Modern Market Alchemy Explained: Converting Junk Debt Into Supersafe Treasurys Out Of Thin Air
When it comes to the actual functioning of capital markets, there is always much confusion within the made for TV punditry for one simple reason: the number of people who truly understand collateral transformation courtesy of the shadow banking system, which until recently was a massive $23 trillion off the books repository of everything the banks did not want you to know about, can be counted on one hand. That certainly would explain the existence of such media trolls as "conscientious" NYT columnists, and various three letter "modern" theories explaining how money would work in a world if only all practical reality was removed.
And while we have previously explained extensively how it is that what actually happens behind the scenes is so very different from what most believe is market reality, especially with our three+ years series on shadow banking, confusion is still rampant. Which is why we hope an extract from Fed Governor Jeremy Stein's speech titled "Overheating in Credit Markets: Origins, Measurement, and Policy Responses", will finally make it sufficiently clear that when it comes to shadow banking collateral transformations, modern day alchemy does in fact work, and one can transmogrify junk bonds into Treasurys with the wave of a magic (yield) wand.
From Stein - extracted from full speech:
The maturity of securities in banks' available-for-sale portfolios is near the upper end of its historical range. This finding is noteworthy on two counts. First, the added interest rate exposure may itself be a meaningful source of risk for the banking sector and should be monitored carefully--especially since existing capital regulation does not explicitly address interest rate risk. And, second, in the spirit of tips of icebergs, the possibility that banks may be reaching for yield in this manner suggests that the same pressure to boost income could be affecting behavior in other, less readily observable parts of their businesses.
The final stop on the tour is something called collateral transformation. This activity has been around in some form for quite a while and does not currently appear to be of a scale that would raise serious concerns--though the available data on it are sketchy at this point. Nevertheless, it deserves to be highlighted because it is exactly the kind of activity where new regulation could create the potential for rapid growth and where we therefore need to be especially watchful.
Collateral transformation is best explained with an example. Imagine an insurance company that wants to engage in a derivatives transaction. To do so, it is required to post collateral with a clearinghouse, and, because the clearinghouse has high standards, the collateral must be "pristine"--that is, it has to be in the form of Treasury securities. However, the insurance company doesn't have any unencumbered Treasury securities available--all it has in unencumbered form are some junk bonds. Here is where the collateral swap comes in. The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade.
Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain them, it may have to engage in the mirror-image transaction with a third party that does--say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet.
There are two points worth noting about these transactions. First, they reproduce some of the same unwind risks that would exist had the clearinghouse lowered its own collateral standards in the first place. To see this point, observe that 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 I said, we don't have evidence to suggest that the volume of such transactions is currently large. But with a variety of new regulatory and institutional initiatives on the horizon that will likely increase the demand for pristine collateral--from the Basel III Liquidity Coverage Ratio, to centralized clearing, to heightened margin requirements for noncleared swaps--there appears to be the potential for rapid growth in this area. Some evidence suggestive of this growth potential is shown in exhibit 8, which is based on responses by a range of dealer firms to the Federal Reserve's Senior Credit Officer Opinion Survey on Dealer Financing Terms. As can be seen, while only a modest fraction of those surveyed reported that they were currently engaged in collateral transformation transactions, a much larger share reported that they had been involved in discussions of prospective transactions with their clients.
Mr. Stein may not have evidence... but we do. Below, direct from the NY Fed, is the total amount of collateral pledged any given month with the NY Fed, courtesy of Tri-Party repo custodian JP Morgan of course:
To summarize: the volume of "such transactions" is currently very large and rising rapidly.
Keep in mind the above is merely the base collateral: one can think of it as SM 0 (or Shadow Money 0). What must be done next is apply a specific "collateral chain" (as explained previously) to get the full level of explicit recycled collateral. The most recent estimate of the average shadow bank collateral chain from Manmohan Singh was 2.5x as of 2011. It is a certainty that this is now back to its 2007 levels of about 3x in net collateral rehypothecation. Which means that just the repo market alone allows market players to create some $6 trillion in credit money out of the Tri-Party repo alone. Add the nearly $2 trillion in hedge fund capital which is then transformed via broker-dealers in the same way, and one gets a whopping $12 trillion in buying power created by, using Stein's extreme example, using worthless collateral and converting it into pristine Treasurys, while promising pennies in front of a steamroller to all the counterparties in the collateral chain.
But wait, there's more.
Because as Matt King explained all too well back in September 2008, when the above alchemy happens, yields are created, trillions in counterparty risk is generated, collateral is transformed and can be used for fingible purchasing purposes and... nothing.
By nothing we mean there is no balance sheet entry!
Thanks to the magic of FAS 140 banks can literally transform worthless garbage into supersafe Treasurys, then use that newly transformed collateral via further repo as cash to fund simple stock purchases, and at the end of the day nobody knows where the exposure came from, who the counterparty is, and what the ultimate liability is!
And that is why in the current market, the Fed has no choice but to keep the music going, because while an unwind of traditional liabilities will result in a maximum collapse of some $13 trillion in conventional financial liabilities, it is the $15-20 trillion in shadow banking exposure which nobody knows about except for the banks themselves (we hope), and which allows banks and hedge funds to literally create purchasing power out of thin air, that once the house of out of control deleveraging cards starts falling, it is truly game over.