At the Heart of the Credit Crisis Is the Network of Highly-Leveraged Off-Balance-Sheet Vehicles—the Shadow Banking System

Pozsar’s initial paper outlined the “constellation of forces that drove the emergence of the network of highly-leveraged off-balance-sheet vehicles—the shadow banking system—that is at the heart of the credit crisis.”

Off-balance sheet (OBS) is an accounting maneuver used by companies to reduce their debt levels for reporting purposes. Enron perfected the use of OBS partnerships to hide its true liabilities from regulators and shareholders. Many at the Fed believed the OBS demon had been forever exorcized with Enron’s fall. But the demon had grown and metastasized, spreading little cancers throughout the financial system.

The resurrection of OBS vehicles had been made possible because banking had been reshaped by deregulation, innovation, and competition. Then the Fed lowered interest rates, creating “an abundance of credit for borrowers and a scarcity of yield for investors.” (Thank you, Alan Greenspan!)

Pozsar pinpointed the 1988 Basel I Accord as the main catalyst for the growth and advances of “credit risk transfer instruments” like CDOs [Collateralized Debt Obligations], MBSs [Mortgage-Backed Securities], asset-backed securities (ABS), asset-backed commercial paper (ABCP), commercial mortgage-backed securities (CMBS), and so on.

Issued after the banking crises of the late 1980s, the new Basel rules required that banks meet a minimum capital requirement and hold even more against riskier assets. For investment bankers seeking to maximize profits, and thus their own compensation, the changes created the need to hide liabilities in the shadows.

—Danielle DiMartino Booth, Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America (New York: Portfolio Penguin, 2017), e-book.