In a recent article entitled "Repoed! How The Fed And Depositors Fund Banks' Big Bets," I described the channel by which banks can launder excess cash. Essentially, banks can purchase Treasury bonds, agencies, and other highly liquid securities, pledge them as collateral in repo transactions, and come away with clean cash to invest as they please. I suggested that if the percentage of banks' financial instruments pledged as collateral in repo transactions was greater now than in the past, then that fact, combined with banks' record government debt purchases and a rising stock market would seem to suggest that excess cash at banks is serving as an incentive for the purchase of government securities which are then pledged for cash that is ultimately channeled into risk assets such as equities, derivatives, and corporate bonds.
I also demonstrated that at two large financial institutions (Morgan Stanley (MS) and Goldman Sachs(GS)), the percentage of financial assets funded in repo was higher at the end of the third quarter of 2012 than it was just prior to the financial crisis. I also acknowledged that while intriguing, that finding was limited in its suggestive power by the fact that it was based on only two institutions. I would add that it is also limited by the fact that it represents but a snapshot in time (May of 2008 versus September of 2012).
The purpose of this article is to extend the original analysis, refute an objection, and discuss another important component of banks' use of repo in order to further demonstrate how this important channel is used and what it means for the market in general.
Can Banks Really Buy Stocks With Excess Cash?
First, I want to refute, up front, what I view is a very naive assertion made in an article published on Tuesday here on Seeking Alpha. The author asserts that banks cannot (by law) and do not invest in equities. By now, I would argue that it is common knowledge that prop trading desks at banks can and do invest in a variety of assets, including stocks. For instance, at Goldman there is a division called the "Special Situations Group" which houses a unit dubbed "Multi-Strategy Investing," or MSI. This is kind of like the financial market equivalent to the Navy Seals, but in short, it is a proprietary trading team. Here is what it does in Bloomberg's words:
It wagers about $1 billion of the New York-based firm's own funds on the stocks and bonds of companies, including a mortgage servicer and a cement producer, according to interviews with more than 20 people who worked for and with the group, some as recently as last year. The unit, headed by two 1999 Princeton University classmates, has no clients, the people said. (emphasis mine)
As noted in a rather sarcastic piece which appeared on the Financial Times' Ftalphaville on January 8, banks are supposed to be banned from so-called 'prop-trading' under the Volcker Rule. In reality, there are so many loopholes as to make the rule nearly meaningless. For instance,
...the ban on prop-trading under the Volcker Rule effectively means a ban on short-term prop trading. Short term is defined as a position held for fewer than 60 days... Goldman says the MSI makes long-term investments that generally exceed the 60-day limit...
Here is a quote from Ashkan Marsh, a former member of Goldman's MSI team:
MSI is very much like a hedge fund.
Here's another quote from another former member:
[It's] a proprietary multi-strategy hedge fund.
You get the point. Critically, the Volcker Rule doesn't apply to banks' market-making activities, so there are always going to be substantial inventories of equities floating around on the books of banks with market-making businesses. In the words of Trader's Magazine,
The rule includes an exception for market making [but] distinguishing between [market-making] and prop trading is not always straightforward.
Similarly, the Shadow Financial Regulatory Committee had the following to say on the subject:
...market making necessarily involve[s] taking inventory positions that can be well nigh indistinguishable from proprietary positions...[there] is considerable uncertainty in distinguishing between market making and proprietary trading.
Lastly, consider the following statement regarding the issue from Yale Law School:
...the [Volker] rule is incoherent because it assumes that banks can somehow operate core businesses, like underwriting and creating secondary markets for securities, without proprietary trading...it is unusable because it would ban essential financial activities like hedging and market making that cannot be performed without taking proprietary positions. Sometimes massive proprietary positions in securities. Even under the Glass-Steagall Act, hedging and market making for this reason were legal for entities like the Chief Investments Office unit of JPMorgan Chase - the division that lost the $2 billion.
Some banks buy stocks -- period. To deny this is to assume a simplistic, idealistic, black and white world wherein everyone follows the rules. Unfortunately, there is a huge grey area in which market-making and prop trading commingle.
Another important point here is that banks with market making businesses probably have little incentive to toe the legal line between prop trading and legitimate market making. One reason for this is that in the days and weeks surrounding the Lehman crisis, the Fed demonstrated its willingness to accept massive quantities of risky stocks as collateral for taxpayer-backed loans via repos in order to avoid the disorderly collapse of a systemically important financial institution.
Essentially, through a tri-party repo in which JPMorgan (JPM) acted as the custodian, the Fed loaned Lehman some $50 billion and took onto its own, taxpayer-backed books a list of collateral that included around $4 billion in stocks (the reference to Barclays (BCS) in the following table refers to the fact that the firm was set to purchase the entire balance of the repo deal from the Fed via JPMorgan, equities are highlighted in grey):
Source: Letter from Jamie Dimon to Barclays
Here is a list of stocks the Fed loaned money against in repo ops with Lehman:
To those who would dispute this comparison on the grounds that Lehman wasn't a bank holding company, I would ask whether anyone really believes that Goldman and Morgan's respective conversions to bank holding companies has fundamentally changed the way they do business under the surface.
More importantly, I ask readers to consider the following questions. Number one: is it realistic to assume that rules which purport to separate market making from prop trading will be sufficient to prevent banks from building large inventories of equities that were not purchased for market making purposes? Number two: is it realistic to assume that in the event of a meltdown, taxpayer dollars will not be loaned (and I mean directly loaned in reverse repos, not channeled through bailouts months later) to these institutions by the Fed in exchange for a book full of stocks just like what occurred in September of 2008? If the answer to those questions is "no," then you can bet that some of the extra cash piling up at banks will be used to bet on equities.
