The Great Unwind Is Good For Us

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Includes: TIP, XLF
by: Martin Lowy

Manmohan Singh, a senior economist at the IMF, has written a paper describing the impact of changes in the re-use of collateral in the global financial system. Re-use (or its sub-category, re-hypothecation) of collateral may not have been at the top of your list of burning issues in global finance. But Mr. Singh’s paper might convince you to take the subject seriously. See the complete paper here.

Collateral, according to Mr. Singh, comes from two basic sources: Hedge Funds engaging in repo transactions or borrowings, and other kinds of institutions such as mutual funds and insurance companies engaging in securities lending to add extra basis points to their yield. The total collateral in use in 2010 was about $2.4 trillion.

Because collateral can be re-used by banks that lend to hedge funds or that borrow securities, a dollar of collateral can be used multiple times in a chain of financing transactions. This increases the effective amount of collateral available to the financial marketplace, and thus the total level of borrowing that the system can support. Mr. Singh estimates that in 2007, at the height of global leverage, collateral was re-used, on average, three times. In 2010, not only was the collateral pool smaller, but also its re-use had declined to 2.4 times.

Mr. Singh suggests that the rate of collateral re-use has important implications for monetary policy, since it so directly affects the overall levels of borrowing and leverage in the global financial system. He also wonders whether the decrease in collateral usage has not decreased overall economic activity, and therefore he wonders further whether higher regulatory capital requirements will further reduce collateral re-use, with accompanying further negative economic consequences. The collateral pool and its use are larger than M2, he points out, suggesting that changes in the collateral pool and its re-use can have significant macro-economic effects that may be similar to changes in M2.

The Financial Times published an article on Mr. Singh’s paper that provides a possible slant on the subject. “Whoosh!” the reporter says. “That’s the sound of up to $5,000bn worth of collateral draining from the financial system. And it is not a reassuring one.”

‘Collateral is the grease that oils the lending system,’ says Richard Comotto of the International Capital Market Association. ‘If the grease starts to freeze or run out, the loan cogs won’t run as well.’

“Some analysts believe,” the reporter continued, “that this fall in collateral use could actually serve to increase ‘hidden’ risk in the financial system as the market devises new ways of tackling the shortage. Moreover, some argue that such services place a question mark over whether risk is being reduced or simply shifted around the system, potentially flowing into less regulated areas as it did before the 2008-09 crisis. . . . The concern over such flows is that the effect, should there be another bout of severe market turmoil, could be similar to the rise of the ‘shadow banking system’, which thrived on leverage in the run-up to the financial crisis and helped cause the huge losses at Lehman and others.”

Thus the drum is being beaten to re-inflate the overleveraged condition of the global financial system as it existed in 2007. Everyone involved in the business of borrowing and lending based on little capital has an interest in pumping the system back up because they all make money on all the turns. The rest of us get to watch them make money; then we share the consequences on the downside as the economy reacts to the contraction that must follow the overleveraging process.

The apologists for the overleveraging will use any excuse they can find to foist its supposed benefits on the rest of us. The bogeyman of the “shadow banking system” is one of their favorites. “Hidden” risk is another.

In fact, the “whoosh” that the reporter describes is a most reassuring sound. An economy built on a mountain of debt that results from financial firms lending to each other based on inadequate equity capital is a fragile economy that is bound to deflate. If we are patient and permit the “real economy” to perform based on education, ingenuity and hard work, we can build a sounder economy than the one we just left behind that was based on a mountain of financial firm debt.

Mr. Singh has done great service by explaining to us yet another aspect of the overleveraging process and the way that it is being unwound. As an investor, this gives me hope that we are building a sounder economic foundation, if only we can resist the siren song of the purveyors of easy credit.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.