For normal people, banking = checking and savings accounts. This involves cash deposits, which are insured by the FDIC. This is traditional banking.
Hedge funds also require the services of a bank, but they don’t use cash. They have their own kind of money, called securities. They “deposit” these securities with other hedge funds, constantly moving them back and forth to manipulate values and thus, to profit from what is called arbitrage
arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.
Now, in thinking of the panic of 2008, keep this in mind:
1) There is no FDIC for this kind of banking.
2) This kind of banking is much larger than traditional banking
3) The hedge fund managers that rule this world are the biggest, most aggressive risk takers on the planet
Hedge fund managers, however, are calculated risk takers. Heavily calculated. In fact, they hire PhD physicists and rocket scientists to do these calculations. These guys are called “quants” and every hedge fund has them.
The quants figured out ways to bundle up risk in these securities so that it was spread out. If you think of risk like a poison, too much of it can kill you. But if you dilute it enough, it is harmless.
But poison is still a scary thing.
Nevertheless, they did this. They diluted the risk so well, spreading it out through all of these securities that they could not tell where the poison was any more. This was great because everyone was happy to invest in these securitized products that were so risk-dilute you could not even “taste” the risk, or poison, any more.
But this proved to be the proverbial double-edged sword.
It turned out that when the poison was unexpectedly activated through a series of fast-acting catalyst-like enzymes, the poison seemed stronger than people expected. And then someone (Bear Stearns) died from the poison and everyone panicked.
Ever have a mosquito bite? It itches. It is difficult, but if you do not scratch it, it gets better. If you do scratch it, however, it gets worse. And if you scratch it too much, it gets infected.
Well, the hedge funds had been “bitten” and the bite catalyzed the poison and now they had a kind of “itch”. We call this particular kind of itch, “panic.” Unfortunately, because they had done such a good job of diluting the poison, they could not tell where it was. The mosquito bite was very localized – but they itched everywhere. And they scratched that itch until the bite became infected.
As a result, they all died.
These institutions, these “shadow banks” no longer exist. Good riddance, you might say. Sounds like a bunch of fools got what they deserve, you say. Perhaps you are right. But I have not been completely honest with you. The shadow banks died, but their skeletons are still with us. Because they were so big and important, no one wanted to bury them. So the traditional banks – your bank and my bank – bought their decomposing corpses.
These banks – our banks – are currently sifting through the bones of these corpses, trying to undilute the poison in the hopes that they can resurrect the ghost.
Unfortunately, we are all shadows now.