from what i understand, AIG lost north of 20 billion on securities lending. this had nothing to do with AIGFP.

The Lucas quote is taken out of context, so it may not represent Lucas’s full view of the regulatory problem with shadow banking. However, the one way focus of the concluding statement, suggesting that the main point of regulation is to provide publicly funded insurance, can lead to moral hazard of the sort behind the S&L crisis and the current financial crisis. (Besides, what the public needs is another question.)

James Kwak; “But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks.”

Fortunately, the second statement is another non sequitur. If regulations are written for shadow banking per se, then the attempt to form a shadow bank would bring it into the regulatory fold. To bring up designer drugs again, Congress showed that it could legislate regulation for things that do not yet exist, but would come under regulation as soon as they are created. They can do the some for shadow banks.

…and opacity is the whole point!

It seems that they’re both right, in a sense. Many of the big problems came from institutions that were regulated in the traditional markets in which they operated, but were not regulated while conducting off-balance-sheet trades. CDS trades, for example, were not subject to traditional capital requirement regulations, and many regulated banks were heavily engaged in these. So the ability of regulated banks to engage in activities which were not regulated was a huge problem.

Obviously, something should be done about derivatives, particularly the CDS’s. You can regulate traditional banking operations all you want, but if you are ignoring the potential for massive liquidity risk in unregulated trading, then you’re wasting your time, or, worse, creating a sense of false security.

But what can be done about derivatives? I do not believe that they can be made safe through regulatory oversight; they are simply too complex for regulators to properly value. And because of correlation issues, market participants are even less able to quantify liquidity risk because they do not have access to information regarding the overall positions of their counter-parties. (Presumably, the regulatory agency would have this information, but that is a big presumption.)

So, If they are not safe now, and they cannot be safely overseen, I think the answer is to ban them. I realize I’ve said this before in comments here, but I do not think this issue is getting enough attention.

It’s up to the buyer to look at the mortgage application and closing files to determine the price that buyer is willing to pay for the mortgage.

Note: A review of the supporting documentation would have shown that many of the 2005-7 loans coming out of the Sand States should have been priced at 20-30 cents on the dollar.

No one can save the lazy, stupid lender — caveat emptor.

BS and M-L were saved because the effects of their failure on their lenders — that is, the too-big-to-fail banks — were deemed unacceptable.

Was it not the case that before G-L-B commercial banks were permitted to loan to investment banks? And if they were, wouldn’t the failure have occurred with or without G-L-B?

What? You wanted more money going to those scallywags? You thought the bubble wasn’t big enough so you wanted to make it bigger?

It is easy to see how substantially unregulated “shadow banks” can destroy us.

That’s what the Fed’s currency-swaps with foreign central banks are there for.

Furriners as dumb as our own dumb, greedy CFOs should be regulated by their domestic central banks.

Quaere: Is there one MMF prospectus which doesn’t permit the fund to put up a gate when redemption requests become burdensome?

We all probably at some time have bounced a check due to insufficient funds in our checking account, or have dipped into a overdraft privilege or credit line to allow an overdrawn check to be paid.

A holder of a check (a payee) has two concerns. One is that the check writer has sufficient funds in the account so payment is received at time of cashing the check, and two, that the bank (as opposed to the check writer) will have sufficient funds to make good on the funds in the check writer’s account. These are two different risks. Government insurance does not apply to the account holder’s sufficient funds risk. It only applies to the bank’s liquidity, bank run risks and the bank’s ability to cash the check. Insurance makes a check holder insensitive to liquidity risks, but not to insufficient funds risk.

When a bank fails, the FDIC has two options. The FDIC can allow another bank to acquire the deposits of the failed bank or the FDIC can make a direct payout to all depositors (an FDIC payoff) of the closed bank.

If there is a direct FDIC payout to depositors and a check is presented for payment, the FDIC states (“When a Bank Fails – Facts for Depositors, Creditors, and Borrowers”, http://www.fdic.gov/consumers/banking/facts/payment.html):

“In a payoff, however, any outstanding transactions or checks presented after the bank has closed cannot be paid or charged against the account. The FDIC needs to freeze all deposit accounts at the time the bank is closed to quickly pay the depositors for the insured deposit balances in their accounts. Any outstanding checks or payment requests presented after the bank failure will be returned unpaid and will be marked to indicate that the bank is closed. This does not reflect on your credit standing. However, it is your responsibility to make other funds available to creditors who receive checks that were returned and did not clear your deposit account because of the bank closing.”

The holder of a check will have a payment priority risk since checking accounts and general creditors are paid on a first come, first paid basis. Nonpayment and the return of the check, which forces the check holder to seek a new form of payment from the payor changes the timing priority of payment and changes the risk of payment. The risk is that at the time the check holder approaches the check writer or his new bank, the writer will no longer have sufficient funds to make good on the check.

Repo collateral needs to minimize and protect against both risks. To the extent that collateral loses value and no longer is sufficient to cover the repo amount, the excess amount due is a general claim against the firm’s non-legally obligated, non-restricted funds. It is a general creditor claim against the firm. Loss of collateral value is similar to having insufficient funds in a checking account.
Obviously, the creditor did not want to be a general creditor of the firm or the firm did not want to borrow without posting collateral. If the lender wanted to be an unsecured creditor, they would have lent to the firm without collateral. The borrower similarly wanted to post collateral most likely as a means to lower the cost of borrowing.

Assuming the lender is indifferent between lending unsecured at a higher rate or at lower rate with collateral, then it is borrower who makes the decision based on factors such as the lower interest rate. However, there is also the possibility that there is no reasonable rate at which the lender will lend funds to the borrower without collateral because the risk of default is already too high.

As the value of Bear Stearns and Lehman’s collateral declined, lenders faced both risks. The collateral, which is equivalent to the funds in a checking account, was no longer sufficient to repay the loan amount. Bear Stearns and Lehman became overdrawn and the lender became a general creditor for the excess amount. Lenders could have renegotiated for a higher interest rate as a general unsecured creditor, if they had deemed Bear and Lehman an acceptable risk. Lenders did not because they perceived the risk of default as too great (bankruptcy too likely, general creditor payout rate too low), or because Bear Stearns and Lehman refused because the apparent costs were too high. In the latter, obviously the firms did not believe they faced a high probability of bankruptcy or they would not have deemed the costs too great.

As Bear and Lehman faced putting up greater amounts of a limited supply of collateral, the market new they would eventually run out of available collateral. The two firms would face a funding crisis only if they could not borrow as an unsecured creditor.

The firms probably had open lines of unsecured credit. They either both drew these lines down and could not obtain more or lenders withdrew these lines due to heighten risk.

How did these firms’ funding staff (CFO, Treasurer, CEO) allow Bear to risk its funding sources by becoming highly concentrated in a single collateral asset class (residential mortgages) or allow it to be so dependent on short term, collateralized funding as opposed to general credit lines and longer term funding? Single asset funding classes have a history of surprising declines, e.g., LTCM, Amaranth, etc.

Bear and Lehman failed either because they were bad credit risks, because they misread their chances of bankruptcy or because they relied to heavily on short term funding. Insurance fixes neither of these problems. The firms failed because of mismanagement. Either they had an unprofitable business model (in a risk-adjusted sense) or their management did not understand the likelihood of failure and bankruptcy due to funding problems.