management services for the lenders. Money market investors like mutual funds lend only on the tri-party repo market where the principal borrowers are the dealer banks (although a few hedge funds and private institutions are credit-worthy enough to be accepted as counterparties on this market).[10]

The clearing banks also provide bank guarantees of liquidity to the tri-party repo market. Because it is the broker-dealers that borrow heavily on this market and because every trade in the market is unwound at the start of each trading day giving the borrowers access to their assets during the day, the two tri-party clearing banks extend credit to the borrowers during the day until the trades are rewound in the late afternoon. Thus the tri-party clearing banks provide a guarantee to the market and bear the risk of a broker-dealer failure during the day.[11] While reform of the tri-party repo market has been high on the Federal Reserve’s agenda, five years after the financial crisis 70% of the market is still being financed by the clearing banks on an intraday basis.[12]

On the bilateral market, where the lender must manage the collateral, the dealer banks are the lenders. The borrowers are prime brokerage clients, such as hedge funds, and other dealers.

As a result of this structure, funding generally enters the repo market via tri-party repo and the dealer banks, then, distribute this funding more broadly to their prime brokerage clients on the bilateral repo market. Thus, when a hedge fund buys an asset on margin, it borrows a significant fraction of the purchase price from the dealer bank that is its broker and posts the asset as collateral for the loan in a repo transaction. The dealer bank can then repo the asset on the tri-party repo market so that the dealer bank is effectively intermediating lending from the tri-party market to its client and earning an interest rate spread for the intermediation services. When the asset is of a type that cannot be used as collateral in the tri-party repo market, the dealer may choose to use the asset to raise funds on the inter-dealer segment of the bilateral repo market.

The dealer banks also hold collateral that is posted against derivatives contracts by other dealers and by prime brokerage clients. Whereas the inter-dealer derivatives contracts may have symmetrical collateral posting requirements, prime brokerage clients have typically been required to post collateral without having the right to require that dealer bank follow the same rule when the balance on the derivatives contracts is in the brokerage client’s favor. As a result a dealer bank is almost certain to receive collateral from its prime brokerage services when its client accounts are aggregated. The collateral posted by prime brokerage clients can then be used by the dealer to borrow in the tri-party repo market. As a result of this structure collateral posting by prime brokerage clients on their derivatives liabilities is also a form of financing for the dealer banks.

Thus, dealers often finance their own inventories, their prime brokerage clients’ assets, and any collateral that is posted against derivatives liabilities by other dealers or prime brokerage clients on the tri-party repo market.

The repo market is very different from the ABCP market and from commercial paper markets in general, because a run in one of the latter markets can only be caused by end investors. In the repo market a run can be started either by end investors or by other dealers and/or prime brokerage clients. Darrell Duffie has explained the many channels by which funding can be withdrawn in a repo market. These include: brokerage clients can move their accounts – together with all the collateral they have posted – to another dealer; dealers or brokerage clients who are derivatives counterparties can seek a novation (i.e. transfer) of a derivatives contract in order to post collateral to or expect payment from a more creditworthy dealer; dealers or brokerage clients may seek to reduce new exposures by entering into derivatives contracts that will require a dealer to post collateral; or repo lenders may increase haircuts or stop lending entirely to the dealer.[13] In short, the repo market is subject to inter-dealer and brokerage client runs, as well as to runs by repo investors.

In 2008 it is very clear that both Bear Stearns and Lehman faced a withdrawal of funding from other dealers, from brokerage clients, and from end investors in the repo market.[14]

3.  Repo Conduits

A repo conduit is a bankruptcy remote financing vehicle. The vehicle issues commercial paper that is backed by a repo with a maturity that matches the commercial paper. Thus, a repo conduit is backed primarily by the credit of the repo counterparty. Only if the repo counterparty fails to pay, can the repo conduit foreclose on the repo collateral. Because the term of the repo matches the term of the commercial paper, rating agencies do not require that a repo conduit have a backup liquidity facility.

The credit rating of a repo conduit typically is based entirely on the credit of the repo counterparty.[15] For this reason, repo conduits can be used – by institutions with high credit ratings – to finance assets that would not be eligible for tri-party repo financing.

B.  What Does Shadow Banking Do?

1.  Shadow Banking is a Funding Mechanism for Banks

The most important role of the shadow banking system is to provide wholesale funding for banks. Unsecured wholesale funding is provided when a bank issues commercial paper. Secured wholesale funding is provided when a investment bank uses the tri-party repo market to finance inventories, the assets of brokerage clients, and any collateral posted by counterparties in derivatives transactions.

As of Dec. 31, 2013, financial institutions raised $550 billion unsecured on financial commercial paper markets and the dealer banks used the tri-party repo market to borrow on a secured basis close to $1.6 trillion. 80% of the collateral posted is Treasuries and Agencies. Only $330 billion of private sector assets are financed on this market.

2.  Shadow Banking is a Funding Mechanism for Assets

Before the crisis, the shadow banking system played an important role in funding assets with liabilities that were secured by assets that were held off of bank balance sheets in bankruptcy remote vehicles. When this secured asset funding relied on bank support, it was usually provided by ABCP conduits. When this secured asset funding was made possible by a tiered liability structure, it was provided by SIVs and similar vehicles. When this secured asset funding relied on a maturity-matched repo, it was provided by a repo conduit.

Before the crisis the ABCP market was the most important source of shadow bank funding of private sector assets. (Not only did the tri-party repo market fund private sector assets that were for the most part on dealer bank balance sheets, but it was dominated by Treasuries and Agencies and thus played a relatively small role in financing private sector assets even indirectly.[16]) In post-crisis markets vehicles like ABCP and repo conduits are financing far fewer assets than they did before the crisis. The ABCP market is continuing its slow but steady decline over time and now hovers in volume around $250 billion.

3.  Shadow Banking Allows Money Market Issuers to Rent Bank Credit and Allows Banks to Avoid Capital Requirements

When assets were directly financed by the shadow banking system, it was usually because financing vehicles paid a small fee to “rent” a commercial bank’s credit rating by purchasing a guarantee of the vehicle’s liabilities. Because these guarantees were off-balance sheet, the bank was able to avoid the capital requirements that would have been imposed if the bank had done the lending itself. The role played by the clearing banks in the tri-party repo market is similar: they provide intraday credit in order to give dealer banks access to their assets during the day, but face no capital charge for the credit. Thus, a key function played by shadow banking is the arbitrage of capital regulations.[17]

The liquidity and credit facilities provided by banks to ABCP conduits are examples of unsecured bank guarantees.[18] By contrast, the tri-party clearing banks provide secured guarantees. The intra-day credit that the clearing banks provide to the dealer banks is secured by the collateral that has been posted on the tri-party repo market. Banks may also issue guarantees in the form of swaps that offset the market risk of collateral; these guarantees may be secured or unsecured depending on the derivative contract.

The collapse of the ABCP market since regulators have become attuned to the problem of regulatory arbitrage of capital requirements is just another piece of evidence that the vast majority of financing on the ABCP market at its peak was not driven by economic efficiencies, but by regulatory arbitrage as banks used liquidity and credit facilities to take on credit risk, while avoiding capital requirements. Indeed, the industry reaction to the 2004 Final Regulation governing such liquidity facilities – which resulted in a “reinterpretation” of the regulation that effectively gutted it – is also evidence of the importance of regulatory arbitrage to this market.[19]

C.  Collateralized Money Markets Are More Unstable Than Traditional Banks

The use of collateral in repo markets makes them particularly unstable for two reasons: leverage and the fact that not just lenders, but borrowers, can start a run.

When the price of the collateral in a repo contract falls, the borrower is typically required to post more collateral within a day, and, in the event that the collateral call is not met, the collateral that was posted can be liquidated immediately. While this description shows how quickly market price changes can be reflected in the sale of collateral on repo markets, it does not take the leverage that is ubiquitous on repo markets into account. Because of leverage small changes in the market price of an assets can force the borrower to sell off a large fraction of the borrower’s holding of that asset.

