A JPMorgan Research Note And The Manipulation Of The Critical Repo Market

Includes: TLT
by: Colin Lokey

In an article published last month, I discussed how the move to centralize clearing of all OTC derivatives as mandated by Dodd Frank has raised concerns regarding traders' access to the collateral that must be posted to back derivatives trades at clearing houses. The problem is that on the whole, trades made between securities dealers aren't backed by as much collateral as trades placed at clearinghouses. Thus moving all trades to clearinghouses will necessitate the posting of far more collateral, and it isn't exactly clear where it will come from:

...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.

In a research note dated Oct. 5 entitled "No Shortage Of Collateral," JPMorgan essentially argues that the issue is overblown. Before discussing OTC derivatives, JPMorgan examines the ECB's role in alleviating the "collateral availability problem." Essentially, the ECB works to ease shortages by expanding the universe of paper eligible for central bank liquidity ops. By giving banks the option to pledge other types of securities for cash, the ECB helps free up top quality collateral for use in private repo markets where the lower quality securities would not be accepted.

While this is supposed to be comforting, JPMorgan's analysis only serves to highlight the mountain of bad assets on the ECB's books. By JPMorgan's estimates, the ECB has 600 billion euros of non-marketable assets, 500 billion of covered bank bonds, 400 billion of Spanish and Italian residential mortgage-backed securities and asset-backed securities, and 350 billion in periphery government-guaranteed unsecured bank bonds. Here's JPMorgan:

So the majority of the €2.5tr collateral currently posted at the ECB represents illiquid collateral or collateral associated with peripheral issuers and thus unlikely to be accepted in private repo markets.

JPMorgan follows this up by noting

...this is how the ECB helps to alleviate the collateral availability problem, by absorbing lower quality collateral and freeing up collateral that would be more likely to be accepted in private repo markets.

Although JPMorgan is clearly indicating that it thinks this is a good thing, it most certainly is not. This is precisely what I and many others have been warning about for quite some time. The ECB's balance sheet is flooded with assets that the private market will not accept as collateral. If the private market will not accept it, neither should the ECB. In fact, the ECB should have even stricter standards than the private market, given that the ECB's purchases put taxpayers at risk. At least when a private firm makes a bad decision, it is shareholders and others with an interest in the company who suffer rather than innocent taxpayers.

Next, JPMorgan notes that when it comes to government bonds, the fact that the number of AAA bonds has declined with the cascade of sovereign downgrades really makes no difference because

...Solvency II treats government bonds as a single asset class, with the same capital charge regardless of credit rating. Basel III for Banks does not differentiate between the credit ratings of sovereign bonds in their Risk-Weighted-Asset framework.

Again, JPMorgan says this like it's a good thing. As I noted in a previous piece, however, the eurozone debt crisis has made it abundantly clear that not all government debt should be considered "risk-free." Assigning a zero risk weighting to all sovereign debt creates a situation wherein banks can reduce their risk weighted assets while increasing total assets:

...banks should be deleveraging and disposing of assets while raising capital. Instead, they are buying more assets, and these assets are the worst kind of oxymoron: They are extraordinarily risky yet they carry a zero risk weighting. Thus banks' assets are increasing yet their risk-weighted assets are decreasing, a trend one analyst cited by Bloomberg calls 'intriguing.'

Ultimately, it is certainly no consolation that poorly constructed rules alleviate a shortage of AAA bonds by essentially allowing all government debt to be counted as top notch, regardless of the issuing government's credit worthiness.

As to the issue of whether QE sucks AAA collateral from the system, JPMorgan says the following:

In fact the opposite is true. By expanding their balance sheets and by creating reserves, G4 central banks are supplying extra collateral to the financial system. Central bank reserves are equivalent to cash and represent highly liquid, high-quality collateral.

So as long as we conceive of cash as collateral, QE doesn't remove collateral from the system. What is interesting about this is that it isn't clear how cash sitting in central bank reserves in any way helps traders in search of pledgable collateral.

Lastly, JPMorgan discusses the issue of OTC derivatives. It concedes that additional collateral in the amount of around $1 trillion will be needed when all OTC derivatives are centrally cleared, but concludes that there is ample supply to meet this demand. Questions about the validity of that conclusion notwithstanding, the truly disconcerting part of the report comes next when the firm begins to discuss a move toward "greater collateral efficiency." Consider the following passage:

The trend [in collateral management] is towards more centralization, mobilization of securities collateral around different pools, optimization of collateral to improve liquidity vs. cost of funding, maximization in the re-use of collateral, reduction of over collaterization, collateral transformation i.e. to swap lower-quality securities that do not meet standards with higher quality collateral." (emphasis mine)

So let's unpack that. We have more mobile securities, maximization of collateral reusage, reduction of over collateralization (which can probably be loosely translated as "never be conservative"), and turning bad collateral into good collateral in a miracle of financial alchemy called "collateral transformation." I ask investors to consider the fact that everything mentioned here is painted in a favorable light by JPMorgan in the above-cited report. While I have given it a negative spin here, Wall Street sees all of these developments as positive. Consider also that collateral is the oil that greases the wheels of the repo market, which is the scaffolding that holds the entire financial system together -- when it freezes, so does the market.

The repo market and the collateral that makes it run are being manipulated by central banks and financial institutions. This large-scale tinkering poses an enormous systemic risk and could have disastrous effects. Due to these considerations, I believe the way to profit from this is to bet against what is being manipulated. While there are many securities involved, U.S. Treasury bonds (NYSEARCA:TLT) will suffer the most if this experiment goes awry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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