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Since launching our new format last month, the amount of reader interaction has increased dramatically.  Part of the reason is due to the expanding list of PM-bullish events – directly contradicting the Cartel’s recent, maniacal price suppression – and part due to people returning from summer vacations and “mentally addressing” the dismal state of the financial world.  However, I genuinely believe that combining David Schectman, Bill Holter, and myself into a single newsletter – and purposefully reducing content to the most “need to know” information – has generated significant dividends.  Moreover, our editing team is spending more time than ever modifying the blog; that is, making it more readable, accessible, and – generally speaking – “likeable.”

Among the numerous messages we’ve recently received, one noted how I do a nice job breaking down complex topics for the average non-financial expert.  Today, I’m going to do my best with a very difficult topic; although my sense is it’s probably far less complex to those engaged in it full-time – of whom, few would likely be categorized as “rocket scientists.”  In my view, readers of the Miles Franklin Newsletter are among the world’s smartest; and thus, could easily be top notch doctors, engineers, or scientists if they put their hearts and minds into it.  As for me, I spent ten years in the oilfield service industry and five in mining; speaking to hundreds of geologists and engineers discussing some of the most complex scientific issues imaginable – as if they were “old hat.”  I’ll bet I could have been a good engineer myself, but I guess I’ll never know.

Today’s article relates to the role of the “shadow banking system”; a term no doubt most have not heard of – or if they have, did not understand.  Until this morning, even I have done little if any research on the topic; as frankly, there are more than enough non-opaque issues to discuss in the context of Precious Metals fundamentals.  In actuality, however, there is not as much to “learn” as one might think; as the shadow banking system – in my view – amounts to nothing more than the utilization of “off-balance sheet” vehicles to evade taxation, regulation, and investor scrutiny.  Sort of like ENRON; i.e., the first time the term S.I.V. – or “Structured Investment Vehicle” – became common jargon in the world of shady, malignant finance.

In essence, it refers to traditional banking services provided by “non-bank financial intermediaries” such as hedge funds, money market funds, SIV’s, exchange-traded funds, securities brokers, insurance providers, and securitization or finance companies.  Moreover, now that the line between “commercial” and “investment” banks has been blurred by the 1999 repeal of Glass-Steagall and 2008 decision to allow Morgan Stanley and Goldman Sachs to become “bank holding companies” – thus, eligible to receive TARP – most companies that would still be considered “traditional” – like JP Morgan, for example –conduct at least as much business in the shadow banking system as traditional channels.  In other words, just as the derivatives business has miraculously grown since it nearly destroyed the world in 2008 – and largely shifted to the “shadow world” – so has the ENTIRE BANKING SYSTEM.

Not surprisingly, “shadow banking” peaked just before 2008’s Global Meltdown I; however, it still remains as large as the traditional banking system – and trust me, TPTB wants nothing more than to move ALL financial transactions out of the light of day.  You know, like vampires.  As it is, the average derivative/asset ratio published by traditional banks is 15% greater than in early 2008; so you can only imagine what it looks like when “shadow banking” activities are incorporated into the equation.

Shadow Bank Liabilites

Bill Holter has noted the unintended ramifications of Quantitative Easing on the Shadow Banking system; specifically, how QE actually drains the system of good collateral (i.e., Treasury Bonds and other AA+ or greater investments), replacing them with “dead money” in the form of less liquid “Fed deposits.”  As I discussed yesterday, the Fed now owns 32% of ALL Treasuries and 42% of ALL Mortgage-Backed Securities, and has promised “ZIRP” until at least 2016; and thus, in the process of “liquefying” TBTF banks, has dramatically reduced the shadow banking system’s ability to grow.  Net, the reduction in “offshore” finance is a positive for the world.  However, were it to seize up as in 2008, we would see a similar, catastrophic crash instantaneouslyThis article served as my “primer” on the topic; and if you feel so inclined, it is well worth reading…

What Shadow Banking Can Tell Us about the Fed’s “Exit-Path” Dead End

As to its title, it explains the focus of this piece.  That is, it discusses how the lack of good collateral creates significant tightness in the interbank market; and moreover, encourages banks to speculate with otherwise inert “Fed deposits.”  This is why margin debt has risen to all-time highs; the disconnect between economic REALITY and equity VALUATIONS has become so gaping; and massive trading losses like JP Morgan’s “London Whale” commonplace.

In other words, banks’ cumulative liquidity requirements can no longer be accommodated by the interbank market utilized in the shadow banking world; and thus, the resulting “liquidity gap” can only be supplied by additional QE.  In fact, the writer believes an additional $3.6 TRILLION of QE will be required to maintain the banking system’s integrity.  However, in the ultimate “Catch-22,” the more QE that is executed, the less good collateral in the market – hence, necessitating further QE in a hideous financial “feedback loop.”

Behind closed doors, “shadowy” organizations like the “Treasury Borrowing Advisory Committee” – i.e., TBTF bankers routinely receiving material non-public information – are terrified of the tightening grip on collateral of QE operations.  Thus, they continue to consider new ways to “exit” QE without collapsing the economy – and with it, any remaining confidence in the fiat dollar.  Oh, they’ll continue to try – utilizing every bit of accounting chicanery imaginable; but in the end, they’ll miserably FAIL.  QE is – by definition – a Ponzi scheme that MUST grow larger to survive; and with every dollar printed, the value of REAL MONEY – i.e., PHYSICAL gold and silver – increases exponentially.