An example (drawn from a Fitch Ratings report) will make the instability inherent in repo market finance more clear.[20] Consider a borrower with a $5 million equity stake, which uses repo markets to finance the purchase of a $105 million portfolio of corporate bonds on which the lender imposes a 5% haircut, so that $1 can be borrowed for every $1.05 in collateral repo’d. The borrower will therefore have a leverage ratio of 21 to 1. A 2% decline in the value of the portfolio would reduce the total portfolio value to $102.9 million, reducing the equity in the portfolio to $2.9 million. If we assume that the borrower has no additional equity to contribute, the borrower can now only finance a $60.9 million portfolio at a 5% haircut. In short, because of the leverage inherent in using repo markets to finance assets, a 2% drop in portfolio value can force a sale of 42% of the assets held. Note that this example doesn’t take into account the possibility that the lender increases the haircut on the repo, which would mean that even more of the assets had to be sold. In short, once a borrower has maximized the use of leverage on repo markets – whether the borrower does this intentionally in order to “maximize” returns or simply ends up in this situation after the collateral has declined in price – very small declines in price can force the borrower to sell a significant fraction of the assets. If the borrower is a large market participant, such as an investment bank, this is likely to be the first step in a liquidity spiral, where asset sales further reduce the value of the collateral and trigger additional assets sales.

Not only does leverage make repo markets inherently unstable, but, in addition, a key characteristic distinguishing the repo market from unsecured credit markets generally is that not only the lenders, but also the borrowers, can start a run. The use of collateral in bilateral repo markets makes a borrower run possible, because the collateral can be rehypothecated, or posted as collateral in a subsequent loan by the recipient of the collateral. In short, the collateral posted by borrowers in the bilateral repo market is a source of liquidity for the lender.

When borrowers decide that they don’t want to be exposed to a troubled lender that may not be able to return the borrowers’ collateral in the event that it fails, the borrowers may seek to transfer their accounts to a lender who is not troubled. When the borrowers’ accounts are transferred, the collateral they have posted it transferred with the accounts, and the troubled lender loses the liquidity that was provided by that collateral.

As a result of this property of the repo market, the dealer bank failures of 2008 were characterized by “runs” by both prime brokerage clients and other dealers, none of whom wanted to be exposed to a failing bank. In fact, Krishnamurthy, Nagel, & Orlov conclude that the evidence supports the view that the 2008 crisis looks more like an inter-dealer credit crunch than a run by end investors on the two firms.[21] For these authors one factor distinguishing the two types of runs is the fact that the dealers are well-informed market participants, whereas end investors typically must decide whether to pull out of the market based on very limited information.[22] In short, it is possible that, far from being comparable to bank runs, the runs that took place in 2008 were runs that started with the most informed participants in financial markets.

Thus, there are two very important differences that make the repo market more unstable than unsecured funding markets. Not only does leverage mean that a small decline in price can easily force a large sale of asste, but in the bilateral repo market a run can be started not only by lenders, but also by borrowers.

In conclusion, it is misleading to describe the shadow banking system that exists today as “money market funding of capital market lending” and to focus on it as a means of financing assets,[23] because at present by far the most important use of shadow banking instruments is to provide wholesale funding for dealer banks and through them indirect financing of assets that sit on their balance sheets. Although the view that shadow banking finances assets directly may have held some truth prior to the crisis when $1.2 trillion of ABCP financed bankruptcy remote vehicles, today, to the degree that shadow banking disintermediates commercial banks, it does so by reintermediating investment banks – using a form of funding that is even more unstable than deposits.

The key question that regulators have yet to answer is whether this collateralized wholesale funding market is a valuable addition to the financial system or whether the risk of instability that accompanies it is so great that lending on this wholesale market should be curtailed.

[1] Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, & Hayley Boesky, Author’s Note in Shadow Banking, NYFRB Staff Rep. No. 458 (July 2010).

[2] Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson, Bagehot was a Shadow Banker (Nov. 2013).

[3] For example, although only $35 billion of private label residential mortgage-backed securities have been issued since 2008, at the end of 2013 more than $1 trillion of such securities remained outstanding. Data from SIFMA:

[4] Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson, Bagehot was a Shadow Banker 2 (Nov. 2013).

[5] See Frank Fabozzi & Michael Fleming, U.S. Treasury and Agency Securities 11 (April 2004), available at

[6] Federal Reserve Commercial Paper Release, Outstanding

[7] In practice, banks sometimes supported these vehicles even in the absence of a contractual obligation to do so, and sometimes did not.

[8] See the letters granting JPMorgan Chase & Co., Citigroup Inc., and Bank of America Corp. Regulation W exemptions that are dated August 20, 2007, available at the Federal Reserve website:

[9] Note that in securities lending, where institutional investors provide high-quality, high-demand collateral like Treasuries to the market, haircuts frequently go in the reverse direction. That is, more money must be lent than the value of the collateral in order to induce the securities lenders to lend.

[10] Tobias Adrian, Brian Begalle , Adam Copeland , Antoine Martin, Repo and Securities Lending, Federal Res. Bank of NY Staff Report No. 529, Feb. 2013 at 5-6.

[11] Adam Copeland, Darrell Duffie, Antoine Martin, and Susan McLaughlin, Key Mechanics of The U.S. Tri-Party Repo Market, 18 FRBNY Economic Policy Review 17, 22, 24 (2012).

[12] William C. Dudley, speech, Introductory Remarks at Workshop on “Fire Sales” as a Driver of Systemic Risk in Tri-Party Repo and Other Secured Funding Markets, Oct. 4, 2013.

[13] Darrell Duffie, How Big Banks Fail 23 – 42 (2011). See also William Dudley, More Lessons From the Crisis, Remarks at the Ctr. for Econ. Policy Studies Symposium, (Nov. 13, 2009), available at; Adam Copeland, Antoine Martin & Michael Walker, The Tri-Party Repo Market before the 2010 Reforms 56-58 (Fed. Res. Bank of N.Y. Staff Rep. No. 477, 2010).
Duffie observes that when there is a repo market run, the coup de grace is almost always given by a clearing bank when it responds to concerns about a firm’s financial position by exercising its right to offset aggressively, by for example demanding collateral for intraday exposures or refusing to give access to deposits. Duffie, supra note 9, at 41¬-42.  See also Tobias Adrian & Adam Ashcraft, Shadow Banking Regulation 17 (Fed. Res. Bank of N.Y. Staff Report No. 559, 2012).

[14] Duffie, at 23-42.

[15] Moody’s Revises Approach To Counterparty Rating Actions In Repo ABCP Conduits, Oct. 21, 2009, available at

[16] Arvind Krishnamurthy, Stefan Nagel & Dmitry Orlov, Sizing Up Repo 22 (NBER Working Paper No. w17768, 2012).

[17] Carolyn Sissoko, Note, Is financial regulation structurally biased to favor deregulation, 86 Southern California Law Review 365 (2013). Sissoko also has a discussion of the broader literature on the role of regulatory arbitrage in the ABCP market.

[18] See id. for details.

[19] See Sissoko, Deregulatory Bias at.

[20] Fitch Ratings, at 8.

[21] Arvind Krishnamurthy, Stefan Nagel & Dmitry Orlov, Sizing Up Repo 19,22 (NBER Working Paper No. w17768, 2012).

[22] Id. at 6.

[23] Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson, Bagehot was a Shadow Banker (Nov. 2013).


How bank regulation fails us

Barbara Rehm is very optimistic about the state of US bank regulation:

What we do know is that Dodd-Frank gave federal regulators numerous and wide-ranging powers to tame too big to fail institutions. … Obviously, for any of this to work the regulators must translate these “words on paper” into tough, sensible rules, and then they must enforce them fairly and consistently.

Examiners have to be on top of what’s happening inside these systemically important firms and pounce when something goes awry.

I realize that’s a big unknown. Everyone — including the regulators — realizes the agencies missed the 2008 financial crisis. They overlooked gaping risk management holes because firms were booking massive profits.

And it’s fair to question how well the agencies are implementing Dodd-Frank so far.

Personally I’m disappointed that no one in power — say, Geithner or Fed Chairman Ben Bernanke — has made it his mission to expand the corps of examiners dedicated to the largest banks. This people should be better trained and better paid.

But when push comes to shove, the regulators will act.

This is a very romantic view of how regulation works and why we should be optimistic about regulation after the financial crisis.  When Ms. Rehm writes that the regulators “overlooked gaping risk management holes because firms were booking massive profits,” she is in fact obscuring what actually happened.

The regulators often understood that the banks’ profits were derived from regulatory arbitrage with the result that insufficient capital was held against the risks held on — or as was frequently the case off — their balance sheets.  They even promulgated regulations that were designed to severely curtail the growth of the asset-backed commercial paper market in 2004 precisely because the banks were not holding sufficient capital against the guarantees they were providing to commercial paper conduits.

