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It's Much Worse Than You Thought

What You Need to Know about Shadow Banking

By
Monday, November 26th, 2012

Shadow banking.

The words alone are enough to make any investor feel a bit uneasy.

After all, we're only a few years removed from a meltdown of the regular banking system that nearly bankrupted the planet...

Shadow BankingThe financial crisis of 2008-2009 showed us clearly the regular banking system was a lot more shadowy than we thought.

So, is it really that much different from the shadow banking system?

You probably already know what I'm going to say. To end the suspense, the answer is no, the regular banking system is not much different from the shadow banking system at all. And most investors mistakenly believe new regulations (Dodd-Frank) have cleaned up the banking sector.

Investopedia defines the shadow banking system as: the financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.

A loan shark would certainly qualify as an entity engaged in facilitating the creation of credit... but... not subject to regulatory oversight.

Hedge funds and money-market funds qualify, too. And so do more exotic sounding things like structured investment vehicles and repurchase agreements.

Still, it's the last lines of that definition that is truly troubling: The shadow banking system also refers to unregulated activities by regulated institutions.

Wait, What?

It makes no sense that a regulated bank is allowed to engage in “unregulated activity.” And because these transactions don't show up on the balance sheet, normal accounting and due diligence are useless for accurately assessing risk.

The results can be disastrous.

On September 5, 2008, CNBC's popular stock barker Jim Cramer proclaimed Lehman Brothers was a “screaming buy.” The stock was trading around $16 a share, and the S&P 500 was in the 1,250 range.

Just 10 days later, on September 15, 2008, Lehman Brothers filed for bankruptcy protection.

How did Lehman fool Cramer (and a lot of other investors)?

It used a type of repurchase agreement called Repo 105. Basically, Repo 105 is an accounting trick that can hide debt. Lehman would briefly lend another bank a bunch of impaired assets (like toxic mortgage securities) in exchange for cash. After a set period of time, Lehman would return the cash and get its bad assets back.

Lehman used this trick three times in the year before it collapsed to hide a total of $138 billion in bad debt.

Repurchase agreements, or repos, are an integral part of the shadow banking system.

The Inmates Are Still Running the Asylum

In the years leading up to the financial crisis, banks were writing their own rules. In some cases, the deals they put together were so complicated, they had to explain them to regulators. No surprise the risk of these deals was understated.

Unfortunately, the Dodd-Frank banking regulation law doesn't do anything to curtail the shadow banking system. In fact, it probably encourages it.

How big of a problem is this?

Do a little digging, and you'll run across a recent report from the Financial Stability Board (FSB) that says the global shadow banking system is currently valued at a mind-boggling $67 trillion.

$67 trillion.

In 2011, the value of all goods and services produced in the world was $69.97 trillion.

For the shadow banking system to be bigger than the combined GDP of every country on earth is frightening.

In 2002 shadow banking was worth $26 trillion. In 2007, before the financial crisis, it hit $62 trillion. Today, even after the crisis exposed the problem, shadow banking is even bigger...

For comparison's sake, traditional banking (you know, where loans are backed by insured deposits) is around $14 trillion.

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Shadow Banking: World's Biggest Confidence Game

The problem with shadow banking is that it's based on confidence. If you believe an asset like a mortgage-backed security is worth a specific amount, then it's not a problem to accept that security as collateral for a loan that could make you 5% in a few short months.

But what if your confidence in that value is suddenly shaken? You'll want your cash back — now.

That's what happened during the financial crisis. The value of the mortgage-backed securities that backed trillions in loans was suddenly in question. So shadow lenders started calling in the loans... and since there wasn't enough cash to go around, panic ensued.

Make no mistake; because nothing has changed, we could see another financial crisis at any time.

And, in fact, because so many sovereign governments are grappling with debt, the resources to bail the banking system out simply aren't there. The global financial system is working without a net.

The Only Rational Response

The only true measure of value is the price at which a buyer can be found. And the value of a loan is only as good as the ability of the borrower to repay.

So, when banks have assets like mortgage-backed securities — French and German bonds and even their own common stock — well, it won't be a surprise to see bank valuations become a moving target again.

The only way to lend some stability to bank valuations is to get them to hold assets whose value are not prone to panics, manipulation, and accounting vagaries.

And believe it or not, a global banking standards group has actually made such a recommendation...

In 2010 the Basel Committee on Banking Supervision ruled gold could be included as a Tier 1 asset. Known as Basel III, these rules make gold just as good as cash or Treasury bonds.

It's not a complete fix for banks, but it's a start. Perhaps more importantly, it's likely to make gold more valuable than it is right now.

Gold's Value to Double Overnight

Before Basel III, banks had to hold around 6% of the value of outstanding loans as collateral for those loans. Most of that 6% was comprised of what's called Tier 1 assets: cash and company stock (Treasury bonds count as cash).

After Basel III, banks are required to hold approximately 12% of Tier 1 capital.

But the big news is gold will now be considered a Tier 1 asset.

Prior to Basel III, a bank could only count 50% of gold's market value as collateral. In other words, gold's value will double as a banking asset. And the price of gold on the spot market will almost certainly launch higher as well.

I don't why this isn't being reported by the major financial media. It's a more significant move regulation than anything in Dodd-Frank.

Basel III will fundamentally change the way gold is valued by the financial markets.

Personally, I view the fact that no one is talking about this story as a gift from the market gods.

Because the new rules for gold isn't conjecture; this isn't a guess as to what the Basel Committee on Banking Supervision might do...

I'm not reading the tea leaves for evidence of some global conspiracy.

Basel III's new rules for gold are coming.

The European Union will adopt Basel III rules in 2013. So will Russia and Japan. China, India, and even Pakistan are on board... Australia, New Zealand, Brazil, and South Africa, too.

What happens next is up to you. You have some time to get positioned before the new rules for gold go into effect — but not much. I recommend learning the full story before they become law.

Profitably Yours,

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Briton Ryle

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Helping individual investors protect and grow their wealth since 1998, Briton has an impressive resume. He has recommended stocks such as Petrochina at \ a share months before Warren Buffett jumped on board. His fundamental analysis, technical analysis, and vast experience has proven invaluable as research assistant for The Wealth Advisory, and his moneymaking insights appear weekly in the pages of Wealth Daily as a contributing writer. To learn more about Briton, click here.


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