Modern Market Alchemy Explained: Converting Junk Debt Into Supersafe Treasurys Out Of Thin Air

Tyler Durden's picture

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.

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Say What Again's picture

B, B, But...

S&P said they were AAA -- good as gold

Rubicon's picture

Alchemy is alive and kicking!

jekyll island's picture

Stop it, my head all ready hurts.  I am bittersweet about what will happen when the system finally breaks, but I am ready for that to occur.  

pemdas's picture

Well good thing this kind of stuff does not happen with paper gold!!

Divided States of America's picture

Basel III is a smokescreen....they have already been relaxing the requirements and its not even 5-6 years from being put into effect. Much like any other regulation, if you are not in the circle, rules will not be changed for you. The banks are definitely in bed with the regulators.

Raymond_K_Hessel's picture

Bravo Mr. Durden. Thank you for shedding light on this. Fucking incredible.

dtwn's picture

Yes, thank you Tyler(s).  I'll be making another donation to ZH as soon as I have a job/income.  Shit like this is un. fucking. believable.

trav777's picture

It's all kinda an exercise in absurdity.

At the END OF THE DAY, this shit only flies because the FED IS the counterparty!

They showed that when these credit instruments are threating to find real value that they will print them to at least nominal value.

That nominal value might buy a carton of eggs, whatever, but the Fed will liquify the transaction chain to prevent the mad scramble for the exits that the math and computers force.

Because just imagine if that pension fund were to get stuck with that shit collateral.  The buck might break on a MMF like Reserve Primary and then everyone and his mother goes to redeem and all hell breaks the fuck loose.

The Fed is there to ensure that if the buck breaks, that Reserve gets paid whatever the difference is to par.

It's a controlled deflation, not a collapse.  It's leaking air like a tire does, trying to come down easy.  Instead of blowing and scattering stuff all over the walls.  The problem is that absent real structural reform, the crooks who abused the previous system are now abusing this one.  And the Fed has not the inclination to stop them.  They keep hoping that if they facilitate, that there is some magic point at which this thing will go back to how it was.

resurger's picture

Basel III considers all Government paper to be AAA and it has 0% RWA

TruthInSunshine's picture

A new Plaza Accord type arrangement will be made soon. It will be done to MANAGE what are the new currency wars (see last paragraph below).

All you need to read to understand the absolute, verifiable Ponzi of a foundation that modern finance and all that it impacts (e.g. real economy) truly is:

 * The Federal Reserve Bank of Chicago, describing, by their own words, the ruse of Modern Money Mechanics (quote from page 6, last paragraph):

"What they [banks] do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) BOTH (capitalization is mine) rise by [the amount of the "loan"]."*


Ask yourself two questions:  If you loan money to a friend, unless and until that loan is repaid, do you find that you have less or more money? Can you then demonstrate with verifiable proof (in technical compliance with the law) that you have MORE assets than prior to making that loan, while that loan is still outstanding?

If you answered "less money" and "no," you are not in The Big Club.

[Modern Money Mechanics was a booklet that was produced & distributed by the Public Information Center of the Federal Reserve Bank of Chicago]

And all these denials by Japan, the ECB and by the U.S. Treasury Secretaries, about how "we aren't intentionally devaluing our fiat currency" (Draghi today -- Currency war follows financial crisis--, Taro Aso of Japan yesterday)....don't be too surprised to find another Plaza Accord type event happening soon.

fourchan's picture

At what point of saddling the us tax payer with 20 trillion+ in debt

and every nonperforming asset the fed's banks created, become unAmerican?

TruthInSunshine's picture

As long as the Proxy LameStream Media spews forth "green shoots, unicorns & rainbows" headlines, as long as the governmental and quasi-governmental agencies keep torturing inflation/employment/GDP data to produce a massively "bullish" outcome, as long as the EBT/SNAP swipe works, as long as the bloated army of federal, state & local government unionized workers get their private sector taxpayer extracted paycheck on time, as long as Medicare/Social Security/Medicaid/The Zillion Other entitlement programs keep paying out, as long as the U.S. Government is able to spend $1.46 for every $1 of revenue it takes in so long as the average hourly wage doesn't require 1/2 a day's work (for those employed) to buy a fast food meal --


-- as long as these things continue, it probably won't completely break down (although I can contemplate massively bearish outcomes that don't require any of these things to end).

pashley1411's picture

The assumption of the Basel committees is that an international body can rate debt, and that sovereign debt is the most credit worthy.   


They probably sit around now and talk about their mistresses and their golf game.