For reasons that remain entirely unclear, at the request of the banking industry the joint bank regulators chose via guidance interpreting the regulation not to implement the regulation as it was written.  It is hard to imagine that this interpretation would stand up to judicial review — if there were a path to judicial review for that guidance.  (For more details on this issue, see Section II.A et seq. of this paper.)

While I would like to believe that “this time is different,” the evidence indicates that just because regulators know they have to act doesn’t mean they will be capable of effectively exercising their authority to do so.

What is the parallel banking system?

Note:  This is part 3 of 3.  See also here and here.

The Traditional Banking System

A small business woman who has been operating her firm for several years on a shoestring budget but always managed to turn a tidy profit walks into an appointment with her local banker.  She has prepared for weeks for this half hour to present her business prospects and her preparation will pay off.  A $100,000 loan is approved and within a week that amount is added to her checking account at the bank.

It’s worth pausing to think for a moment about where that $100,000 of loan money comes from.  When a bank finds a creditworthy borrower who is able and willing to pay a market rate of interest on a loan, the bank does not need to have cash on hand.  Any bank has the capacity to create money by simply crediting the borrower’s checking account with the amount approved for the loan.  From the bank’s point of view both its loans and its deposits increase by $100,000.  However, since checking accounts are an important component of the money supply, from the economy’s point of view, the bank has just created money out of thin air.

The limitation on the bank’s ability to create money is its capital stock.  While the calculation of regulatory capital requirements is complex, in general a bank’s capital should be no less than 4% of its total loan portfolio. Thus in order to make the $100,000 loan, the bank will have to have $4,000 of capital over and above the capital required before the loan was made.  Now, you need to understand that capital is, by definition, not money that a bank can raise by borrowing.  The capital that stands behind a bank’s loans needs to be the bank’s own money – it cannot be owed to depositors or other banks or even to a Federal Reserve Bank.  Capital is the money the owners of the bank have invested in it plus any profits that have been reinvested.

Of course, for every $4,000 the owners invest, the bank can make $100,000 worth of loans, so a bank’s ability to create money is substantial, even if it is limited.  Furthermore, the bank can  earn interest on the whole $100,000, so capital requirements leave plenty of room for a bank to make good profits on its lending activities.  For this reason, in a country with a well functioning banking system borrowing is usually not particularly difficult for those who can convince a bank that they are creditworthy.

(For any reader who’s just decided that opening a bank is surefire way to solve all of your financial problems, I have to inform you that that scam has been tried so many times that the regulators are already on to you: Loans to the managers and owners of a bank are tracked very closely.)

It’s true also that the bank will be required to hold reserves against the $100,000 increase in deposits.  A $100,000 increase in deposits will lead approximately to a $10,000 increase the balance the bank is required to hold at its local Federal Reserve Bank.  This, however, is not a constraint on the bank’s lending to good clients, because the bank can always choose to borrow the $10,000 at an interest rate significantly lower than the one it is charging its customer.  Furthermore, our business woman undoubtedly borrowed the money because she had a use for it, so that $100,000 is not likely to sit in the bank increasing required reserves for long.

It is important to notice in this example that our bank has not used depositors’ money to make this loan.  Even if our business woman uses the full $100,000 to write a check purchasing a piece of equipment, the bank still does not need to turn to depositors to fund the loan.  When the check is cleared, as far as the Fed is concerned $100,000 of the bank’s reserves have been transferred to another bank.  Our bank, however, can simply replace the reserves by borrowing them on the interbank lending market at an interest rate well below that which it is earning on the loan.

Some might argue that in order for there to be funds available for borrowing on the interbank lending market it must be the case that some bank has deposits that have not yet been lent out.  This is indeed true, but, of course, we know that some bank has deposits that have not yet been lent out – because some bank just received the $100,000 in deposits that our bank created.

In fact, the only circumstance in which depositors’ money would be needed to fund the loan is when our business woman takes the $100,000 in cash from the bank and spends it somewhere, where it will not be deposited back in the banking system.  This is one of the reasons that economies which rely heavily on banks find that simply being a banked economy gives them a huge boost in terms of economic growth:  banked economies have an easy time creating money to meet the needs of entrepreneurs, whereas under-banked economies have a much less effective mechanism for making loans via money creation.  (See Diagram 1.)

Bank money

It is true that the Fed can choose to restrain the banking system from creating money so easily.  This is possible because the Fed can use open market operations to control the total quantity of reserves available to the banking system.  The $100,000 loan/deposit that was just created raises the total quantity of reserves that the banking system as a whole needs to maintain by $10,000.

If the Fed keeps the total quantity of reserves constant, we will see that the demand for reserves on the interbank lending market has increased without a change in supply.  This will mean that banks with reserves available for lending can charge a higher price, and we would observe an increase in the federal funds rate, which is the interest rate at which banks lend reserves from one to another.

Since the 1980’s, however, it has been Federal Reserve policy to manage reserves with the goal of ensuring that the federal funds rate is at a specific target level.  Thus, for the most part banks find that as they create money by making loans and generating deposits the Fed increases the supply of bank reserves to accommodate the increase in the money supply.  Of course, when the Fed has just put into place a policy of tightening the money supply and raising the federal funds rate, there is a sudden reduction in reserves.  Once the new, higher target interest rate has been reached, banks can again expect the supply of reserves to expand as they generate new – higher interest rate – loans.

As a tool of monetary policy, changing the target level of the federal funds rate is a very effective way of changing the lending behavior of all the banks in the economy.  When banks have to pay more to borrow reserves, they charge a higher interest rate to the customers who are borrowing from them, and this higher interest rate has the effect of reducing the amount that people want to borrow from banks.  This is the actual mechanism by which modern monetary policy can put a damper on bank lending and on money supply growth.  Of course, lowering the federal funds rate has the reverse effect.

Because the Fed can choose to set the interbank borrowing rate so high that there is very little demand on the part of businesses and individuals for loans, the Fed has the power to put a complete stop to money creation by banks.  In fact in the early 1980s, the Fed actually caused the federal funds rate to rise above 18%.  While this was a short-term policy with a very specific policy goal, it was remarkably effective at bringing the economy to a standstill.  Needless-to-say,  this was an exceptional circumstance, and typical Fed policy does not involve stopping the money creation function of banks or the economic activity it generates, even temporarily.

The key here is to understand what it means when we say that banks create money:  Banks generate deposits by making loans.  This process creates an interdependent relationship between the local business community and the local banking system, because both benefit from each other.

Regulators limit the banking system’s ability to create money by setting a target level for the interest rate at which reserves are borrowed on the interbank lending market.  This monetary policy is intended to keep banks from creating so much money that prices and inflation start to rise.

At the level of the individual bank, regulators limit the bank’s ability to create money by imposing capital requirements.  Capital requirements put banks in a position where the owners of the bank can afford to absorb the expense of loans that have gone bad.  If the quantity of bad loans exceeds the capital position of the bank, the bank will go bankrupt, and in the absence of deposit insurance, depositors will experience losses.  In the presence of deposit insurance, the purpose of capital requirements is to keep the claims on the deposit insurer to a minimum so that the deposit insurer does not risk bankruptcy – which in the US will trigger a taxpayer bailout of the deposit insurer.

Hopefully the attentive reader now has alarm bells ringing in his head:  “Wait a minute, didn’t you just say in the last chapter that one purpose of creating asset backed commercial paper conduits was so that banks could make loans that weren’t subject to the regulators’ requirements?  What’s supposed to keep bad loans from driving the conduits into bankruptcy if they aren’t subject to capital requirements?  What’s supposed to keep the money supply from growing so fast that inflation takes off, if conduits aren’t subject to reserve requirements?”

Good questions.

The parallel or shadow banking system

Recall how an asset backed commercial paper conduit functions:  money market fund managers buy asset backed commercial paper and, thereby fund a wide variety of loans that traditionally were made by banks.  Asset backed commercial paper conduits invest in residential and commercial mortgages, unsecured corporate loans, automobile loans, credit card receivables, other accounts receivable, corporate and government bonds and a whole variety of structured finance products like CDOs, CLOs and SIVs.

The reason that Paul McCulley of Pimco coined the term “the shadow banking system” to describe the early 21st century role of ABCP is that ABCP conduits perform the same function in the economy that banks do.  Investors in money market funds often treat them as interest-bearing bank accounts – with the understanding that they are uninsured accounts.  The fact that over a 40 year history there has been only one case in which a money market fund lost money contributes to investors’ impression that they are no different from deposits, as does the fact that many funds come with check books.[1] When money market funds invest in ABCP conduits, their loans are use to finance corporate working capital, corporate fixed capital and residential investment.  Traditionally, it was the banking sector that specialized in these areas of finance, particularly for small and medium sized firms.  See Diagram 2 for an illustration of how ABCP can be used to create money.

