Desperately Seeking $11.2 Trillion In Collateral, Or How "Modern Money" Really Works
Over a year ago, we first explained what one of the key terminal problems affecting the modern financial system is: namely the increasing scarcity and disappearance of money-good assets ("safe" or otherwise) which due to the way "modern" finance is structured, where a set universe of assets forms what is known as "high-quality collateral" backstopping trillions of rehypothecated shadow liabilities all of which have negligible margin requirements (and thus provide virtually unlimited leverage) until times turn rough and there is a scramble for collateral, has become perhaps the most critical, and missing, lynchpin of financial stability.
Not surprisingly, recent attempts to replenish assets (read collateral) backing shadow money, most recently via attempted Basel III regulations, failed miserably as it became clear it would be impossible to procure the just $1-$2.5 trillion in collateral needed according to regulatory requirements.
The reason why this is a big problem is that as the Matt Zames-headed Treasury Borrowing Advisory Committee (TBAC) showed today as part of the appendix to the quarterly refunding presentation, total demand for "High Qualty Collateral" (HQC) would and could be as high as $11.2 trillion under stressed market conditions.
In short, there is a unprecedented "quality" collateral shortage (for more on what the definition of quality is, read on).
And since the topic of HQC scarcity only emerges when market conditions are stressed, one can ignore the TBAC's baseline case of normal conditions, which see a topline of collateral requirements of "only" $5.7 trillion. Needless to say that if not even the Basel III required asset/collateral creation of $1-$2 trillion was a failure, even the base case requirement would never be satisfied.
The bigger picture however is one of an ever-growing asset-liability mismatch, as happened during the Lehman collapse. Since there is a total excess of shadow money and other liabilities already created that may need up to $11.2 trillion in collateral at any one moment for full book netting (which incidentally is based on SFAS-140 accounting rules which are self-contradicting), the only hope for the financial system is to chug along for the next decade without major risks and tremors, and slowly create the much needed high quality collateral.Or such is the hope.
Furthermore, since the private sector still appears to be in a state of shock from the Great Financial Crisis, collateral creation is all but halted. In the purely physical sense this is further aggravated by the lack of private sector CapEx investment, whereby corporations refuse to spend in order to procure hard assets, which may then be transformed into HQE via assorted lending pathways ending up on bank balance sheets indirectly, and then be further absorbed by the financial system providing even more quality collateral.
Intuitively this should make sense: while private sector companies can create unlimited balance sheet liabilities courtesy of the ZIRP-enforced scramble for yield, which means any and all debt can be issued without limits, it is the use of funds that is critical, and it is here that companies have been failing desperately because as also explained previously, instead of investing the newly created cash in CapEx and PP&E due to the Fed's disastrous policies, management teams use the company as a toll, with the cash promptly dividended out or used for buybacks and other short-term shareholder benefiting transactions, not growing corporate assets in any way, and certainly not creating any secured liabilities, only unsecured. Sadly the liabilities thus created are of such low quality that they can not result in HQC replacement, and instead are merely a levered equity extraction out of the private sector which implies an even greater explicit private sector risk without offsetting asset creation (the matching accounting entry is a reduction in shareholder equity which does nothing for system collateral).
As a result of this unwillingness or inability of the private sector to create quality collateral, which could then become someone else's quality asset and so on up the fractional reserve repo chain, it is all up to the Fed.
The TBAC acknowledges as much when it says that all QE is, is a "transformation of non-cash HQC to cash HQC." Stated otherwise, in addition to all its other practical QE roles, such as monetizing the US debt, and enforcing the wealth effect as Primary Dealers repo out QE reserves and use the barely haircut cash to purchase risk assets (instead of engaging in loan creation), what QE is also doing, via reserve transformation through the monetization of Treasury debt and MBS a topic we have also explained previously, is to inject into the financial system, billion after billion and trillion after trillion, the "safe assets" that banks will need to fall back on if and when the risk flaring episode comes, and there is a scramble for quality assets.
An immediate implication is that should the private sector continue to hold back on collateral creation via such "Old Normal" conduits that feed the shadow money system, such as securitizations and repo expansion, it will be up to the Fed to inject up to the $11 trillion in additional HQC before the financial system is proclaimed safe. This means QE will continue for a loooooooong time.
