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How The Shadow Banks Hijacked The Fed, The Law of ONE

Politics / Credit Crisis 2009 Aug 19, 2009 - 12:00 PM GMT

By: Andrew_Butter


Best Financial Markets Analysis ArticleThe way it's supposed to work is that the way the Fed "controls" the US economy is mainly by adjusting short-term interest rates; lower rates and more money sloshes around the system and GDP goes up, but that can be inflationary, so the Fed keeps a wary eye on that, and if the dangerous iceberg of inflation is "spotted" it raises rates.

That's why whenever "Captain" Greenspan would mumble something unintelligible on Prime Time, the world would hold its breath, and then there would be a frenzy of debate about what he meant, and more important what he was going to do next?

But the captain of the ship was a wily old hand who could keep the world guessing. And he stood resolutely on deck, fair weather or foul, scanning the horizon for icebergs; deftly" easing 25 basis point here and "tightening" 50 basis points there, stroking that steering wheel with deliberate calm concentration and skill.

Then in about 2000 some hooligans disconnected the mechanism linking the steering wheel to the rudder. It looks like he didn't notice (the economy is like an oil tanker it takes time to react (unless you hit a credit crunch)), but from that time on "someone" else was steering the ship. And then, over the next seven years, they bled America dry.

The precise "tool" used to hijack the ship was securitization.

The Fed can increase or decrease the money supply by buying Treasuries (that increases it) or by selling them (that decreases it).

So can the Shadow Banking System (well it could), from 2000 to 2007 it bought $17 trillion of mortgages and re-packaged those into securities; leaving aside where it got the money to pay for those mortgages in the first place, and what that did for the money-supply, they sold half of their "output" to foreigners, so that increased the money supply by $8.5 trillion right there (they used the money to buy more mortgages). As a yardstick, over that period the Treasury sold about $2 trillion of bonds to foreigners.

In that context what Chairman Greenspan was doing with interest rates and the other tools he had at his disposal, was irrelevant.

I wrote an article recently about that ( My Big Idea was that over the past ten years secuitization was the main "supplier" of credit to USA, my thesis was if the government wants to "fix" things, then it needs to fix or facilitate fixing that.

One comment I got back was (I paraphrase); "securitization caused the problem in the first place (and good riddance)" (

Perhaps I missed something obvious? Well that has happened before (more than I care to admit), so I had a look.

This is a plot of the cumulative total amount of residential mortgaged backed securities (RMBS) plus collateralized debt obligations (CDO) issued in USA since 2000 up to the "pop" of the bubble in 2006, compared to where the S&P Case-Shiller Index reached at the end of the year in question (i.e. December).

Looks like a "fit" to me.

OK that's only seven paired points of data but the correlation (R-Squared) is 99.6%, what that means is that up to the "pop", 99.6% of changes in the Index can be explained by securitization (which "predicts" the index 4% at the 95% confidence level).

Of course another way of reading the chart is to say that 99.6% of changes in the level of securitization can be explained by changes in the Index, i.e. the issue is either (a) did house prices going up drive demand for credit, or (b) did an over-supply of credit drive up house prices? Take your pick; my guess is that it was a feedback loop.

Perhaps it wasn't Greenspan's "fault" after all?

What I had always assumed (and I think a lot of other people did too), was that what happened was:

  • For some reason (why is irrelevant) in 2001 he dropped interest rates to the floor.
  • Then for some other reason(s) (also irrelevant), but as a direct consequence of that and obviously something to do with easy money and/or credit there was a housing bubble.
  • Then the bubble popped and here we are.


There are some other theories like "yes but what about Clinton and the "Lesbian-Lobbyists" (not my words), "pressurizing mortgage originators to make loans to "deadbeats"?" (Not my words either); there are other theories.

This is a plot of the change in the S&P Case-Shiller 20 City Index compared to the yield on the Fed Rate (one divided by the rate), which is a sort of measure of the "inflatability" of the Fed Rate (I put it like that because it's easier to eyeball).

Well I suppose if you stand on one leg and squint, you can say that there was perhaps some sort of correlation.

The thing is that house prices were going up pretty "healthily" before Chairman Greenspan put his foot on the gas. So the annual increase went up from about 10% a year to about 15% a year, so what?

The Law of ONE
Only ONE thing causes catastrophe; the rest is noise.

  • Roger Boisjoly an engineer warned his superiors that an O-ring used on the Challenger Space Shuttle rocket was likely to fail particularly below Minus 1 Degrees Centigrade, his boss overruled him, the launch went ahead, and the rocket broke up. ONE Thing.


