Obama Administration Must Revive "Shadow Financial System" to Revive U.S. Banks

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[This is the eighth installment of an investigative series in which Money Morning examines how U.S. banks are using federal bailout funds.]

By William Patalon III
Executive Editor
Money Morning/The Money Map Report

To ease the ongoing credit crisis and get banks lending again, the Obama administration realizes that it first has to resuscitate the "shadow financial system" that's dominated by hedge funds and other large-scale private investors.

Surprisingly, two key ingredients of this turnaround formula will be structured investments, such as asset-backed securities, and leverage – the combination and poorly policed use of which acted as the accelerants that helped fuel the financial inferno that's now sweeping the globe in wildfire fashion.

But the reality is that new U.S. Treasury Secretary Timothy F. Geithner probably realizes that he has little choice.

Nevertheless, there are problems throughout this plan, says Shah Gilani, a retired hedge fund manager and credit-crisis expert who is a contributing editor to Money Morning.

"Maybe I don't get it because I'm not on the inside of the new Treasury fire-fighting team," Gilani said. "But it strikes me that the part of the proposed plan to stimulate consumer loan growth by courting opaque hedge funds with an offer to lend them as much as $95 for every $5 they put up, at a giveaway interest rate, so they can buy new security pools of already overly leveraged consumers' additional borrowing obligations, is like trying to put out a fire with gasoline."

As Democrats and Republicans continue to tussle in Congress over a controversial economic-stimulus package worth an estimated $825 billion, Geithner will today (Tuesday) formally unveil a financial-markets rescue plan that's going to be heavily reliant on private investors buying the "compromised" debt-backed securities that are clogging bank balance sheets like "plaque" clogs the arteries of a heart patient.

The plan Geithner is scheduled to outline represents a revamped approach to the $700 billion Troubled Assets Relief Program (TARP) announced by the Bush administration and then approved by Congress last fall. About half the money has been spent in that program, which was initially designed as a way for the government to buy troubled bank assets, but which ended up with the federal government taking direct stakes in the banks themselves.

TARP has been heavily criticized for its lack of accountability and lack of controls. As the ongoing Money Morning investigation has demonstrated, banks have used the money for everything from buying other banks to paying out bonuses – although they often refuse to admit it.

While most investors will refer to today's proposal as another "banking bailout plan," the reality is that fixing the banks is the end game, and not the actual strategy. The misconception is easy to understand; after all, most investors believe the credit crisis is due chiefly to a decline in lending, the truth is that this lack of liquidity is due to a decline in "securitization" – the process under which loans made on Main Street are bundled together and repackaged on Wall Street and then resold to investors worldwide as highly rated bonds.

Geithner, in a speech last year when he was still serving as the president of the New York Federal Reserve Bank, said the total value of assets in the "shadow financial system" – a system consisting of hedge funds, investment banks and financial "conduits" such as "structured investment vehicles" (SIVs) – outstripped the those in the traditional banking system as early as 2007.

That's no surprise: Just one year before that (2006), securitization was for the first time responsible for more than twice the volume of loans being made by regular lenders, Mark Sunshine, the president of middle-market lender First Capital in Boca Raton, told Fortune.

Through securitization, a lot more credit could be created than when banks just originated loans and then held them on their balance sheets. This new reality substantially boosted the "velocity" of lending and credit growth, and provided much of the financing consumers needed to buy cars, houses and other wares.

Then came the subprime-mortgage debacle, which caused a shutdown of the shadow financial system and a virtual halt to lending.

According to First Capital's Sunshine, between the first quarter of 2007 and the third quarter of 2008, bond issuance fell 93% in asset-backed markets, 73% in corporate-debt markets and 47% in mortgage-related areas. And without those asset-backed bonds being issued, lending dried up.

Bond issuance has "just fallen off the cliff," Sunshine told Fortune. "The reality is that the banks don't have the infrastructure or the capital to lend in the kind of volume to make up for the collapse of the credit markets."

Though the problem is fairly clear, there's no single obvious fix. When he makes his speech to unveil the latest bailout initiative today, Treasury Secretary Geithner is expected to announce a multi-pronged effort – including government guarantees of losses on some assets and greater assistance for troubled homeowners.

