My favorite bond guru, Robert Smith of Smith Capital, has been pounding on me for many months about the risks attendant with the weak underbelly of American finance --- the shadow banking system of unregulated hedge funds, money market mutual funds, family investment offices, sovereign wealth funds, exchange traded funds(ETFs) and the dealers involved in the very murky business of finding and lending securities as collateral for leveraged finance.
When you add together the assets in hedge funds, ETFs, money market mutual funds, sovereign wealth funds and family investment offices(think Soros) t he total amount of assets that are subject to oversight and regulation appears to be $18 trillion, down from $25 trillion before the 2008 meltdown. This money is what we call "the shadow banking system." And is where the most "games" are being played using other people's money.
Risk taking, I have been warned , has moved to the "shadow banking system," which utilize flow of funds accounts that are outside the purview of the Dodd-Frank Act, Basel III, and even the ministrations of t he Federal Reserve. None of these regulators have the obligation of overseeing the re-use of this pledged collateral, which are being supplied by asset managers to other dealers or players who "mine" this collateral for other purposes than were first intended.
You want to worry about money you can't see-- and don't know where it is located? Then, worry big-time about some $5.8 trillion of the "shadow banking" system that are in some kind of crazy-quilt daisy chain where they are pledged by some huge unregulated hedge fund or sovereign wealth fund, and then end up as collateral being used by yet another financial dealer. There's no central collateral clearing desk or depositary-- where all of these transactions can be observed. It means long term savings can be turned into short-term transactions that are part of the counter-party web of global financial markets.
If a hedge fund can use its Treasury bills to finance various transactions, which lead to related transactions, how are we to monitor5 the use o the $5.8 trillion-- much less the whole lot of $18 trillion in the system at the end of 2010? You can be sure this IMF study won't be the first investigation of this phenomenon.
The way to comprehend this transformation of finance into a shadow banking system is to understand that this is how MF Global got into trouble and went under. Reverse maturity transactions that are "t he do0minant source of marginal demand for money-type instruments in the financial system," were the tools used by MF Global's CEO , Jon Corzine to take his fatal leveraged bond position in European sovereign debt.,
Luckily, I found an IMF Working Paper by economists Zoltan Pozsar and Manmohan Singh, issued sometime in the last few weeks that fingers the "Non-Bank-Bank Nexus-- which gathers trillions of funds from the members of the "shadow banking system" and re-pledges the money to dealers who "mine" it and re-pledge it , "Creating dynamic collateral chains," These chains rehypothecate or reuse these "mined" assets in a process that is not transparent to the public and cannot be controlled by any one regulator.
At year-end, the IMF paper assets there was "$5.8 trillion in off-balance sheet items that can "freely recycle in financial markets. These operations lead to cross-border interconnections that straddle multiple jurisdictions," write the IMF economists.
Think of the process this way; " Since a single piece of sourced collateral can be re-used several times by several different dealers, the aggregate volume of re-pledged collateral reflects both the volume of source collateral(that is collateral "mined" from ultimate source asset managers) as well as t he velocity (or re-use rate) of source collateral."
Does this sound kosher to you in the wake of such a terrible financial crisis and meltdown in asset valuations? I'd vote for seriously curtailing this ability to repledge assets for uses that could threaten the stability of financial institutions a great deal more crucial to the day-to-day workings of finance. This is a way to get around the margin restrictions. And it must be stopped now.