  • The story I was told is that in Air France the pilots get rated on how much fuel they use, the more fuel you load up with the more you use. The way I heard it when the pilot of the airliner that went down recently, saw the dangerous tropical storm ahead, he had no choice, he didn't have enough fuel to go round so his only option was to turn back, so he risked it; forget about finding the black box, all they need to do is check how much fuel he bought. ONE Thing.
  • I drove for thirty-five years and I never had an accident, six months ago I was driving my brother to the rail-station through Scotland. It started to snow and the temperature dropped to zero, we were late, I was pushing it. Came into a corner too fast, hit some ice or some slush, lost it and rammed dead center into the only tree for two hundred yards in any direction. I was driving too fast on a road I did not know in lousy conditions. ONE thing.

ONE thing caused the bubble that caused the credit crunch.

Chairman Greenspan thought he was the captain of the ship, but in fact, at least with regard to one of the most important "unnatural" disasters in American History, he was irrelevant, he thought he was steering, but he wasn't.

What was relevant was the huge amount of credit that was being created by (defective) securitization and being pumped into the economy, and the driver for the creation of that credit had little or nothing to do with short-term interest rates, it was driven by the perception that house prices would go on going up faster that mortgage rates, forever.

The hooligans had much more money at their disposal than the Fed; listen to all the wailing about the $3 trillion the Fed pumped into the bail outs so far [2], the Shadow Bankers would "manufacture" that much in a good year.

Go figure who was "in charge".

What happened was that the major source of "economic activity" in USA was no longer controlled by the Fed, it was controlled by the Shadow Central Bank that had staged a coup d'état by stealth, and then once it had control, it bled America like a vampire.

And the irony is that the Fed handed over another $3 trillion of taxpayer's money to "save" them. Talk about having your cake and eating it.

Securitization is dead, long live securitization

There is nothing wrong with securitization, it is a tool and used properly and responsibly it is a very effective tool.

The US government borrows money against the promise that it can tax its citizens in the future to pay back the loans, which is fine, if you believe that in the future the citizens will be willing or able to be taxed at that rate.

Securitization borrows against assets, and so long as the value of the collateral is more than the value of the loan at the point in time that the loan goes bad (if it goes bad) that is perfectly safe.

How you corrupt that system is as old as the hills.

You just find a way to not do the valuations properly. That was achieved by the corruption of the rating agencies and the audit profession, who were persuaded to sign off that there was a very reasonable expectation that the assets could be sold, in the future, for much more than in reality they could be.

Dr. William Black, the guy who unearthed how the frauds were done to create the S&L debacle, explains how that was done in his video (

I never suggested that the corrupt procedures of the past should be revived, and I still stand by my argument that America will be stuck in a deflationary spiral until securitization is fixed. And I don't believe that increasing the liability of the US taxpayers by providing deadbeat bankers with insurance at less than what they can buy it in the marketplace is anything less than lunacy, I suggested just two things:

  • Only allow covered bonds to be used instead of Treasuries when calculating capital adequacy, until such a time as a viable and safe alternative system is found (if ever). That's like the "old" originate and hold banking, except that the loans can be bought and sold.
  • Mandate that every line item on every loan that was ever subsequently securitized is published in the public domain, that's what Dr. William Black calls the "tapes". That would allow the "market" to do proper valuations, and that would start off the process of dealing with the pile of rotting toxic assets that threaten to poison America and the world, like a heaving garbage tip.

I still find that hard to believe Dr. Black's claim that the rating agencies often didn't even review the "tapes" before putting their AAA stamp on; certainly every time I ever put in something to get rated we would include all the details of the underlying collateral, whether they looked at it or not I have no idea.

But if indeed they didn't, perhaps it wouldn't be a bad idea to do what Dr. Black suggests and to get the FBI to investigate every single toxic asset that went bad, and identify every single individual who signed off on a rating, a valuation or an audit, without checking the "tapes", and to arrange for them to be prosecuted for criminal negligence and/or racketeering. Black said that after the S&L debacle 1,000 people went to jail, well this is ten times bigger, so rough numbers that's 10,000; which sounds about right.

And if the FBI doesn't to that job, well expect chaos, because that's what happens when hooligans find out they can get away with murder. I just wonder how much of the $4 trillion that has been thrown at the "problem" so far, is going to get spent recruiting and deploying prosecutors and investigators?

Or perhaps the hooligans are still in charge?

By Andrew Butter

Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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