Another implication is that finally, after years of confusion, someone gets it. Gets what? This:
"Effective money = shadow money + M2"
This is precisely the point we have been making for the past three years in all those posts focusing on the relative moves in the US shadow banking system, i.e., shadow money, and which virtually none of the current monetarists (and by extension Keynesians) seem able to grasp since all textbooks on monetary theory appear to be from the 1980s when shadow liabilities, repo and custodian assets simply did not exist. They do now, and certainly did in 2008 when they reached a record of $21 trillion (give or take, depending on one's definition of shadow money), double what M2 was.
Of course, our definition is more granular and is simply the sum of all credit money liabilities held by the traditional banking system, to which we add the money held in the shadow banking system - money that is literally created in a limbo where "confidence" is really the only collateral, and is why the Fed is, more than anything, terrified about what the next market collapse will do to the shadow banking system which unlike 2008, will almost certainly experience a terminal run on the liabilities as there is no effective collateral!
What all of the above means, is that when considering quality collateral, one has to consider the amount of all liabilities in existence - both conventional and shadow! And it is this shadow delta of $15 trillion that is always ignored and/or forgotten by everyone except those who know quite well that any reminder of the massive delta can lead to an instant deep freeze of confidence in the system.
Because what it means is that as the Treasury's own advisor has said, there is a $11.2 trillion undercapitalization gap in the consolidated financial system, a gap which can only be filled by the Fed over a period of years.... an assumption which means that the market has to not only be priced to perfection for years, but that the Fed will not lose control over not only the US market but that the MIT-BIS diaspora will keep the entire G-7 capital markets in check for the duration of this experiment. Of course, it won't be the first time the Fed and the capital markets have made the fatal assumption that a handful of academics with zero real world experience can contain several hundred trillion in unforeseen consequences.
So just what does the TBAC define by "high quality collateral"? Hint: there is no mention of the word gold anywhere so don't go getting any ideas. Of course, for the Treasury and its advisors, even the mere concept that a barbarous relic may have more "quality" than paper-created "assets" is preposterous. We can only imagine the intellectual bloodbath that would result if any of them were ever exposed to the Exter pyramid...
Anyway: here are is how the "very serious people" in the establishment see "HQC"...
Money-like assets, with little credit, duration and liquidity risk.
Anything Bernanke says is a high quality asset (until it isn't of course):
This one is really funny: "an asset not expected to depreciate" - like housing:
Anything that has low haircuts... Just because banks look at where other banks mark them, and a result in 2007 give a 5% haircut on a BBB+ rated CDO tranche just before it blows up with zero recovery.
Now we get to the important part: what is the total demand for high quality collateral? Based on back of a napkin calculations, somewhere between $2.6 and $11.2 trillion!
Demand comes from regulatory requirements such as Basel III (since mothballed, as it became quite clear not even the $1.0 trillion in minimum collateral needed could not be sequestered).
Another demand driver: standardized clearing of derivatives which will require a far higher Initial Margin as well as, knock on wood, the end of collateral rehypothecation. Incidentally the latter is precisely why central clearing as designed will never fly, as rehypothecating what passes for safe assets now is the primary source of incremental collateral 'creation':
Another demand source: bilateral margin requirements for non-central clearing transactions. The reason why up to $4.1 trillion in additional collateral is needed here is precisely why gross is never net, until it is, and one the weakest link in the bilateral chain of counterparties breaks, forcing immediate gross netting without offsets. A fact so simple, that only the smartest people in the room always tend to forget it.
Finally, the most intangible demand source of all: economic uncertainty, and "flight to quality" - or in other words, the fudge factor for the unpredictable. The $1 trillion estimate provided here is very arbitrary, and the real number may be less, but likely will be orders of magnitude greater as the real life example of the Exter pyramid collapse takes place in shadow space:
That takes care of the demand. Now, the far more thorny question: supply. And here is where the Fed comes into play.
Because the safest of safe collaterals in a fractional reserve banking system, in which money creation always falls back to the monetary authority, we have sovereign collateral creation. Yet where would sovereigns be without QE. As the TBAC itself says, in bold, black letters, "QE is a transformation of non-cash HQC to cash HQC" - said otherwise, without the Fed, which is indirectly facilitating the ramping of risk assets as we explained to Steve Liesman before, the Primary Dealers would be unable to buy stocks without the repo transformation of reserves which results in Dealers ending up with risky stocks instead. This is the closest to an admission of the above we have ever seen.
