Standing In The Shadows

Standing In The Shadows


Much has been made of the failure of the so-called Shadow Banking System. The question we are most asked regarding this topic is: What is the Shadow Banking System?

The Shadow Banking system consists of non-traditional financial entities which perform the lending functions of a bank. Some components of the Shadow Banking System are investment banks, SIVs, Hedge Funds, etc. These participants either provide financing by borrowing short-term and lending long-term or provide the necessary functions for other members to do so.

On the positive side, without the Shadow Banking System enabled more people to purchase homes and permitted the economy to grow as never before. On the negative side it resulted in lax lending standards, the abuse of credit and opaque risk and collateral exposure to investors. Some pundits the apparent demise of the Shadow Banking System. These pundits should be careful of what they wish for.

The problem does not lie with the idea of an alternative source of funding, but the abuses therein. Instead of the original intent of making borrowing easier and more affordable for qualified borrowers, the Shadow Banking System made it easy for non-deserving, unqualified borrowers obtain credit. The result of less-than-qualified borrowers obtaining mortgages is a record amount of delinquencies, defaults and foreclosures. The problem is moving from a market-to-market, unrealized loss problem, to a realized loss problem as banks either seize homes and sell them for what they can or make deals with homeowners to take whatever the home sells for and call it even with the borrower.


To what extent has the problem infected bank balance sheets? Even now, no one (except, maybe, for the banks themselves) is sure. The combination of the known problems in the housing market and the cloudy picture of bank balance sheets are frightening investors. Until investors are sufficiently confident to purchase uninsured corporate debt and private label (so-called jumbo) mortgage backed securities, which are only backed by the mortgage collateral and not whatsoever by the issuing bank, the housing market will be mired in its current morass.

The government has put itself on the hook for bank survival. Not only has it agreed to explicitly guarantee corporate TLGP bonds, but it has also purchased a preferred equity interest in the banks. The two actions are related. Because of Basel II banking requirements, the banks needed to raise Tier-I capital. Banks could not issued more debt (Tier-II capital) until Tier-I ratios were improved. This is why the government came in at the preferred equity level.

Investors should not consider a government investment at the preferred equity a vote of confidence, but an action of necessity. Advisers and clients should note that although the government’s preferreds are ranked equally with non-cumulative perpetual preferred equity, the so-called TARP preferreds are cumulative. The government gave itself some protection should it become necessary to have a bank (or banks) suspend dividends. If the government had a choice, it would have invested on the most senior place on bank capital structures, the senior secured debt level. However, that would have provided banks with Tie-II capital and not the much-needed Tier-I capital

Why would the government order a bank to suspend dividends? How about to fund operations and pay its debts? After all, a bank can suspend dividends and continue to function. However, if a bank cannot make its coupon payments or mature its debt and it is out of business and not a problem for the government. The problem is two-fold. First: the troubled bank becomes a problem for the FDIC. If that bank happens to be a large money center bank, the FDIC could be stressed to the point of fund depletion. Also, the government would now be responsible for the FDIC-backed TLGP bonds. The government would likely do anything it could not to get to this point.


Some pundits have suggested that investors buy what the government is buying. In other words, invest in the banks the government is backing. I agree with that when it comes to bonds (for reasons I have already mentioned), but not with preferreds. Since the government bought bank preferreds because it needed to do so to boost Tier-I capital ratios and not because it believed doing so was a wise investment and could and would suspend dividends if necessary, preferred investors should get above the government and purchase trust preferreds which, being junior subordinate debt, have a better chance of paying and are cumulative.

Advisers and investors should avoid swinging for the fences and play small ball. A single is better than a strike out.