Conduit money
ABCP conduits are like banks because both depend on deposit-like financing that can be withdrawn at very short notice, and both use these funds to invest in longer-term assets such as mortgages and corporate loans.  The crucial difference between the banking system and the ABCP market is that the banking system has access to financial support services when it runs into problems.

After the Great Depression in which one third of all banks failed, the FDIC was created to provide federal insurance for bank deposits, and the Federal Reserve took on the responsibility of supporting sound banks through a crisis.  Precisely because the government has committed to support the banking system through a financial crisis, the banking industry is possibly the most regulated industry in the country.

Thus the difference between the ABCP market and the banking system is that the latter is protected from a bank run by (i) the fact that every bank can borrow directly from the Federal Reserve in case of a sudden withdrawal of deposits and (ii) deposit insurance.  Because the federal government guarantees that depositors’ funds will be repaid even when a bank goes bankrupt, there is no reason for depositors to flood an unstable bank with withdrawal requests.

The fact that the ABCP market is both unregulated and unprotected explains why it is called the “shadow” banking system.  ABCP conduits have no required reserve ratios and no capital requirements.  They are subject only to the discipline of the market.  Unfortunately, ABCP usually matures in three months or less and typically pays less than one half of one percent more than Treasury securities.  For this reason the cost to an investor of carefully reviewing a conduit’s assets and structure generally exceeds the benefits an investor can expect from investing in the ABCP of the conduit.  And so we find that the evaluation of a conduit’s creditworthiness was outsourced to the credit rating agencies.

The end result of an environment where “market discipline” is enforced only by the threat of a downgrade from the credit rating agencies is that the credit rating agencies become the de facto regulators of the ABCP market.  The credit rating agencies are, of course, not true regulators, because stability of the ABCP market as a whole is not within their purview.  They have a much narrower agenda:  they evaluate only the ability of individual conduits to repay the commercial paper that they issue.  To put it bluntly, as long as contracts are in place to ensure that the commercial paper issued by the conduit will be repaid even if the conduit collapses, the credit rating agencies don’t need to do a thorough evaluation of the risk of collapse of the ABCP conduit itself.

The credit rating agencies recognized that ABCP conduits, like banks, are subject to runs, because money market investors can suddenly decide to withdraw their funds, and they recognized that, as is the case with banks, bad assets can bankrupt a conduit and generate losses for ABCP investors.  To address the liquidity risk, instead of required reserves, conduits must have access to a liquidity facility that stands ready to cover their whole issue of commercial paper.  It is the banks that provide this liquidity facility in exchange for a fee.  To address the credit risk, instead of capital requirements, ABCP conduits are also required to pay the banks for credit enhancement, which offers some protection against bad assets.

In short, the credit rating agencies “regulated” the ABCP conduits by requiring that the banking system stand ready to support all of a conduit’s commercial paper in case of a run and be ready to support a conduit’s bad debt as long as it remained below a certain fraction of assets.  Because conduits were never required to be capitalized or to maintain reserves, in retrospect we can conclude that the ABCP market was indeed a shadow banking system – it was entirely dependent on the real banking system and could never hope to stand alone.

The problem with this system where highly regulated banks support an alterego that is monitored only by the credit rating agencies, is that nobody can be responsible for the stability of the integrated system.  Bank regulators tried to limit the banks’ exposure to conduits by adjusting the capital requirements relating to liquidity facilities and credit enhancement.  In the meanwhile, the credit rating agencies were approving the use of liquidity and credit facilities that allowed banks to evade the intent (if not the letter) of the regulatory requirements.  An example of this is the liquidity put described in the previous chapter.

I should note here that the term “shadow banking system” was coined after the financial community experienced a run on asset-backed commercial paper.[2] While it is easy to see in retrospect that it was a mistake for regulators to allow the development of a parallel banking system in which bank supported lending took place beyond their view, the simple fact is that only a very, very few people recognized how profoundly unstable financial markets can be.[3] Everyone else thought it was simply impossible for a market with as many participants as the ABCP market to find that suddenly there were no buyers – and not just for one week, but for week after week after week.  Because of this profound failure to understand the nature of financial markets, regulators viewed the growth of ABCP as a benign event, which served only to increase the availability of credit throughout the economy. [4]

The parallel banking system matures

By 1997 the ABCP market was well enough established to grow at a rate of more than $100 billion each year.  While 2002 saw the start of a three-year break in this pattern of strong growth, this is easily explained by the collapse of Enron and the consequent uncertainty surrounding the regulation of ABCP conduits. By the middle of 2004 the regulatory issues had been resolved and ABCP was once again growing at a rate of more than $100 billion a year.

The greatest growth in ABCP took place from June 2006 to June 2007.  In this period, ABCP increased by more than $238 billion.  As domestic deposits in the banking system over the same period grew by $255 billion, the ABCP market was providing almost as much additional liquidity to the U.S. economy as the banking system itself.

In this period from June 2006 to June 2007, banks were required to back any assets that were supported by a liquidity facility with one tenth of the capital that would be required if the asset was owned by the bank.  Against any assets that were supported by credit enhancement the bank was required to hold capital just as if the asset were on its balance sheet.  If 10% of the average conduit’s assets had a credit enhancement, then  each dollar of bank capital could support approximately $125 of loans when the loans were placed in a conduit (as compared to $25 when the loans were kept by the bank).

One thing is clear.  The outsourcing of bank lending to ABCP conduits made it possible for bank capital to support a far greater number of loans than could have been supported in the traditional banking sector.  Since housing prices were rising at the same time as a massive increase in securitization was taking place and the increase in ABCP represented in part an increase in the funds available to finance the purchase of homes, it is entirely possible that this increase in funds contributed to the increase in housing prices.    In other words, the price inflation we have seen over the past year in housing and other real estate, may be explained, in part, by the growth of conduits that were subject only indirectly to regulatory capital requirements.

[1] In 1994 Community Assets Management paid only 96 cents on the dollar to investors.  Money market funds were added to the definition of M2 in 1980.

[2] I believe the first use of the term is by Paul McCulley of Pimco in his September 2007 newsletter.

[3] Raghuram Rajan is one.

[4] On the other hand, there were quite a few in the investment world who viewed the growth of asset backed commercial paper and, in particular, its important role in funding complex structured finance products with caution and even concern.  Several money market fund managers took a conservative approach and avoided asset-backed commercial paper entirely.

The parallel banking system: The regulation of ABCP

Note:  This is post 2 of 3.  See also here and here.

The problem of implicit recourse

While asset backed commercial paper programs started as a way for firms to borrow against the collateral of their financial assets, such as accounts receivable, it didn’t take long for banks to realize that a very wide variety of assets could be financed using ABCP.  All of the loan types that banks held on their balance sheets in the past found their way into asset backed commercial paper conduits:  residential mortgages, commercial mortgages, unsecured business loans, corporate bonds, government bonds, etc.

Thus by the late 1980s ABCP conduits had evolved such that banks were deliberately taking loans off their balance sheets and placing them in conduits in order to reduce the amount of capital that regulators required of them.  For the most part regulators viewed this phenomenon as a positive development, since it meant that a third party, the conduit, would absorb a large portion of any losses on the loans.  To the degree that the conduit would be taking the losses, there was no need for the bank to hold capital against the loans.

While the relationship between conduits and sponsoring financial institutions was subject to steadily increasing regulation over time, the conduits themselves were not regulated.  They fall into the same regulatory category as hedge funds:  because investments in conduits cannot be marketed or sold to the general public, regulators rely on the self-interest of sophisticated investors to act as a market force that makes government supervision of conduits unnecessary.

Through the 1990s, it became clear that the conduits which were created by banks to hold bank loans were far less independent in practice than they were on paper.  While some banks ignored the structured finance revolution and continued to hold loans on their balance sheets as they had in the past, the banks that chose to create conduits developed a new business model.  They originated loans with no intention of holding them on balance sheet.  Banks that followed the new originate and distribute model of lending were dependent on their conduits in order to continue their loan activities.

Thus, when problematic assets were going to cause a conduit to default, the sponsoring bank suddenly found itself in a position where, if the conduit was allowed to default, the bank would lack the credibility to continue placing assets in any other conduit – and this would be extremely detrimental to its business model.  Repeatedly throughout the 1990s regulators agreed that it was in a bank’s interest to support a faltering conduit – despite the fact that on paper the bank had no obligation to do so.  In short, it became clear that when a bank sold a loan to a conduit, it was in practice a recourse sale – that is, a sale where the bank can be required to take back the asset when it goes into default.