The Larger Issue
In reality however, my previous article was meant more to draw attention to the financing of risk assets in general via the cleansing of excess cash than with whether or not banks bought stocks specifically. It should be noted here that another argument leveled against my previous article is that banks would have no reason to wash their cash through repo transactions because they can do whatever they choose (well, except for buy stocks, ahem) with their excess reserves:
...they [the banks] do not have to engage in repos to obtain "clean" cash in order to [gamble].
Maybe not, but repo financing carries a distinct advantage: it allows the banks to hold government debt on their books for regulatory oversight purposes while still spending the cash. Remember, the banks take the cash, buy Treasury bonds, pledge them and get their cash back at nearly par, and the Treasury bonds stay on the books. It is literally the best of both worlds.
The bigger issue here however, is that it isn't just "risk free" government debt that get pledged as collateral. For instance, take a look at Morgan Stanley's latest balance sheet (I use Morgan Stanley again not to single them out, but simply because I used the firm as a test case in the previous article so it should be easier for readers to follow):
Source: Morgan Stanley 10Q
Note that from this data we can not only see what percentage of the firm's financial instruments are pledged as collateral (see my last article cited above for the other figure which must go into this calculation) but we can also infer the bare minimum amount of the firm's non- government securities that are pledged.
The total amount of financial instruments pledged as collateral in repo transactions is $181.5 billion ($133.77 billion from the balance sheet plus another $51.7 billion which can be found in the Notes section of the 10Q). If we assume that every single government and agency security is pledged ($52.134 billion) that still leaves $129.4 billion in either sovereign debt, corporate bonds, equities (those things they aren't supposed to have), derivatives, and commodities that are pledged for cash loans. Now take a look at the firm's cash balance: adding the three cash line items sums to just $65.433 billion. So Morgan Stanley has taken out cash loans against collateral other than safe government bonds in an amount that is twice the cash they have on their books. Why this could be dangerous should be clear but in case it isn't, here's Citi's Matt King:
...the size of the repo financing of equity and [non-government] credit is substantially greater than that of cash held on the balance sheet, meaning that, if it were to evaporate, they could be forced to sell a sizeable volume of potentially illiquid paper into the market.
In other words, taking out loans against collateral other than government bonds is a risky proposition in the first place. The riskier the collateral (haircuts notwithstanding), the more likely it is that lenders will pull back at the first sign of trouble. This proposition is made even riskier when the amount of the loans secured by the relatively riskier collateral is more than double the cash on the balance sheet. Incidentally, the $65 billion discrepancy between Morgan Stanley's non-government debt and equity secured repos and its cash balance has improved. It was $96 billion in 2008.
As discussed at the outset, I demonstrated in the predecessor to this piece that the percentage of total financial instruments pledged in repo transactions for Morgan Stanley and Goldman Sachs has increased since 2008 (markedly so for Morgan). When considered with a concurrent increase in excess cash, Treasury holdings, and stock prices, the correlations suggest a positive relationship between the four variables. In English: banks are laundering excess cash through repo channels and coming out with clean cash and balance sheets full of risk free government debt.
Correlation does not necessarily imply causation and there certainly is no room for an exhaustive analysis here. Furthermore, the limitations to this analysis have been clearly spelled out in this article and in the previous piece. That said, I offer two final pieces of evidence here.
First, I have heard it suggested that the Fed's purchases of Treasury bonds and MBS should reduce the financing of government debt via repo by reducing the amount of Treasury bonds on banks' balance sheets. Put simply: there is no reduction of government securities on banks' books. Primary dealers typically purchase new Treasury bonds to replace the ones they sold to the Fed. A quick look at the latest Fed Flow of Funds report (the Level tables) shows that U.S. Depository Institutions' holdings of Treasury bonds and agency securities is near an all time high of $1.86 trillion (that data can be found easier at Bloomberg). Here is the table from the Fed's report:
Source: Federal Reserve
Lastly, note that the institutions which function as the money launderers in this equation are Bank of New York Mellon (BK) and State Street (STT). They are the custodian banks which act as the middlemen exchanging the securities for cash and holding the securities in the interim period. Consider that at the end of the third quarter of 2012, State Street had $23.44 trillion of assets under custody, a 37% increase from 2007. Similarly, Bank of New York Mellon had 27.9 trillion under custody compared with $23.1 trillion just prior to the financial crisis. The repo market is alive and well.
As was the case with my previous article on the subject, the overarching claim here is that the repo market is the primary mechanism by which banks can clean excess deposits and cash in order to redeploy resources in proprietary trades. In this piece specifically I hope to have demonstrated how banks may circumvent the Volcker Rule in order to acquire equities, how the Fed is willing to backstop this practice in emergencies by accepting billions in stocks as collateral for taxpayer-backed loans to the institutions who purchased the equities, and how in some cases, the amount of cash on the balance sheet may not be sufficient to cover loans secured by less-than exemplary collateral. Finally, I demonstrated that the amount of assets under custody at the two main custodian banks has increased meaningfully since the financial crisis.
Ultimately the conclusions are the same: an observed correlation between multiple extraordinary events shouldn't be trusted. Investors are witnessing record high stock prices, record high cash balances at banks, record high Treasury holdings, and record low corporate bond yields. Upon reflection, perhaps the most important takeaway is not one related to cause-and-effect but rather that all of these elevated asset prices and gorged balance sheets ultimately rest atop a foundation built on repurchase agreements. That is not a situation I would trust going forward. I recommend a focus on capital preservation and an avoidance of risk assets including equities (SPY) (QQQ) in 2013.