Friday, October 24, 2008

"What we are observing is the demise and the collapse of the shadow banking system"

Are you having trouble understanding this credit meltdown? Of course, by now you know that the stuff floating around the Internet blaming it on "minority homeowners" and "politically correct lending" is a bunch of nonsense. But, what exactly is going on here? And how long should it last?

Start here: this video of Professor Nouriel Roubini on Bloomberg News explains the entire mess in a fairly straightforward way. He focuses on the "shadow banking" system and the large role it has played in all of this. Essentially, for some time now, a number of people have wanted to get around the rules for bank capital ratios and have done so by going through hedge fund managers and the like. So, for instance, if you want to make a loan, but the rule is that your bank has to have ten cents for every dollar you lend (hypothetically), another way to do it is to go through things like hedge funds, where the capital ratio rules don't apply. What this has created is another banking system.

Right now, investors are fleeing that system and pulling their capital out, so it's basically collapsing. The government is trying to shore up the economy by lowering interest rates. If we could pick two culprits for the whole fustercluck, the other one would be the government's lowering of interest rates over the past decade or so, which has fueled the now-popped bubble. And the first would be the shadow banking system (created by banking capital ratios), which in retrospect was doomed to collapse once investors realized that there was no there there.

And then, as I noted previously, there were those "credit risk transfers" that were just leveraging everything higher and higher by transferring risk around and around with no apparent end. As Rubini puts it, "the whole system of securitization has led to more systemic risk instead of less systemic risk."

Of course, the big problem here is that America has been living well beyond its means for a long time now and it's catching up. All of the creative book-keeping has just allowed people to buy junk they can't afford. Since they still can't afford the crap they want, the best answer is for everyone to grow up and tighten their belts. Expect, instead, a lot of talk about "returning to normal", even though normal was clearly dysfunctional!

So, how long should this last? Rubini estimates at least 24 months, and that might be a bit optimistic! Not only is speculative money fleeing the market- it was all borrowed anyway; but investors are looking for something safe, and only finding a few currencies to invest in. So, the only thing that's going up now is the US dollar, the Swiss frank, and the yen. Every other currency should be plummeting (and the Canadian dollar sure is!), and areas other than mortgage loans should be overtaxed and collapse- expect credit cards to be imploding, which will just mean that they won't be given out like candy anymore.

In the end, all of this will probably mean that a much more stable banking system will emerge, like it did after the Great Crash. But, for people who want to retire now, and are finding their 401Ks suddenly drained, waiting for years is not a great option.

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