Here, we run into a problem.  The accounting rules for recourse sales are crystal clear:  a recourse sale is not a “true sale,” so a loan sold with recourse cannot be removed from the seller’s balance sheet.  While implicit recourse was not yet explicitly covered by accounting rules, the violation of accounting principles was evident.  Throughout the later years of the 1990s, regulators struggled with the problem of implicit recourse for loans sold to conduits, and by 2002 had a new policy:  Banks that provided recourse for assets that had been sold to conduits were threatened with an increase in regulatory capital requirements.

The main effect of stricter regulation was, however, to drive implicit recourse deeper underground.  For example in the early years of the current decade there was a noteworthy growth in loans bought back from conduits on the basis of fraud.  Under accounting rules a clause requiring the repurchase of fraudulent loans does not make the sale a recourse sale.  In 2001, NextBank was forced by regulators to take a conduit on balance sheet, because it was clearly using “fraud losses” to hide the fact that it was buying back bad assets from the conduit.  This caused the bank to fail and be seized by the FDIC.  NextBank, however, is an exceptional case that did not set a precedent for the banking system as a whole.  Researchers have found evidence that other banks were also using “fraud losses” to hide recourse loans and did not suffer regulatory interference.[1]

In short, while it was well understood that banks were using conduits to reduce and even avoid regulatory capital requirements, it is not clear that anyone – the bankers, the regulators or the researchers – was genuinely concerned that the banks were undercapitalized.  Many seem to have held the view that capital requirements were too strict and thus that, at least to some degree, avoiding them was in the interests of economic efficiency.  (It is worth noting that in precisely these years the Basel II international regulatory standards for banks were being negotiated – and that one goal of Basel II was to reduce the conservative regulatory capital requirements that had been put in place by the Basel I accord.)  The regulators, like the banks themselves, could not imagine a real-world scenario in which many conduits would simultaneously draw on their credit and liquidity facilities.

Efforts to regulate liquidity facilities

By March 2004, the Enron scandal had led to the revision of accounting standards.  Enron used conduits to hide losses from the public.  And the new accounting rule, FIN 46R, stated that, if a single organization was exposed to the majority of a conduit’s expected losses then that organization would have to take the conduit on balance sheet.  The new rule also required firms to evaluate the degree to which they were either implicitly or explicitly exposed to losses from off balance sheet conduits on a regular basis.  This new rule forced several banks to consolidate asset backed commercial paper conduits onto their balance sheets.

However, since banks were using conduits to fund new loans, not to hide losses, regulators did not view the accounting changes as particularly relevant to banking.  The regulators argued that, because the banks’ exposure to losses from conduits was limited to the credit and liquidity enhancement that they were contractually obliged to provide, treating banks as if they were exposed to 100% of the conduits losses by forcing them to take the conduits on balance sheet results in excessive capital requirements.  Thus, to this day the calculation of a bank’s risk-based capital requirement does not include any ABCP conduit assets that have been consolidated on to the bank’s balance sheet.[2]

Despite such regulatory indulgence, banks have shown a strong preference for conduits that do not need to be consolidated on balance sheet.  Now ABCP conduits are designed so that multiple banks or firms sell assets into the conduit and each is obliged to buy back only a portion of the assets in case of default.  In this manner no single entity is exposed to the majority of the conduit’s expected losses.  At the end of 2006 about half or $600 billion of the ABCP conduits in the US took this form.[3]

Although the regulators decided to allow banks to ignore ABCP conduits when calculating their risk based capital requirements, they were well aware that implicit recourse could be a problem for conduits.  Thus, the regulators also put into place stricter capital requirements for commitments to provide credit and liquidity enhancement.

Since 1992, the capital requirements that banks faced were much higher for credit enhancement than for liquidity support.  In fact a bank that provided 100% credit enhancement to a conduit was required to hold capital, just as if the loans were on its balance sheet.  When credit enhancement was only for a fraction of the conduit’s assets, the bank was required to treat that fraction of the assets as though they were on its balance sheet.  On the other hand up through the middle of 2005 there was no capital requirement for any liquidity facility of less than one year’s duration. It didn’t take banks long to figure out that, by designing a 364 day liquidity facility that also provided credit enhancement, they could minimize regulatory capital requirements.

This practice of combining a liquidity facility with credit enhancement did not escape the notice of regulators.  Thus, in the same final ruling that mitigated the effects of post-Enron accounting changes on banks, the capital requirements for short-term liquidity facilities were increased:  “ineligible” liquidity facilities would be treated as equivalent to credit enhancement, while “eligible” liquidity facilities would require a tenth of the capital required for credit enhancement. The following scold was published with regulatory guidance on the ruling:

The agencies reiterate their position that the primary function of an eligible ABCP liquidity facility is to provide liquidity – not credit enhancement. Further, the agencies emphasize their view, as stated in the ABCP rule, that an eligible liquidity facility should not be used to purchase or otherwise fund assets with the high degree of credit risk typically associated with seriously delinquent and defaulted assets and assets that are below investment grade. [4]

An eligible ABCP liquidity facility includes a provision that reduces the funding obligation, before any funds are drawn, by the quantity of assets that are 90 days or more past due, in default, or below investment grade to the degree that these assets are in excess of the credit enhancement available to the conduit.  In other words, a liquidity facility is eligible as long as it explicitly precludes the funding of high-risk assets that are not already covered by credit enhancement.[5],[6]

It is worth observing that the qualification “to the degree that these assets are in excess of the credit enhancement available to the conduit” is not actually part of the final rule issued by regulators on July 28, 2004.  In fact, in the background information published with the final rule, the regulators state that commenters had requested that “guarantees providing credit protection” be taken into account and for this reason a clause was added to final rule excepting assets protected by a government or agency guarantee.  The relaxation of the final rule as it relates to private sector credit enhancement took the form of interagency guidance published on August 4, 2005.  It is not clear to me how this guidance can be considered consistent with the plain text of the final rule.

In order for a conduit to receive an A1/P1/F1 rating from the credit rating agencies, typically a conduit must have 100% liquidity support.  Thus, as soon as the assets in default exceed the credit enhancement available to the conduit, this rule creates a very awkward situation for the sponsoring bank.  Either the liquidity facility is reduced so that it does not cover the impaired assets and this puts the conduit’s credit rating at risk, or the liquidity facility becomes ineligible and the bank must treat all the assets in the conduit as if they were on balance sheet.

In the context of this regulatory environment, let’s try to make sense of an event that shocked the financial world in November of 2007:  $25 billion of new sub-prime CDO exposure suddenly appeared on Citigroup’s third quarter balance sheet.  The question everybody was asking was:  How could Citi have failed to report this exposure in previous financial statements?  The explanation:  When Citi sold these CDOs to conduits they were sold with a “liquidity put.”  The liquidity put “allowed any buyer of these CDOs who ran into financing problems to sell them back – at original value – to Citi.”[7]

How can a “liquidity put” be consistent with the regulatory standards we’ve just explained?  A liquidity put could be part of an eligible liquidity facility as long as financing problems could trigger a repurchase of the asset only if the asset retained its first tier rating.  Furthermore, since typically under the law, the reason a recourse sale is not considered a “true sale” is that the seller retains the credit risk of the loan, a liquidity put may not be used to purchase an impaired asset.  Thus a liquidity put must be triggered by a financing problem and explicitly rule out repurchase of an asset that has been downgraded or is seriously delinquent.

The example of Citibank indicates, however, that, because delinquencies and downgrades are anticipated before they occur and commercial paper is rolled over on a frequent basis, the expectation of asset impairment precipitates a liquidity crisis for the conduit before the assets are formally recognized as impaired.  Thus, in practice, the seller of a liquidity put is exposed to the credit risk of the underlying loans.

