Instead, these institutions participant in the shadow banking system. They
hold bonds or other financial assets which they can easily turn into cash in the
repurchase or repo market. In the repo market one institution will agree to buy
a bond from another institution and then sometime later, often 3 days, the
original institution will buy the bond back.
This essentially serves as a loan from one institution to another. However,
in a larger sense it can be thought of as making a cash withdrawal from the
shadow banking system. In that way, the bonds held by these companies serve as
their bank accounts. As long as the repo market is functioning they can always
make withdrawals based on the bonds they have.
Where do these bonds come from?
Some are government bonds issued to fund national deficits. However, many of
the bonds - at least before the crisis - were created from private loans taken
out by individuals and businesses. Included in these are infamous mortgage
As global finance and international trade grew larger and larger institutions
needed ever larger shadow bank accounts. This requires ever larger quantities of
bonds. Unfortunately, most of the world was saving not borrowing, and even the
US had dramatically reduced its debt-to-GDP ratio.
This international demand for bonds not only drove interest rates way down
but promised huge profits for anyone who could find a new source of safe bonds.
In order to be useful as collateral bonds have to have little risk.
In response investment banks developed mathematical techniques to combine
risky mortgage loans in such a way as to produce bonds that appeared safe. The
extent to which this process involved fraud, hubris or simple error is still
debated, but the outcome was not.
The issuance of these bonds fed a world-wide housing boom. That boom peaked
around 2006 and as it faded the once safe bonds were no longer safe at all. The
shadow banking system experienced a run. The repo market shut down. Major
financial firms collapsed and the world economy hurtled into the Great
The issuance of that type of debt went badly.
The problem, however, is that the underlying thirst for debt has not be
quenched. This implies that new credit bubbles are waiting to happen. Currently,
that demand for debt is partially though not completely met by soaring US and
UK budget deficits.
Yet, politicians in both nations are busying themselves attempting to drive
down the respective deficits. As this happens the demand for new sources of debt
will only increase and the propensity for bubbles will only grow larger.
This a part of a twin problem. The aging of the world population means that
there are ever more savers and relative to young people to invest in. At the
same time the global financial system depends on large quantities of safe