Last September I warned that new regulations, ostensibly designed to make the financial system safer, may be inadvertently setting the stage for the next great collapse. Specifically, I noted that an industry-wide shift towards the centralized clearing of derivatives would likely create a shortage of high quality collateral.
By way of explanation, consider that unlike bilateral, over-the-counter (OTC) derivative transactions, clearinghouses require the posting of initial margin in the form of highly liquid collateral that can be easily turned into cash in the event of a default. The OTC market by contrast, runs more on an honor system of sorts, where "the posting of initial margin is optional subject to one counterparty's credit view of another." Clearly then, a move to centralized clearing will have the effect of increasing the demand for securities which can be posted as collateral -- U.S. Treasury bonds for instance.
While this might seem like a way to make the system safer, the unintended consequences may in fact increase systemic risk dramatically by creating an incentive for banks to scale-up their collateral transformation businesses. As I explained in the piece cited above, collateral transformation is the process whereby a counterparty who wishes to enter into a derivatives transaction but doesn't possess the type of collateral necessary to initiate the position can go to a bank and swap low quality collateral (like junk bonds) for so-called "pristine" collateral (like U.S. Treasury bonds) which is then posted at the clearinghouse. The process then, is modern day alchemy.
It is important to understand that there are several factors conspiring to squeeze the amount of available collateral just as the push to centralized clearing increases the demand for such securities. First, consider that under Basel III, banks are required to hold high quality, liquid assets totaling 100% or more of expected total net cash outflows over a 30 day period of stress -- this is known as the Liquidity Coverage Ratio (LCR).
The stress period is characterized by deposit withdrawals, collateral calls triggered by downgrades, and a reduction in secured and unsecured funding. Net outflows are calculated by multiplying liabilities by a standardized set of liquidity run-off rates. For instance, total deposits would be multiplied by somewhere between .05 and .10 (between a 5 and 10% run off rate). Other liabilities on the balance sheet are multiplied by their respective run off rates and the sum total of these products (classes of liabilities times their respective run off rates) equals the amount of high quality, liquid assets the bank must hold.
Assets which qualify as "high quality" and "liquid" include cash, central bank reserves, and of course, government bonds. Assuming that cash is depleted during a stress period and that banks don't depend too much on central bank reserves to meet the liquidity coverage ratio (an issue studied in depth by the Bank for International Settlements), it is reasonable to assume that as the LCR is phased-in beginning in 2015, the demand for Treasury bonds will grow. Here's Harvard professor and Fed governor Jeremy C. Stein:
...a variety of new regulatory and institutional initiatives on the horizon [such as] the Basel III Liquidity Coverage Ratio...will likely increase the demand for pristine collateral.
In addition to regulatory pressure, there is another dynamic at play which not only suggests that high quality collateral is becoming more scarce, but also explains many larger economic phenomena such as why inflation has remained subdued even in the face of a rapidly expanding M2 money supply.
To understand exactly what is going on, one must first be prepared to accept that the standard textbook description of how money, deposits, and loans interact tells less than half the story in terms of total credit creation. Students of economics are taught that money and credit is created via fractional reserve banking. The process starts when someone deposits say, $100 into their bank account. The bank of course, is only required to hold a fraction of that (let's say 10%) as reserves. As a result of this, the bank can lend $90 out of the $100 deposit to someone else. If that person buys something with the $90 loan and the seller deposits that $90 in their bank account, the receiving bank can then make $81 worth of new loans ($90 minus the $9 it must hold as reserves). The process then continues down the line with more money created and more loans theoretically extended along the way.
It is fairly simple to determine just how much in new deposits (and by extension, new loans) can be created based on an original deposit. Simply dividing 1 by the reserve requirement which, in this case is .10 (10%), gives the money multiplier. Multiplying the money multiplier by excess reserves -- which would just be the initial deposit minus the amount that must be held as required reserves, so $90 -- tells you how much in new deposits a given initial deposit can eventually create. In our example, we would divide 1 by .10 to get the a money multiplier of 10, then multiply 10 by $90 to get $900. This is the deposit-creation potential of our initial $100 deposit.
For those content to accept the textbook description of deposit, liability, and credit creation (i.e. for those content to live in the Matrix), this is all there is to it. In reality, this process accounts for only half of all credit money. The process by which the other half is created takes us deep into the shadow banking system and out of the comfortable confines of the observable banking system Matrix (to continue with the cinema imagery from above).
Imagine a hedge fund that wants to post some of its bonds as collateral for cash in a repo transaction. The bank which serves as the counterparty haircuts the bonds (i.e. requires the hedge fund to post more in bonds than it receives in cash), sends the hedge fund the money, and holds the bonds as pledged collateral for the loan. The bank can then repledge (reuse) those bonds in a separate repo transaction with yet another counterparty. The collateral is haircut by the receiving bank in this instance as well. It is quite easy to see the parallel between this process and the textbook process of money creation described above. Consider the following excellent description from Manmohan Singh, senior financial economist at the IMF:
...collateral that backs one loan can in turn be used as collateral against further loans, so the same underlying asset ends up as securing loans worth multiples of its value...Plainly this re-use of pledged collateral creates credit in a way that is analogous to the traditional money-creation process... Specifically in this analogy, the bonds are like high-powered money, the haircut is like the [required] reserve ratio, and the number of re-pledgings (the 'length' of the collateral chain) is like the money multiplier.
We can see then, that there is a credit creation system based on the rehypothecation of pledged collateral that runs parallel to the textbook system and functions in a very similar manner. The degree to which the component parts (haircuts vs. reserve ratios, and repledgings vs. the money multiplier) are analogous is extraordinarily instructive. As the following chart shows, this "shadow" system (if you will) actually creates more credit money than its visible counterpart:
Note that in the years leading up to the financial crisis, the growth of shadow banking liabilities far outpaced the growth of traditional banking liabilities. Since then, the two have converged in dramatic fashion. In short, the shadow banking system has experienced a period of rapid deleveraging.