As a dramatic overhaul of the treatment of off-balance sheet entities in financial statements is underway, it is appears that regulators and accounting professionals have a clear understanding of the deficiencies of recent industry practices. [8]


[2] From a final rule published in the Federal Register on July 28, 2004 and available at:

“The agencies [The Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of Thrift Supervision] believe that the consolidation of ABCP program assets generally would result in risk-based capital requirements that do not appropriately reflect the risks faced by banking organizations involved with the programs. Sponsoring banking organizations generally face limited risk exposure to ABCP programs. This risk usually is confined to the credit enhancements and liquidity facility arrangements that sponsoring banking organizations provide to these programs. In addition, operational controls and structural provisions, along with overcollateralization or other credit enhancements provided by the companies that sell assets into ABCP programs, mitigate the risks to which sponsoring banking organizations are exposed. …

The final rule will make permanent the exclusion of ABCP program assets consolidated under FIN 46-R and any associated minority interests from risk-weighted assets and tier 1 capital, respectively, when sponsoring banking organizations calculate their tier 1 and total risk-based capital ratios.”

“Effective September 30,2004, the federal banking agencies amended the risk-based capital standards to permit bank holding companies and other sponsoring banking organizations, when calculating their risk-based capital ratios, to exclude from their risk-weighted asset base those assets in asset-backed commercial paper (ABCP) programs that are consolidated onto the sponsoring banking organizations’ balance sheets.”

Federal Bank Holding Company Law, 1997, by Pauline B. Heller, Melanie Fein p. 5-16.7

[3] MARKETS AND INVESTING: Guide to the vehicles: conduits, SIVs and SIV-lites

Financial Times

Published: Aug 15, 2007,id=070815000650,print=yes.html

[4] SR Letters 2005-13. .

[5], p. 18.  Note that the original rule proposed that eligible liquidity facilities require one fifth of the capital required for credit enhancement and that the liquidity facility be reduced by the quantity of loans that were 60 days or more past due.

[6] SR Letters 2005-13. .

[7]Loomis, Carol, November 28 2007 Robert Rubin on the job he never wanted, Fortune Magazine

Bank of America also announced $10 billion of CDO exposure due to liquidity puts.


The parallel banking system: What is Asset Backed Commercial Paper?

Note:  This is post 1 of 3.  See also here and here.

Before there was asset backed commercial paper …

Asset backed commercial paper is a relatively new invention, but commercial paper is not.  Traditional commercial paper is way for firms to borrow money without offering the lender any collateral for a period of time from overnight up to 270 days.  Because there is no collateral to secure the loan, typically only large well-known firms can issue commercial paper.

Commercial paper has been around for centuries and predates the development of a modern banking system.  World famous bankers like the Medici in Florence, the Fuggers of medieval Germany and the Rothschilds made fortunes by trading in commercial paper.  Thus, commercial paper is an asset class that has stood the test of time.

The basic idea behind commercial paper is this:  When a large company with stable revenues and sound finances like General Electric Corporation wants to borrow money for three months, there are plenty of people who will lend the company money on an unsecured basis (in other words, with no guarantees aside from GE’s promise to repay the funds). Why are people willing to trust GE with their money?  Because there is virtually no likelihood that GE will go bankrupt within the three month duration of the loan instead of paying off the debt.

Of course, once in a while a firm that issues commercial paper does go bankrupt.  One of the more recent examples, Mercury Financial Co., a major issuer of automobile loans, defaulted on $315 million of commercial paper in 1997.  But such cases are very rare, so large, creditworthy firms in the US continue to borrow huge sums using commercial paper on a daily basis, and this has been common practice in the US and Europe for centuries.

Since the 1970s, the number of buyers in the commercial paper market has increased dramatically in the United States.  The reason for this is the growth of money market mutual funds.  Money market mutual funds accept investments of as little as $1,000 and invest in short-term assets like commercial paper and U.S. Treasury bills.  Because they aim to invest in assets that are so safe that they will not experience losses (and historically there have been almost no losses),[1] each share in a money market fund is worth $1 and this allows the fund to function just like an interest paying bank account.  Many money market funds even allow investors to withdraw money using checks.

The reason money market funds grew so dramatically in the last quarter of the 20th century is that they offered investors interest payments close to the return on U.S. Treasury bills – and this return was much higher than that offered by banks on savings or checking accounts.  Chart 1 shows how the assets in money market mutual funds have increased from 1975 to today.  You can see that in 1980 less than $100 billion were invested in money market funds, and nowadays more than $2 trillion is held by investors in money market funds.  Thus over the past quarter of a century there has been approximately a 20 fold increase in the funds available to purchase commercial paper.

Chart from “US Money Market Funds: A Regulatory Success Story”, Peter G. Crane, Crane Data LLC – 28 Nov 2006

What has been happening over the past 25 years is that corporations have been able to borrow money directly on the commercial paper market instead of turning to banks for loans.  The flip side of this transition is that investors have been choosing not to deposit their money in banks, but to invest in money market mutual funds and thus indirectly in commercial paper.  This process where the traditional lending relationship between firms and banks is displaced by market based lending is called disintermediation.  Charts 2 and 3 show how the issue of commercial paper increased from 1965 to the present.

Chart 2:
Chart 2:

from Instruments of the Money Market, edited by Timothy Q. Cook and Robert K. Laroche, 1993

Chart 3:  Data from
Chart 3: Data from

Asset backed commercial paper:  The early years

Asset backed commercial paper (ABCP) was first issued in the mid-1980s.  An important impetus for the development of ABCP was the introduction by the Securities and Exchange Commission of regulation for money market mutual funds in 1983.  The big change was that money market funds were required to invest the vast majority of their portfolio in first tier commercial paper.  First tier commercial paper must receive the highest possible rating from one of the major credit rating agencies, such as Standard and Poors, Moody’s or Fitch.  The rating A1 (S&P), P1 (Moody’s) or F1 (Fitch) means that the commercial paper is as unlikely to default as the US government.

This regulation dramatically reduced the demand for second tier commercial paper, which is rated A2/P2/F2 and is somewhat more likely to default than first tier paper.  Many firms, which had been actively issuing second tier commercial paper, suddenly found themselves looking for a new source of funds.  Asset backed commercial paper programs were established so these firms could continue borrowing on commercial paper markets.

In an asset backed commercial paper program a special purpose entity, often called a conduit, is created.[2] The firm takes a group of assets that it could typically use as collateral for a bank loan, like a portfolio of credit card receivables or car loans, and sells the assets to the conduit.  The firm usually continues to service the assets by collecting payments and sending them on to the conduit.  In this early period, it was also common for the firm to retain the obligation to buy back assets that go into default.

The conduit, which is legally an independent third party,[3] sells commercial paper to finance its purchases of business loans.  This is asset backed commercial paper because it is literally the income from the loans owned by the conduit that enables the conduit to pay the interest on its commercial paper and, as the loans are paid off, to reduce the amount of commercial paper that it issues.[4]

Notice the structure of a commercial paper conduit:  the loans owned by the conduit are often scheduled to be paid off only after a few years, while the commercial paper comes due in a matter of months.  Thus, the conduit does not have enough money to pay off the commercial paper in full when it comes due.  This means that the conduit will run into trouble if it cannot issue new commercial paper when the old commercial paper matures.  In other words, the conduit is dependent on the liquidity of the commercial paper market.

From a financial point of view this means that in order for the conduit to find buyers for its commercial paper, it must have a plan for what it is going to do if it cannot issue new commercial paper.  To deal with this liquidity risk all conduits pay a bank to guarantee that the bank will buy the conduit’s commercial paper if the commercial paper market is not functioning.  This guarantee is called a liquidity facility.

Not only does a conduit need to have a liquidity facility, but it also needs to have a plan for what it will do if a bunch of the loans that it owns go into default.  In particular, since the SEC requires that a money market’s assets be composed mostly of first tier commercial paper, asset backed commercial paper programs need an A1/P1/F1 rating.  To earn their highest rating the credit rating agencies require (i) that a liquidity facility covers 100% of commercial paper issues and (ii) that an asset backed commercial paper program protect lenders from default by ensuring that even if 15% (and sometimes more) of the assets go into default, the commercial paper will be paid.  This protection against default is achieved by some combination of the following three possibilities:  (a) the firm that sells the loans is required to buy them back if they go into default,  (b) over-collateralization, where the amount of commercial paper issued (and the amount paid by the conduit for the assets) is less than the full value of the assets, and (c) credit enhancement, where a bank commits – for a fee – to purchase some of the conduit’s assets at full value if they go into default.

For a bank that sells a liquidity facility only, the distinction between credit enhancement and a backup line of liquidity is important.  In the event that the conduit cannot roll over its commercial paper because it has assets that are in default, the bank does not need to honor the liquidity commitment.  (Legally this is usually called a “material adverse circumstance,” which negates the initial commitment.)