Stock Tips Investment's picture

This has always been part of the plan from the Fed. And as in every aspect of this plan, success depends not been many variations (downward) in the prices of financial instruments or in home values??. We know what would happen if these falls occur.

midtowng's picture

The alchemy never stopped. It almost did, but it was brought back to life. It's now a zombie that feeds on real assets.

Renewable Life's picture

Those bankers must feel like I do, when I turn in my depreciating fiat dollars for solid OZ's of PM's!!!!

It's glorious! Almost feels like it shouldn't be legal;) uh oh

TheGardener's picture

tried transmogrify on the command line, shit I`am not the Unix hack I used to be, I just keep diminishing myself,
shit I`m off to space, control Strg out of reach, with the
00.1K bandwith I`am worth now : shit I`m down rated , glad space keeps
me afloat unlike in the movies...calling major tom

Now I`m save, still got to pee into the telephone booth before on line pickup, how the hell I got out of the matrix
into this filthy receiver ? Get me out of there !

Disclaimer : stuck in coding while fully rejecting logic if it refers to human affairs...

TheGardener's picture

Curious whether me or my junker misunderstood Tyler`s transmogrify ?

bobthehorse's picture

I've got your modern market alchemy.

I've got it hanging between my legs.


cossack55's picture

Wish they would capture a SEC drone so we could view some top grade porn.

stinkhammer's picture

stifle it Edith!

Big Corked Boots's picture

"pristine Treasuries"

That's a laugh. Garbage in, garbage out.

francis_sawyer's picture

They should just label them as "kosher"... Probably a lot easier to understand that way & much more aligned with reality...

Renewable Life's picture

Only as "pristine" as a shiney new drone armed with hellfire missiles, can guarantee!!!

jekyll island's picture

What exactly is backing Treasuries?  I think I missed it last time.  

francis_sawyer's picture

The full faith & credit that the chosen Sith overlords will tax your great great great grandchildren into the deepest parts of the stinkin' dungeon & turn you all into lepers...

Nothing To See Here's picture

But as one CNBC talking head observed last week, nothing backs gold!

Now back to banging my head on a wall.

mayhem_korner's picture



The Fed is de facto printing Treasuries.  The only thing backing them is the illusion they will be repaid.

secret_sam's picture

     What exactly is backing Treasuries?

The most powerful military empire of human history.

Anusocracy's picture

The faith and stupidity of a lot of faithful and stupid people.

secret_sam's picture

Hell, no.  The Saudis don't take dollars for oil because of any "faith," I assure you.

NotApplicable's picture

I think they were referring to the "dollaraires."

WojtekSz's picture

actually they accept dollars but DO NOT keep them but immediately invest into other tangible assets including gold and, unfortunately, also paper gold.

l.kimbot's picture

At 1 soldier suicide a day, on average, and now setting the wheels in place to draft all women as well, in the soon-coming national emergency, will child soldiers be far behind.  

Thinking Iran-Iraq conflict and Germany WWII...

malek's picture

I thought the bigger laugh is

"Imagine an insurance company that wants to engage in a derivatives transaction. To do so, it is required to post collateral with a clearinghouse..."

Ahem, how many derivatives are run through a clearinghouse?

socalbeach's picture

$1.96 trillion worth per the "Total Tri-Party Repo Collateral" graph.  Or are you talking about something else?


Tri-party repo

"The distinguishing feature of a tri-party repo is that a custodian bank or international clearing organization, the tri-party agent, acts as an intermediary between the two parties to the repo."

malek's picture

And how big is the overall derivatives market again?

ziggy59's picture

Even Mr. Ponzi would be jealous!

hooligan2009's picture

racketeering is not a crime if the goverment does it. who is going to bring the case? the government? 

NEOSERF's picture

Criminal, the only word for it.  Government should be careful who they sue.  If they think S&P weren't working in the government interests they are completely wrong.  Their complicity allowed inflated housing, employment, money velocity and GDP numbers...if S&P starts doing its job as a consequence of this lawsuit, watch out below.

Bay of Pigs's picture

Three Card Monte

otto skorzeny's picture

stocks flat by close. shitty economy #s now to be blamed on this weekend's big NE storm(global warming-bitchez)

ebworthen's picture

And isn't this the problem with the entire economy?

There is no such thing as risk or collateral except for the non-elite citizenry.

Mercury's picture

Thanks to the magic of FAS 140 banks can literally transform worthless garbage into supersafe Treasurys,...

But at what kind of ratio/haircut?

$1mm nominal in worthless garbage can be converted into how much (generally) in repo-able Treasuries when all is said and done?

MachoMan's picture

In a fractional reserve world, why would you presume there is a haircut?