Shadow Banking

Despite all the noise about financial reform, the shadow banking system that helped create the financial crisis would remain fundamentally unaltered by the legislation now pending in Congress. Indeed, leveraged entities such as private-equity, venture-capital, and hedge funds get only minor regulatory attention.

These barely regulated, nontransparent bastions of speculation propagated systemic risks beyond any that could be created by the banks themselves. Whether housed at banks, created by banks, or freestanding, they exist to enable speculative risk-taking hidden from either regulatory or market scrutiny while camouflaging layers of debt and enabling the complex-securitization deals that caused the financial collapse.

Yet, neither the House bill passed last December nor the most recent Senate bill submitted by Sen. Chris Dodd does more than impose marginal adjustments on the shadow banking system. Even those measures contain loopholes so inviting that JPMorgan Chase, the largest hedge-fund manager by assets worldwide, scoffs at the notion it will be adversely affected.

Leaving Shadow Banks Intact. Under the most recent Senate bill, hedge funds managing more than $100 million worth of assets would have to register with the Securities and Exchange Commission as investment advisers. But private-equity and venture-capital funds would not. Dodd's bill leaves it up to the SEC to construct a definition for private-equity and venture-capital funds as differentiated from hedge funds. (There's no standardized definition of hedge fund yet.) Cue industry lawyers.

Loophole No. 1: Private-equity funds are financial-pyramid bottom-feeders; they buy distressed companies or assets, load them up with debt, extract near-term profit, and are gone before any collapse occurs. And since private-equity funds can both invest in hedge funds and do anything a hedge fund does (it's all a matter of how they pitch what they do to their investors), hedge funds could just change their name to avoid registration or information sharing. Dodd's bill would charge banks and any non-bank financial company supervised by the Fed holding $50 billion or more in assets to pay into an "orderly liquidation fund." But hedge, private-equity, and venture-capital funds wouldn't have to contribute.

Loophole No. 2: Neither the Senate nor the House bill alters the way in which hedge and private-equity funds do business. They only minimally alter where a fraction of the funds' business can't be done. A collapse of all or part of the banking system due to hedge-fund or private-equity abuses would necessitate use of a resolution fund -- into which shadow bankers have made no payment. They pile on the risk but don't pay for the fallout.

The Volcker Rule Minus Teeth. The latest Senate bill ostensibly adopts the so-called Volcker Rule restrictions prohibiting depository institutions and bank-holding companies from sponsoring or investing in a hedge or private-equity fund (it makes no explicit mention of venture-capital funds). A new Financial Stability Oversight Council would decide how to implement and interpret this regulation. Additionally, the comptroller general is required to conduct a feasibility study regarding a self--regulatory private-equity and venture-capital fund oversight and submit a report to the House Financial Services and Senate Banking committees within a year after enactment. Of course, a year gives lobbyists plenty of time to figure out ways to circumvent any form of regulation.

Loophole No. 3: Under the Senate bill, foreign-based firms that aren't directly or indirectly controlled by a firm organized under U.S. laws are exempted. European banks could thus expand their private-equity and hedge-fund game on our soil, thereby spreading globalized risk.

Loophole No. 4: Though large banks like JPMorgan Chase and Goldman Sachs run hedge funds, the language in Dodd's bill doesn't prohibit a bank from managing the portfolio of a client who chooses to invest in hedge funds. Since banks aren't required to delineate or disclose exactly what's proprietary and what's client-oriented (a major deficiency of the Volcker Rule itself), there's nothing to keep them from calling nearly every hedge-fund activity client--oriented, thereby getting around this rule.

Missing the Problem: Hedge Funds. Despite lobbyist claims to the contrary, the hedge-fund industry played a key role in the run-up to the banking crisis. It was an eager buyer and trader of the equity in toxic collateralized-debt obligations (CDOs) and other complex high-risk securities while heavily leveraging the higher-rated pieces of these securities. In other words, the industry provided the seed money to create these securities and a market for them while excessively borrowing money from the banks creating them. By doing so, the industry inflated the perceived value and demand for these securities, as well as systemic risk and leverage.

Indeed, the hedge-fund industry tripled to an estimated $1.8 trillion business between 2002 and 2008, just as the sub-prime loan and complex--securitization market was expanding. Not a coincidence.

Bear Stearns' infamous credit hedge funds were designed to leverage structured credit securities by as much as 35 to 1, enticing "hot money" investors who ultimately ran for the hills when they smelled potential losses, creating chaos in their wake. Current proposals might prohibit banks from outright owning such funds (and only if they aren't "client oriented"), but they don't constrain how the funds operate.

Private-Equity Firms Weren't Innocent Bystanders. Private-equity funds financed both mortgage-lending and real-estate-development companies, both directly and by purchasing equity in commercial CDOs. Now, they are picking up the broken pieces of those endeavors by buying failed banks and lenders on the cheap (as hedge funds go about buying cheap bank stocks in bulk).

Major private-equity firms like Fortress and the Carlyle Group are busy raising capital to buy chunks of more than $1 trillion of distressed commercial real-estate debt that lies underwater on the books of banks, insurance companies, and other lenders. Much of that original debt had been securitized in complex assets with high leverage, just like sub-prime loans were -- and could ignite another crisis when defaults cumulate.

Between 2002 and early 2008, roughly $1.4 trillion worth of sub-prime loans were originated by now-fallen lenders like New Century Financial. If such loans were our only problem, the theoretical solution would have involved the government subsidizing these mortgages for the maximum cost of $1.4 trillion. However, according to Thomson Reuters, nearly $14 trillion worth of complex-securitized products were created, predominantly on top of them, precisely because leveraged funds abetted every step of their production and dispersion. Thus, at the height of federal payouts in July 2009, the government had put up $17.5 trillion to support Wall Street's pyramid Ponzi system, not $1.4 trillion. The destruction in the commercial lending market could spur the next implosion.

As long as leveraged funds bolster these markets (whether inside or outside of banks), the true value of complex securities will be unknowable and subject to extreme cycles of bubble and collapse. This time it was sub-prime; next time it could be commercial real estate, oil, or food.

The Reforms We Need. Current reforms won't deter the reckless financial engineering, investing, and inflation of values upon which leveraged funds thrive. Right now, Wall Street funds are inhaling a host of new distressed security concoctions (a k a toxic assets part II) that scoop up all the junk out there and regift it to the markets. This all operates under the radar screen.

Thus it is imperative that banks with any form of leveraged fund, even if it belongs to a client, must provide detailed information to the SEC, no exceptions. Every hedge fund, private-equity firm, and venture-capital company, no matter what its size, should be required to register with the SEC and be subject to stringent reporting requirements and limits on leverage.

Private-equity firms should have to confer with regulators and make public all steps of their actions when buying and operating failed banks whose deposits are government-insured; otherwise we will maintain this unbalanced situation where banks can't own private-equity funds, but private-equity funds can manage banks.

Hedge funds should have restrictions on the percentage of securitized assets they can buy and the percentage of federally backed banks or financial firms they can own. Hedge funds currently own 6 percent of Citigroup, for example; if they dump their stock, the ripple effect could generate a need for more federal aid.

Without addressing these structural issues, shining a high-beam of transparency, and dramatically restraining the leverage and risk that these funds can take or enable, we are doomed to crash again.