As you may have noticed, from the beginning ABCP programs provided ample opportunities for banks to earn income from fees.  Not only could banks provide credit enhancement and liquidity facilities, but they often earned income from advising the firms that set up ABCP programs.  Banks usually determined the credit standards for assets that were placed in an ABCP program including the appropriate level of over-collateralization, and they monitored the program’s portfolio of assets on an on-going basis.  Thus, banks were very supportive of the growth of ABCP because it opened up an important role for them to play in the new world of market-based lending.

The regulatory changes faced by banks in the 1980s also encouraged the development of asset backed securitization programs.  Regulators were increasing the capital requirements for banks.  To increase capital, a bank needs to raise money.  This can be done by holding onto and reinvesting profits or by selling new shares of ownership in the bank.

Another way to meet the higher capital requirements demanded by regulators was to reduce the quantity of assets on which the capital requirements were based.  When a bank makes a loan and keeps it until it is completely paid off, the loan is an asset on the bank’s balance sheet.  When the bank sells the loan, the asset is removed from the bank’s balance sheet.  Bank capital requirements are based on the assets a bank holds on its balance sheet.  Thus banks could meet regulators’ demands by selling some of loans that they held on their balance sheets.

Asset backed commercial paper programs give firms access to the funds they seek, generate fee income for banks, and place the loans created with a third party, the conduit.  By keeping these loans off the bank’s balance sheet, these programs help reduce the capital requirements faced by banks.

Asset backed commercial paper conduits are one of the founding pillars of the securitization revolution.  Securitization is a term that refers to the practice of financing loans that were traditionally held on a bank’s balance sheet by selling the loans to an independent conduit.  Securitization takes hard-to-sell loans and turns them into a tradable asset.

The commercial paper issued by these conduits can only be sold if it carries a first tier credit rating, and a first tier credit rating will only be granted if the conduit has sufficient liquidity protection and credit enhancement.  Thus the legal contracts that are used to create the conduit must be carefully structured to meet the demands of the credit rating agencies.

Let’s pause for a second and think about what it is that securitization is doing in the commercial paper market.  It replaces traditional commercial paper, or a promise of repayment backed by the full faith and credit of a large firm, with ABCP, or a promise supported by collateral and bank guarantees.  Now, since the extra interest you can earn by investing in asset backed commercial paper is much less than 1% and ABCP is very short-term, it simply isn’t worth an investor’s time to go through and carefully check out the quality of the collateral backing the conduit.  This means that investors in ABCP are placing their trust in the bank guarantee and sponsorship of the conduit – even though the bank usually only guarantees a fraction of the assets.

The fundamental contradiction of these structured finance products is this:  the investor is counting on the bank sponsorship and guarantee of the conduit to protect the investor from losses, while the bank is counting on the investor to absorb the losses if the conduit turns out to have more bad assets than expected.  Because exposing the investor to losses on low-yield commercial paper is a sure-fire way of scaring the investor away from that bank’s conduits, if not from the ABCP asset class as a whole, banks face a very strong incentive to provide support to the conduit well beyond a bank’s contractual obligations.  Of course, when a bank takes action to protect the investors in a conduit, one cannot help but question whether the conduit is in fact a truly independent third party.  As ABCP programs evolved, signs of this fundamental contradiction between the contractual and the actual behavior of these conduits continued to grow.

Sources:  Asset-backed commercial paper programs.

From: Federal Reserve Bulletin  |  Date: 2/1/1992  |  Author: Boemio, Thomas R.; Edwards, Gerald A., Jr.; Kavanagh, Barbara

The evolution of the U.S. commercial paper market since 1980.

From: Federal Reserve Bulletin  |  Date: 12/1/1992  |  Author: Post, Mitchell A.

[1] “Only one small money market fund in the US has ‘broken the buck’, in the 1990s.”

[2] The terms conduit, special purpose entity (SPE) and special purpose vehicle (SPV) are used interchangeably.  (Observe, however, that a qualifying SPE (QSPE) is a distinct term defined by the accounting regulation SFAS 140.)

[3] To be more accurate the conduit needs to be “bankruptcy remote.”  This is a very technical term, which speaking roughly means that its activities are strictly limited in scope, that it has an independent director, that any claimants to the assets in the conduit other than the commercial paper owners cannot force it into bankruptcy and that it is run as a business entirely separate from all other persons and entities.  The last two conditions are meant to ensure that, in the event of the bankruptcy of the sponsoring bank or firm, the conduit’s assets are protected from the bankrupt entity’s creditors.  For the gory details see pp. 19 ff.

[4] In practice, the conduits that are created by asset backed commercial paper programs are typically designed as on-going concerns that continuously replace any loans that are paid off with new loans and replace any commercial paper that is paid off with new commercial paper.

The parallel banking system: An outdated introduction

I was surprised that the discussion at the Atlantic implied that there are a lot of people who don’t understand the basic structure of the parallel banking system that has developed since the 1980s.  I wrote a piece in early 2008 that was outdated as soon as it was completed and that I mothballed.  I think I explained the parallel banking system fairly clearly, however — and so I thought I’d put what I wrote up in a series of posts.

For amusement here is the (totally outdated) introduction.  (It’s pretty clear at this point that the current crisis extends far beyond asset backed commercial paper.)

The Anatomy of a Crisis:  Introduction

The financial crisis of 2007 that has roiled markets across the world and caused investors to question the solvency of some of the world’s largest financial institutions was set off by unusually high default rates on sub-prime mortgages issued in the US.  For this reason, politicians and regulators have spent a lot of time talking about how to fix the mortgage markets.  Unfortunately these well-meaning individuals have been confusing the catalyst of the crisis with the cause of the crisis.

This book will explain the cause of the crisis – and while we will certainly spend some time exploring why the subprime mortgage market is in such a bad state – our main focus will be the asset backed commercial paper market, which is the key to understanding why the crisis happened – and how to avoid crises in the future.

Initially the problem with subprime mortgages was viewed as nothing more than a bit of noise that would indeed result in losses for some financial institutions, but would have no more effect on financial markets than any other bad investment.  At least that’s what people thought, until the second week of August.  To get an idea of why asset backed commercial paper (ABCP) is so important take a look at this graph.

The financial crisis started in the second week of August 2007 when issuers of asset backed commercial paper failed to find buyers for their paper.  The financial crisis will end when the asset backed commercial paper market stabilizes.

CP to 2007

The reason that it is taking a long time for the asset backed commercial paper market to stabilize is that buyers of this paper don’t like taking on risk.  ABCP buyers are almost always people who are responsible for watching over money that their employers or clients want to have access to at any point in time.  The one thing they can’t do is go back to the boss and say:  “Sorry, I lost some of your money.”  Higher returns are definitely better than lower returns, but genuine risk of losses is an absolute no-no.  Money market fund managers, corporate treasurers and fiduciary institutions were all parking their excess funds in asset backed commercial paper because they had been told by their brokers and the rating agencies that it was perfectly safe — and that they could earn higher interest rates on their money without significant risk.

Now, there is a whole crowd of people who will read that last sentence and just crack up laughing.  Why?  Because there’s one unbreakable rule in the world of finance and that is that you don’t earn higher returns without taking on greater risk.  If that were actually possible, your broker wouldn’t be selling the product to you – he’d be too busy buying into this “free lunch” himself.

ABCP funds most of the new-fangled financial products that were used to finance everything from corporate loans to commercial real estate loans to residential mortgages to consumer car loans.  Did you catch that?  Residential mortgages.  Yep, that includes sub-prime.

When these risk averse investors realized that they could be exposed to the losses on sub-prime mortgages, they also realized that they could potentially be exposed to losses from all those other loans they were financing.  In other words, they finally realized that they were taking on the risk that they might have to admit to the boss that they had lost money.  The drop you see in the ABCP chart is these investors deciding that ABCP is too risky for them.

Bill Gross, manager of one of the world’s largest mutual funds, predicted that ABCP will disappear entirely.[1] Even if it doesn’t disappear, the flight of money away from ABCP is a problem for many of the investment products created by Wall Street over the last decade.

CDOs, CLOs, SIVs and a host of other Wall Street acronyms are structured finance deals that have a pretty similar structure.  About 10% of the deal is high risk.  Anyone who invests in this portion of the deal is agreeing to take all of the losses that the deal incurs up to that 10% investment amount.  Precisely because there are investors who take the first losses, the other 90% of the deal is considered relatively low risk.  A big chunk of the rest of the money is raised using asset backed commercial paper.  Once the money is raised, it is used to buy loans.  As I noted above, these loans can include a wide variety of commercial, consumer and real estate loans.

