The clear and present danger of the shadow banking system.

What created this Monster?
here is the link to the article in the Times

from NYT

I feel sorry for Mr. Gross having to set his timer at 2:30 am. every day in the morning to get to work as the world's biggest bond fund manager with nearly a trillion dollar in assets. He has to do this in a time of financial crises, probably the worst since the Great Depression. Mr. Gross says his firm has set aside $50 billion in case trading partners suddenly demanded payment, and he has done so because he knows a thing or two about our financial system. Back in August last year when the Fed was still concerned with inflation Mr. Gross much like an athlete swimming against a strong current saw the tide turning and predicted Fed easing what he called to a three handle. Turns out he was too optimistic. The current Fed Funds rate is at 2.25 percent.

Mr. Gross is one of those who point towards a very dark corner, the "shadow banking system", as the main reason for the current panic that engulfs Wall Street. The outstanding value of credit default swaps or CDS has been bloated to more than 45.5 trillion dollar in 2007 , up from only 900 billion in 2001. An attempt to regulate this out of control market has failed so far, although many maintain that this will change in the future because of today's problems. Mr. Geithner, the head of the New York Fed, in a series of meetings in 2005 and 2006 pushed for changes in credit derivatives trading in investment banks, but was blocked by this powerful institutions with the help of politicians in Washington. The prevailing notion at the time about the benefits of derivatives was their ability to differentiate and allocate risk.

Alan Greenspan, the long term chairman of the Federal Reserve, opposed new regulations at a time when he could have made a difference.

Speaking in Boca Raton, Fla., in March 1999, Alan Greenspan, then the Fed chairman, told the Futures Industry Association, a Wall Street trade group, that “these instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it.” Although Mr. Greenspan acknowledged that the “possibility of increased systemic risk does appear to be an issue that requires fuller understanding,” he argued that new regulations “would be a major mistake.” “Regulatory risk measurement schemes,” he added, “are simpler and much less accurate than banks’ risk measurement models.”

In the meantime financial institutions have written down their balance sheets by almost 200 billion dollar, credit markets have repeatedly frozen and the Federal reserve has resorted to actions not seen since the Great Depression. The developments came to a climax last week with the demise of Bear Stearns, one of Wall Street's most distinguished firms. They should have listened to Warren Buffett, who in 2003 said derivatives were potential "weapons of mass destruction."