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Jon Talton

Analysis and commentary on economic news, trends and issues, with an emphasis on Seattle and the Northwest.

April 16, 2012 at 9:56 AM

How shadow banking blew up the economy

Feeling a little lighter in the wallet? According to the Federal Reserve, the collapse in housing values from their peak destroyed $7 trillion in paper wealth. Yet this was a trillion less than was vaporized by the dot-com bust. The latter resulted in a mild recession, while the former was accompanied by the Great Recession which is still dragging down millions of households. Fed Chairman Ben Bernanke attempted to explain the differences in a speech on Friday.

The big differences: The collapse of the shadow banking sector (which was not nearly as potent in 2001); more reliance on short-term funding by the shadow banking sector and traditional banks; way too much leverage for everybody, poor risk management (hello, WaMu), too much risky “innovation” and lack of protections and safeguards for the shadow banks. “When it became clear to investors that these alternative protections might not be adequate to protect against losses,” Bernanke said, “widespread flight from the shadow banking system occurred, with pernicious dynamics reminiscent of the banking panics of an earlier era.”

The shadow banking system is often called the “banker to the banks.” It was comprised of the likes of structured investment vehicles, hedge funds and special purpose entity “conduits.” All were virtually unregulated, handling highly risky investments and, once housing prices started collapsing, provided the ideal pathways for the problem to spread into a crisis. Into a classic financial panic on steroids.

Bernanke is a great teacher, but then he says, “The financial crisis of 2007-09 was difficult to anticipate…” As they say in the South: Huh, do what?

It was anticipated by a number of economists and commentators, including Homey your humble blogger here. House prices could not keep rising. Systemic risk was high. More and more derivatives were “derived” from nothing. Regulators were compromised. And the lack of oversight of the shadow banking sector was well known. True, most of the mainstream opinion said the good times would roll forever, or suffer a mild but manageable correction; among them was Ben Bernanke. Meanwhile, the shadows lost trillions on paper but still lack proper regulation. Indeed, many of their activities shouldn’t exist, and the gambling capital should go into creating jobs and real products.

Who knows what evil lurks in the heart of the financial system…

And Don’t Miss: Percent job losses — Great Depression and Great Recession || Calculated Risk

Today’s Econ Haiku:

E-book mystery

Did Amazon bite Apple?

A clue in that smile?

Comments | More in Banking, Federal Reserve


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