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In an article last month titled "QE Is A Flawed, Lose-Lose Strategy," I noted that one of the undesirable things quantitative easing does is rob the system of much needed AAA-rated collateral:

"...when central banks purchase government debt they are sucking senior collateral out of the system at a time when good collateral is in high demand and short supply."

This problem is likely to become particularly acute starting next year, when new rules regarding the posting of collateral to back derivatives trades go into effect. The rules are designed to prevent a systemic collapse like that which nearly occurred in 2008 by shifting most derivatives trades to clearinghouses such as the CME Group, where collateral must be posted to back-stop potential losses. Bloomberg quotes Morgan Stanley analysts as saying that trades between securities dealers are only backed by net .005% in terms of posted collateral. The firm estimates that moving these trades to clearinghouses will mandate the posting of some 700% more than this, or .04% of trades cleared.

Estimates of the hole in terms of available collateral vary, but a good midpoint seems to be around $1.5 trillion. Between the Fed's purchases and banks' record $1.84 trillion in Treasury holdings, it may prove difficult for traders to access the collateral they need to make their trades through clearinghouses. However, Wall Street has devised a plan. Bank of America (BAC), JPMorgan (JPM), Goldman Sachs (GS), Deutsche Bank (DB), State Street Corporation (STT), Barclays (OTC:BCBAY), and Bank of New York Mellon (BK) have decided to effectively create a new repo market wherein traders can pledge dodgy collateral (non agency MBS, etc) in exchange for Treasury bonds, which in turn, will be pledged as collateral at clearinghouses to back derivatives trades. This process is ominously dubbed "collateral transformation."

If there ever was an indication of how little Wall Street has learned from the financial crisis, this surely is it. These banks are now going to poison their own balance sheets by loaning their Treasury bonds out to traders who will use them to place bets in the derivatives market. If these trades go wrong and the clearinghouses seize the pledged Treasury bonds, the banks are left holding the bad collateral. Worse, understand that the Treasury bonds being lent by the banks may not belong to the banks - they may have themselves borrowed the Treasuries. This sets up a potential cascade of collateral calls.

Of course, the ultimate irony here is that Congress mandated the move to clearinghouses to reduce systemic risk. Unbeknownst to lawmakers, tougher requirements regarding the amount of high quality assets banks must hold, combined with the Fed's asset purchases, have effectively made the move to clearinghouses impossible by creating a shortage of agency MBS and Treasury bonds. As such, the best intentions have now served only to create a new nightmare scenario, wherein traders are placing bets with derivatives using borrowed Treasuries as collateral, exposing the very institutions (big banks) lawmakers sought to fortify many times more prone to risk taking.

This is not a discussion about some theoretical, worst-case scenario. This is very real. At least two of the banks listed above are already advertising this service, and it is expected to generate billions in fees. This may offer a rare opportunity to be the first mover in terms of betting against what is quite honestly an absurdly risky proposition. You can bet there will be a way to determine how much the above listed banks make in fees from "transforming collateral" beginning sometime around the second quarter of 2013. The banks that collect the most fees from this "service" are the banks that are taking on the most risk and these, like Bear Stearns and Lehman before them, will be the first dominoes to fall if this incredibly unscrupulous practice begins to produce losses.

Source: U.S. Banks' New Business Could Sow The Seeds For Outsized Losses