Bill Gross

I often enjoy trying to make my way through Bill Gross' montly "Investment Outlooks" on the PIMCO website. I say "trying" because his arguments can be a bit opaque for someone without a solid economic background, but he's a smart guy so I give it my best shot.

This month's Outlook is a witty letter to "President Obama" (Gross, a Republican, thinks he'll win).

Here's an excerpt from his January Outlook where he comments on the shaky banking situation that's been making headlines again this week:

In addition to the pyramid shape of its securitized assets and the endless chain of its letters, finance and especially modern finance is centered around banking and now, unfortunately, around shadow banking. Both, The Economist magazine points out in its September 22nd issue, are built on a fundamental (and ever present) mismatch: they borrow short and lend longer and riskier. Recognizing this flaw, governments have for over a century mandated that banks have an ample percentage of reserves in order to bridge the liquidity and investment risks that periodically ensue. Like Jimmy Stewart in It’s a Wonderful Life, the critical job of a traditional banker was to have enough reserves or cash on hand to prevent a run. Stewart’s modern day counterpart must follow similar guidelines, although a 21st century banker now can always look skyward for a guardian angel in the form of the Fed, the ECB, or the Bank of England. Recent infusions of over a half a trillion dollars by this triumvirate point to the perennial need for reserve banking in either an earthly or a more heavenly sense.

But today’s banking system as pointed out in recent Investment Outlooks, has morphed into something entirely different and inherently more risky. Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party’s accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant "black swan" run that might break them. Jimmy Stewart—they hardly knew ye! According to the Bank for International Settlements (BIS), CDS totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks.