Shadow Banking : A Form Of Regulatory Arbitrage

On October 3, 2008 President George W. Bush signed the Emergency Economic Stabilization Act of 2008, otherwise known as the “bailout.” The Purpose of this act was defined as to, “Provide authority for the Federal Government to purchase and insure certain types of trouble assets for the purpose of providing stability to and preventing disruption in the economy and financial system and protecting taxpayers, to amend the Internal Revenue Code of 1986 to provide incentives for energy production and conservation, to extend certain expiring provisions, to provide individual income tax relief, and for other purposes” (Emergency Economic Stabilization Act). In my paper I will explain and show the relationship between the Emergency Economic Stabilization Act of 2008 and subprime lending, the collapse of the housing market, bundled mortgage securities, liquidity, and the Government 's efforts to bailout the nation 's banks.

In 2008 the United States economy faced it most serious economic downturn since the great depression. This crisis began in 2006 when the subprime mortgage market showed an increase in mortgage defaults. This would lead to the decline of the U.S. housing market after a decade of high growth. The problems in the mortgage market where able to spread to other sectors of the economy especially in financial markets because of Collateralized Mortgage Obligations or CMOs. CMOs where mortgage backed securities that where given out by investment banks and where not regulated by the government. These securities fell as did mortgages due to increasing default rates. Because of CMOs companies bought Credit Default swaps or CDSs. These CDSs where nominally

The shadow banking system can be approximately defined as “the system of credit intermediation that includes objects and activities outside the regular banking system”. Its form is correlated to the way in which the banking sector and the

11. Peter J. Wallison. Hidden in Plain Sight. New York, NY: Encounter Books, 2015, 17. the major functions provided by big banks into different organizations be reconsidered?12

Shadow Banking Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky Federal Reserve Bank of New York Staff Reports, no. 458 July 2010 JEL classification: G20, G28, G01

Investors who had invested in Mortgage back securities were baffled. The houses as a collateral were worthless and AIG – biggest insurance provider for credit default swaps – went bankrupt. Investors started selling their CDOs but there were no buyers. These billions worth of CDOs and mortgage back securities turned into worthless piece of papers. By December 2007 economy was in recession. Banks decreased credit lines, business couldn’t get loans to function, therefore, workers were laid off which further deepened the

In 2008, amidst record unemployment, foreclosures, swollen housing values which spawned a credit crisis; a dangerous recession occurred. To stop the bleeding, the President and Congress 's swift action saved Freddie Mac and Freddie and a host of collapsing Banks and sought to reform Wall Street by passing the Dodd- Franks act and Consumer Protection Act, which increased regulation and oversight over the entire financial industry The sad fact is neither bars nontraditional mortgage or restrict which ones can be securitized. Therefore, these high risk options can resurface if a revived market demands it. There are signs that money has migrated to unregulated places with unknown risk, bubble prices could be attached. (thefiscaltimes.com/2015/06/05). The reason for this stealthy resurgence of the shadow market is the economy has improved markedly: housing values have rebounded, unemployment rate is down, financial markets are stable and newly formed government agencies are underfunded and cannot muster up any long term policing of a market, that has an un-quenching thirst for home ownership. My plan would require a joint and focused effort between government and financial entities.The guiding principles of my plan, which will combat past mistakes include, unemployment manipulation, land valuation control, fully funded enforcement agencies, comprehensive foreclosure prevention, Treasury, Freddie Mae, Freddie Mac and HUD and FHA reform. Otherwise, we are doomed to repeat the past.

Shadow Banking System (SBS) refers to a collection of financial entities, infrastructures and practices which support financial transactions but beyond the regulation and monitor from the government or official regulators. Some financial institutions, like investment banks, may conduct some their transactions in the shadow banking system, but they are not SBS institutions themselves. The term was first proposed in 2007 by Paul McCulley, CEO of Pacific Investment Management Co., and soon became popular with the spread of global financial crisis around the world.

Shadow Baking in China refers to the group of financial institutions that operate in unregulated environments. As noted throughout this paper, shadow banking is important to both China and the global economy given that financial intermediaries are more risk averse than regular banking institutions. As the second largest economy in the world, China’s shadow banking system inherently poses a threat to investors looking to reduce risks. Additionally, the risks associated with shadow banking originate from the lack of capital adequacy requirements, lending to individuals that be refused credit under traditional banking institutions, and higher potential returns (shadow banking offers higher returns given the level of risk).

Despite the fact that the name “shadow banking” is reminiscent of a sinister, unexplored sector and a “pejorative connotation”8 It is the commonly used term for credit intermediation activities that are market funded (as opposed to bank-funded). As a result of this there is a sector-wide agreement on the key characteristics of shadow banking and the key ones are credit intermediation,maturity transformation, the lack of guarantee for raised funds and the absence of explicit public sector backstops in the event of liquidity problems.9 There is disagreement on some characteristics such as Leverage and Off-balance sheet treatment. There is disagreement on leverage as a result of the fact that, while some shadow banking activities are dependent on leverage for an increase in returns, Hedge funds, banks and private equity funds also do employ leverage as a tool in business. Therefore this is not a unique characteristic. Similarly disputed is

Yet, once many homeowners began to default on these loans is when the risks became clear (with some of these securities losing up to 100% of their value). This had a negative impact on economic growth and it changed the debate surrounding financial regulations. As a result, these events are illustrating how these guidelines are important in controlling greed and excesses in the economy. (Government Regulations 2008)

The decline in the housing market set off a domino effect across the U.S. economy. When home values declined and adjustable rate mortgage payment amounts increased, borrowers defaulted on their mortgages. Investors globally holding mortgage-backed securities (including many of the banks that originated them and traded them among themselves) began to incur serious losses. Before long, these securities became so unreliable that they were not being bought or sold.

Shadow banking is the inevitable creation of economic development. It brings liquidity, flexibility and credit risk transformation to the financial market. On the other hand, shadow banks can do harm to economy because of their inherent defects—asset quality, funding fragility and liquidity mismatch (Adrain & Ashcraft, 2012). In 2008, shadow banks played a massive role in propelling the global financial crisis, which was “the worst financial crisis since Depression” (IMF, 2008). Since the size of shadow banking system is related to financial stability, the

I have read many articles and journals on the subject of past crisis that took place, but this crisis, stood out from the rest enough to catch my attention and want to read about it. The causes that led to the subprime crises were low interest rates and low housing costs or price, which eventually created what is called a “housing bubble.” The shadow banking companies caused the Alt A assets, which was primarily through means of securitization, such as bonds, etc. This is where the mortgage approved and backed paper and the collateralized loan debt responsibilities of these shadow banks that were mainly assured by housing loan reimbursements or repayments. However, when later defaulted, there was a move on these shadow banks, and as a result the Alt A assets collapsed, then there was a total collapse of the entire financial system as well. Hence, the economic issues involved in this subprime crisis consisted of these main economic concepts and outline for my paper listed below:

Financial markets have been subject to significant changes in recent years due to the credit crisis. Experts believed that risk was being under-priced, which was expressed in the markets by a narrow spread. They believed that once the market corrected this under-pricing and re-priced the risk, it would likely cause a dislocation in financial markets by overshooting its equilibrium. Hence the prices, yields and returns on bonds have been significantly effected by the global financial crisis. Looking at the effects this credit crisis had on the short term money market by evaluating bond performance over the past 10 years can give us significant insight into the extent of this dislocation.