Why is most of the deal financed using asset backed commercial paper and other short-term notes?  Because short-term loans are generally cheap – investors don’t expect to earn too much in interest if they’re lending the money for a year or less.  This frees up more of the return from the underlying loans to be paid to other investors.  Without this ability to increase the returns for the investors who were bearing the first risk, these deals could not have been put together.  In other words, cheap money borrowed through asset backed commercial paper markets was crucial to most of the structured finance deals created by Wall Street over the past decade.

When investors got scared about the risks involved in asset backed commercial paper, it became a lot harder or even impossible for many structured finance deals to be completed.  Unfortunately, more than 50% of residential real estate loans[2], 28% of commercial real estate loans[3] and 67% of corporate leveraged loans[4] had been going into structured finance products over the last few years.  Thus when structured finance products couldn’t raise money, this meant that there was much less money available to finance mortgages and many other loans.

Sub-prime mortgage lending was the first section of the credit market to freeze up, but it was just the canary in the coal-mine.  At first, investment banks hoped that investors were only refusing to buy asset backed commercial paper with subprime exposure, and so they stopped buying subprime mortgages.  In the summer of 2007, x mortgage lenders who specialized in the origination of subprime loans went bankrupt.

Soon, however, it was clear that investors were worried not just about subprime but about asset backed commercial paper in general.  Through 2007 as investment banks adjusted to a $100 billion per month reduction in the funds they could raise to buy loans, they became much more selective.  They stopped buying most mortgages, leaving the market to two special government sponsored mortgage-buying firms, Fannie Mae and Freddie Mac.  Since both of these firms wouldn’t buy any loans in excess of $417,000, it became very hard to get a “jumbo” mortgage in excess of this amount.  The credit contraction extended, however, beyond real estate.  Banks also looked for ways to avoid making leveraged loans (which are used to finance businesses buying other businesses) that they had spent the last six months negotiating.

Some might think that this credit contraction isn’t really such a big deal – after all a bunch of loans that would have been made in the past were not made.  Sure, if you happened to be one of the few people who really wanted to buy a house in the last few months of 2007, you were pretty unlucky, but why should the rest of us care?

Well, when you’re talking about expensive assets like houses that can really only be purchased with the help of a loan, a major reduction in credit can have a lot of side effects.  In particular, the first effect of a reduction in credit is a reduction in the number of people buying houses – without a change in the number of houses for sale.  Now instead of having two buyers bidding up the sale price of the house, a lucky seller may only get one offer.  And unlucky sellers may watch their house sit on the market for months.

Thus, the second effect of a credit contraction is an increase in the number of unsold houses sitting on the market.  Since credit conditions mean that the market still has a shortage of buyers, the tendency is for selling a house to get harder and harder the longer the credit contraction continues.

Of course, when there are a lot of houses for sale and just a few buyers, we expect some of the sellers to start offering a really good deal to any buyers they may find.  The third effect of a credit contraction is a fall in housing prices.

If you are one of the people who bought recently and you’re looking to sell your house, you may find that you can’t get what you paid for it.  And, if you happened to make a very small down-payment, you may find that you owe more money on your house than you can get by selling it.  In this situation, if you’re unlucky and sickness or unemployment prevents you from making your mortgage payments, you won’t be able to pay off your mortgage by selling your house.  You may have no choice but to default on the loan and lose the house.

And those who bought the house as an investment may look at the size of their loan, compare it to what they could get by selling it and then conclude that the investment was a mistake.  They may just send their keys in to the bank and walk away with no house, but no mortgage either.

In other words, in markets where buyers are dependent on loans in order to make a purchase, a credit contraction can lead to a downward spiral with a self-reinforcing feedback loop:

Fewer buyers — fewer sales — increase in houses for sale — prices fall — increase in foreclosures — increase in houses for sale — prices fall further

This process is likely to continue until the credit situation stabilizes and the number of buyers increases.

Of course, this negative dynamic in which a credit contraction drives prices down doesn’t only happen in the housing market.  It can happen in any market where most purchases are depend on loans.  The process is starting in commercial real estate.  And has reduced the value of corporations that are targets for take-over.  But most of us first saw the consequences of the credit contraction when we realized that house prices were dropping faster than we ever thought possible.

This book is about a financial innovation called asset backed commercial paper and how it ended up wrecking havoc on the lives of tens of thousands of home-owners and profoundly affecting the opportunities available to just about everybody who lives in the United States of America.

[1] “The commercial paper market, in terms of the asset-backed commercial paper market, is basically history,” Bill Gross, manager of the world’s biggest bond fund at Newport Beach, California-based Pacific Investment Management Co., said in an interview today.

[2] Chain of fools, Feb 7th 2008, The Economist 19% in private MBS

[3] Wall Street Gears for Its New Pain, By LINGLING WEI and RANDALL SMITH

March 3, 2008; Page C1,

[4] In death, afterlife, by Vipal Monga, Updated 03:19 PM EST, Mar-7-2008

The shadow banking system was an important cause of the crisis

There’s an amusing debate going on over at the Atlantic over whether the shadow banking system “caused” the crisis.

A timeline of events will help:

March to July 2007:  deteriorating subprime culminates in Bear Stearns hedge fund blowups

August 2007 to December 2007:  The financial crisis starts with the collapse of asset backed commercial paper (ABCP) markets (which had some exposure to subprime, but mostly relied on companies like Bear Stearns to do quality underwriting).  The Fed then released banks to discount ABCP issues that they guarantee themselves and within months the market stabilized after falling by $0.4 Trillion.  The Fed’s Term Auction Facility may have contributed to the stabilization (i.e. banks can now dump their ABCP at the Fed).

NOTE:  Asset backed commercial paper is a cornerstone of the shadow banking system.  ABCP  is how securitizations get financed by money market funds which play the same role as bank deposits in the traditional sector.

March 2008:  Bear Stearns collapses largely because 50% of its balance sheet (see page 25 in link) was financed on an ultrashort term basis in repo markets.  Bear experienced a banker’s bank run that took it down in a matter of days.

NOTE:  Whether repo markets are technically a part of the shadow banking system depends on your definitions.  They are, however, unquestionably part of the unregulated financial sector that two years ago our regulators were claiming banks could manage on their own.  They supported the process by which securitized assets got financed by money market funds, because they allowed investment banks to treat assets in the process of being securitized (i.e. warehoused product) as liquid assets.

UPDATED 6-17-09:   Upon reflection I realized that of course repos are part of the shadow banking system, because money market funds invest heavily in them.  Data is available in the Investment Company Institute Factbook.  While the data doesn’t go back to the late 70s, I suspect that repo markets and money market funds grew up together.  In particular, government money market funds have a long history of being major repo investors — usually investing one-third of their assets in repos.  Non government money market funds invested only 5% of funds in repos in 1992 increasing to 9% in 2004 (during which period funds quadrupled).  2005 through 2007 saw 11-12% of funds invested in repos.  At the end of 2007 more than $600 billion was invested in repos via money market funds.  Of that approximately $380 billion was invested by government funds (and therefore presumably backed by Treasuries and Agencies).

Summer 2008:  Fannie Mae and Freddie Mac stabilized only after government takeover.

NOTE:  This is definitely a case of failure in the regulated sector.

September 2008:  Lehman failure disrupts money markets.   AIG bailed out.  Goldman Sachs, Morgan Stanley rescued by Fed granting them special treatment due to emergency conditions (see p.3 in both docs).  Merrill Lynch, Washington Mutual and Wachovia sold to commercial banks.

NOTE:  Lehman was a barely regulated investment bank.  It demonstrated that banks had so mismanaged the shadow banking system that the banks themselves could fail because of it — resulting in a generalized flight from commercial paper.  Every single one of the lightly regulated investment banks had to be rescued.   Highly regulated commercial banks (JP Morgan, Wells Fargo, Bank of America) assisted the regulators in the rescues.  Some of largest  commercial banks (e.g. JPM, WFC) had spent the last few years foregoing bubble driven profits in order to profit from the coming collapse.  None of the investment banks were able to do so without an extraordinary assist from the Fed, which in theory had no business helping them (since the SEC was their primary regulator).

So Charles Davi, I have a question for you:  In the absence of the $1.2 Trillion asset backed commercial paper market that made it possible for money market fund investors to finance securitization and in the absence of the multi-trillion dollar repo market, do you honestly believe that we would have had a financial panic in August 2007 and seen the failure of Bear Stearns in 2008 — in other words, do you honestly believe that this crisis would have taken place anyhow?