This has occurred because the length of the so-called "collateral chain" has gotten shorter. The collateral chain simply refers to the amount of times a given asset is reused or repledged -- it might reasonably be called the "collateral multiplier." As the Financial Times recently noted,
...in Singh's mind, collateral is money-like. It has its own velocity as well as its own multiplier effect...The issue, consequently, is not a shortage of assets per se, but rather the declining reuse rate of assets that already exist.
Put simply, pledged collateral is not being reused as much as it was pre-crisis. Alternatively, we might say that the velocity of collateral has declined. The following chart shows how the collateral multiplier has contracted since 2007:
Source: Manmohan Singh
The next graphic is a bit more difficult to understand but its implications are important. The top line (green) is the M2 money supply in both the U.S. and the euro plus pledged collateral. The middle line (red) is only M2:
Source: Manmohan Singh
Note the convergence between the green and red lines. This represents a shift away from credit creation via collateral reuse and towards the expansion of credit via an expanding money supply. There's only one problem: the traditional method of credit creation isn't as efficient as the shadow banking method. Here's Singh:
As of end-2011, the overall financial lubrication is back over $30 trillion but the 'mix' is in favour of money which not only has lower re-use than pledged collateral but much of it 'sits' in central banks. (emphasis mine)
As ZeroHedge has noted on several occasions, this is why multiple iterations of QE have not produced inflation. Deleveraging in the shadow banking system has offset the Fed's money printing. If you need proof, consider the following chart which shows the veritable implosion of shadow banking liabilities on a month by month basis beginning in the Spring of 2008:
Coming full circle now to the issue of collateral transformation, the decrease in the reuse of pledged collateral and the subsequent deleveraging in the shadow banking system translates to a reduction in the available supply of high quality collateral. As Singh puts it,
...with fewer trusted counterparties in the market owing to elevated counterparty risk, this leads to stranded liquidity pools, incomplete markets, idle collateral and shorter collateral chains, missed trades and deleveraging.
Given all of this, one can expect collateral transformation services to be in high demand as trillions of derivatives are moved to clearinghouses. The collateral transformation process however, introduces an enormous amount systemic risk into the system and, incredibly, this risk may not even feature on the balance sheet.
In order to demonstrate this, allow me to paraphrase, truncate, and simplify a hypothetical scenario posited by Jeremy Stein in the article cited above. Imagine an insurance company wants to engage in a derivatives transaction but doesn't have the Treasury bonds it needs to post as collateral at the clearinghouse. The insurance company then goes to a bank and pledges its junk bonds in a repo transaction for the Treasury bonds it needs. As it turns out, the bank doesn't have any Treasury bonds to spare (which wouldn't be surprising given the new liquidity ratio coverage rules discussed above) so it turns to a pension fund and pledges the insurance company's junk bonds as collateral for Treasury bonds which it then passes back to the insurance company. The insurance company then pledges the Treasury bonds as collateral at the clearinghouse.
The potential for a disastrous domino effect should be abundantly clear from this example. If there is a sudden crisis of confidence in the market, the first thing that will become impaired will be the less-than-pristine collateral that initiated the entire transaction described above. Here's Stein's description of the knock-on effect:
...if the junk bonds fall in value, the insurance company will face a margin call on its collateral swap with the dealer. It will therefore have to scale back this swap, which in turn will force it to partially unwind its derivatives trade--just as would happen if it had posted the junk bonds directly to the clearinghouse. Second, the transaction creates additional counterparty exposures--the exposures between the insurance company and the dealer, and between the dealer and the pension fund.
As if this isn't bad enough, note that in the above example, no cash was exchanged at any juncture -- all of the swaps and repos were securities-for-securities. It would seem then, that each leg of the transaction could reasonably be classified as a "borrowed versus pledged" transaction. The problem, as I noted in a previous piece, is that under FAS 140, borrowed versus pledged transactions are not required to feature on the balance sheet. Could the entire collateral transformation business thus be simply disappeared at the participating institutions' discretion? I doubt it, but I believe there is a very real chance that much of the exposure and attendant risk will be obscured by the magic of repo accounting.
This certainly casts doubt on the sincerity of the following statement from JPMorgan regarding the transparency of the collateral transformation business:
"Collateral transformation is a client service that does not hide risk" (emphasis mine)
It should be clear from the above that the combination of regulatory pressure and a generalized contraction of the shadow banking complex has the potential to put a squeeze on the supply of available high quality collateral. The timing of this collateral scarcity certainly leaves something to be desired. The centralized clearing of derivatives will invariably increase the demand for high quality, liquid securities. In the absence of either a more friendly regulatory environment or a re-energized shadow banking system, pressure will mount for banks to expand their collateral transformation businesses.
Consider one final chart which shows the percentage of dealers, hedge funds, REITs, mutual funds, pension funds, and insurance companies either engaged in or considering collateral transformation transactions:
Source: Jeremy Stein
Clearly, a seachange could be on the horizon.
Let this piece serve as both an educational foray down the shadow banking rabbit hole and as a cautionary tale to those who own stock in the firms who will invariably spearhead the collateral transformation push. The two main candidates (due to the size of their derivatives operations) are Bank of America (BAC) and JPMorgan (JPM), but as you can see from the chart above, the potential exists for the entire system to become entangled. Investors should keep a close eye on this issue and should always be aware that whether it is disappearing collateral, an unexplained stock market rally, or eerily subdued inflation, things are not always as they seem.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.