With Congress already angry about how much is being spent on rescue programs, Geithner must find a way to make the needed fixes, while keeping the final price tag as low as possible.

"We want to get the private sector to take responsibility for a situation that in many ways was created in the private sector," Lawrence H. "Larry" Summers, a top economic aide to President Obama, told CNN yesterday (Monday). "If the government is going to be putting money at risk, we want to make sure somebody in the private sector is willing to take the same risk the taxpayers are being asked to take."

Thus, to get the "shadow financial system" re-started, Obama administration insiders had to think creatively, and possibly accept a higher level of risk than taxpayers might realize or be comfortable with. That includes attracting private-sector investments – no easy task, given that the securitization market is still frozen, U.S. unemployment is soaring, and the American housing market remains in a free-fall.

"The administration is having to juggle three different chain saws," Brian Olasov, a managing director at the Atlanta office of law firm of McKenna Long & Aldridge LLP, told Reuters. "The key question is, does the plan make it attractive for the private sector to participate?"

Geithner must generate support for a greater flow of investor funds into key areas such as the markets for mortgage-backed securities, auto loans and asset-backed bonds, Reuters said.
Olasov says plans like the U.S. Federal Reserve's Term Asset-Backed Lending Facility, or TALF, hold great promise for jump-starting private credit flows. Under the TALF program, buyers of "AAA-rated" securities backed by credit cards, student loans and other assets can swap those bonds for U.S. Treasury securities that they can use to get new financing.
In The Fed created TALF as a $200 billion program back in November, but never deployed it, for it was too complicated to roll out that quickly.

Already, however, federal officials are considering expanding the types of securities eligible for the TALF, as well as related plans to include residential and commercial mortgage securities. That's creating some real concern about the level of risk the federal government may be taking on, especially since the potential exists for private-sector investors to "game" – manipulate – the financial system, if the guidelines aren't strict or specific enough, some experts worry.

Under the $200 billion TALF program, the central bank will loan money to virtually any U.S. firm that's willing to use this government financing to buy securities that are tied to  auto, credit-card, small-business or student loans, The Wall Street Journal reported.

In other words, since the government doesn't want to buy these securities itself, it is lending money to make it possible for professional investors to buy the securities – and in some cases is even guaranteeing payment on the loans that back these securities in order to make this happen.

Some hedge funds – the shadow-financial-system players that borrowed money to boost returns for clients – are "are lining up to get in on the Fed program, seeing a chance to make high double-digit-percentage returns with little downside using low-cost loans made on easy terms," The Journal reported. Some Fed officials are admittedly nervous about relying on unregulated and often opaque hedge funds, but see the arrangement as a necessary trade-off to increase the velocity of lending and utlimately get capital into the hands of consumers.

"This is exactly what the financial system needs," Andrew Feldstein, chief executive officer of Blue Mountain Capital Management LLC, a multibillion-dollar hedge fund that is gearing up to participate in the Fed program, told The Journal. "Sending help through the banking system is like sending an ambulance through a traffic jam."

Others see big risks, however, since the program essentially combines the very same elements that led to the financial crisis in the fist place – leverage, asset-based securities, and questionable credit ratings on debt.

"Between setting up an aggregator bank to buy toxic assets that still no one has any idea how to value and setting up "foxy" hedge funds with their own henhouse of government-backed consumer-weary loan pools, it's probable that the Treasury will succeed in bringing in private capital," Money Morning's Gilani said. "It's just too bad that if the scheme actually works, it will be the rich-money hedge funds that win and if it doesn't work, it will be poorer U.S. taxpayers that get their necks rung." 

[Editor's Note: Money Morning contributing editor and credit-crisis expert R. Shah Gilani, who is also the editor of The Trigger Event Strategist, will write more about the details of this banking-system rescue program in an analysis later this week.]

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About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning. With his latest project, Private Briefing, Bill takes you "behind the scenes" of his established investment news website for a closer look at the action. Members get all the expert analysis and exclusive scoops he can't publish… and some of the most valuable picks that turn up in Bill's closed-door sessions with editors and experts.

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