Shell Game

Hi!

I heard an interesting interview on NPR's Fresh Air with Gillian Tett, British Business Journalist of the Year in 2008. Tett, whose book "Fools Gold" uses J.P. Morgan as a case study for the financial meltdown, described the banking system with an analogy that made a lot of sense to me. I'll expand on it a bit here.

Imagine a bank is like your house. Regulators and investors are visitors who come over as guests and you give them a tour. (Note: This is decidedly different from an inspector or appraiser who will look around on his own, preferably without you being present.) Just about everyone has a "junk drawer" and you decided not to display its contents to your visitors because this is where you keep the stuff you'd prefer to keep hidden. Your visitors figure you have a junk drawer, but don't make an issue of it.

Now, imagine you've got too much junk for a drawer, so you decide to move it to a closet. Your guests return, you don't show them the contents of the closet, but it's still not an issue. Your junk continues to grow and soon it is moved to the garage. Visitors come, don't ask too many questions, still no issues. You gather more and more junk and eventually have to build a warehouse in your back yard that is about the same size as your house. In other words, half of your "stuff" is really "junk." The regulators and investors are so used to NOT asking questions about this "junk" that they continue to see it as a non-issue.

In the case of banks, "junk" is VERY risky mortgage-backed securities, derivatives, collateralized debt, etc. This junk was kept in so-called "shell" companies whose books were kept separate from the main bank, so separate as to be invisible. By 1997, the "shadow banking" system in the U.S. was as big as the visible banking system. This means that on average, there was the same size warehouse full of junk for every bank, but regulators STILL weren't acknowledging it and the rating agencies were STILL awarding AAA ratings to what was really junk.

In order to fix this system and prevent this shell game, we MUST increase regulation and force the shadow banking system into the light. Regulators should be expected to rifle through a junk drawer as part of their jobs, but MUST not ignore a warehouse full of junk out back.

Thanks,
Matt