What Shadow Banking Can Tell Us About The Fed's "Exit-Path" Dead End

Tyler Durden * ZeroHedge

Over four years ago, in “Chasing the Shadow of Money“, Zero Hedge first presented a curious if perverse aspect of the Fed’s QE experiment in the context of the modern monetary system: the extraction of “quality” collateral by the Fed’s daily purchases of Treasury (and MBS) securities, and it replacement with reserves – a transformation which while boosting asset prices, results in an ongoing deleveraging of shadow liabilities, as well as a persistent slowdown in the velocity of collateral (due to both its increasing degradation and increasing counterparty risk). Our concurrent investigation into the properties of shadow banking led us to the correction conclusion back in March 2012, and explanation why, the Fed would have to do at least another $3.6 trillion in QE. We are now $1 trillion in, and rapidly rising even as the 10 Year equivalents held by the Fed now represents almost one third of the entire Treasury market: an unprecedented collapse in available private-sector collateral.

And while there has been a small if vocal subset of voices warning about the problems of collateral scarcity, and the implications for the global financial balance sheet if and when renormalization is attempted, for the most part, this remains a very much misunderstood process. Perhaps the main reason for this is that, as Peter Stella summarizes, “When it comes to reducing excess reserves, the ‘how’ matters as much as the ‘when’ and ‘how much’. Understanding this point requires mastery of the brave new world of shadow banks and re-hypothecation – a world that either did not exist or was truly in the shadows when most of us were taught about money and credit creation.”

Over the past 5 years we have attempted to provide a glimpse into how modern shadow banking (with a world in which rehypothecation is the “source” of tens of trillions in deposit-free credit money), however, the vast majority of modern economists and those espousing modern “magic money tree” theories, still view the world through the lens of a 1980s textbook, which is absolutely insufficient when attempting to explain marginal credit creation amounting to tens of trillions in the shadow banking system. Ironically, it was precisely the collapse in collateral chains and the freeze in shadow counterparty derivative exposure just before the failure of Lehman, captured with stunning precision by Matt King’s “Are the Brokers Broken?” report issued a week before the Lehman bankruptcy, that explained more about the perilous nature of modern finance, than any other paper written before or after (p.s. Yes, the brokers were, and still are, broken).

continue article at ZeroHedge:

http://www.zerohedge.com/news/2013-09-22/what-shadow-banking-can-tell-us-about-feds-exit-path-dead-end