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?