What happens next is the magic of rehypothecation. As the TBAC says, once issued, this sovereign "collateral", aka debt, or assets for the buyer, "35% of this amount is reused 2.5 times." This means that depending on the terms of the rehypo agreement: the haircut, the reuse velocity and other metrics, this could be the sole source of collateral if needed, especially when one adds the Fed in the equation.
One key aspect of central clearing houses and bilateral margin requirements would mean the end of the kind of rehypothecation that send MF Global into a liquidity tailspin. This means that up to $7.6 trillion in supply would be removed. Alternatively, and this is perhaps that biggest punchline: rehypothecation, which is nothing but the paper shuffling of a security from point A to point B to point C and back to point A again, provides up to $7.6 trillion in Schrodinger collateral: or securities which are there but aren't, and certainly not there if and when everybody demands delivery at the same time!
Remember rehypothecation does not mean the collateral is there. It is merely representing a counterparty can have access to said collateral.... eventually... maybe... possibly... in an ideal world in which no other counterparty has claims to the same collateral.
Putting it all together, it means that should the system finally wise up and remove the black box gimmick of rehypothecation which is literally "accounting magic" (and also financial fraud), the Fed and its peer central banks would need to fill a hole as large as $10 trillion!
Still think QE is ending ever?
So now that we understand the fine nuances of the impending collateral scarcity? Well, from a policy standpoint it means that as long as asset prices are rising, there is no fear of a collateral crunch. It is, after all, "procyclical"
Ever heard of the trivial saying "money is whatever people agree it is" - well, that's great. But problems emerge when one assumes houses are money. As the chart below shows, households chose to hold less cash during the last bubble as the "moneyness of houses rose. Sure enough, "when the moneyness fell, cash holdings rose abruptly." Still confused why the Fed is desperate reflate the housing bubble at any cost? Simple: it is the only lever left for the Fed to force households to not only spend, but to ramp up on credit.
So while we are on the topic of money, and in order to tie it all together, let's close the loop and introduce the final variable - Shadow Money. In this context, the TBAC has their own definition of shadow money: the value of outstanding bonds*(1-average repo haircut). In other words, if the repo haircut is zero, the outstanding shadow money stock is effectively double what the Treasury has issued. Confused why bonds sometimes appear like Giffen goods? This is why.
A visual example based on the TBAC's definition: there is now some $30 trillion in total public and private shadow money! Still think M2 is the full story?
And finally, vindication: proof that all those other 'experts' on money creation really have absolutely zero understanding of what money creation truly is. Putting it all together: Effective money = shadow money + M2. To wit:
The unprecedented amount of shadow money chasing "safe assets" explains one thing: why bond yields are where they are, and why the more bonds central banks issue, the lower yields will go. That is, of course, until the entire shadow world described above comes crashing down.
The one missing link in the above has been the absence of the private sector from collateral creation. The problem is that for the private sector to step up, confidence level has to be so high so as to no longer demand public sector QE-transformed collateral. But therein lies the rub: since the Fed's QE is pushing collateral into the market, not having it pulled, there is little demand for exogenous private sector collateral. And thus we have the close loop where more QE creates demand for more QE, even as the private sector is increasingly more closed out of the marketplace. Of course, for true capital formation, it is the private sector that would be responsible for all collateral. That however would imply risk of failure, and the elimination of a Risk Put, such as the global Bernanke Doctrine. In other words, welcome to the biggest Catch 22 possible (and conceived) in the centrally-planned universe the Fed has created for itself...
The next chart should be familiar to regular readers. It shows that when private sector collateral generation broke following the Lehman collapse, the Fed had to step in:
Yup: those who said Zero Hedge noted precisely this in "The Fed Has Another $3.9 Trillion In QE To Go (At Least)" back in September 2012, are absolutely correct.
And there you have it. All you have about money creation in textbooks, all fancy three letter theories that purport to explain the creation and reality of "Modern Money" are 100% wrong, because while they attempt to explain a theoretical world of money creation, what they all happen to forget and ignore is one simple thing: practical reality.
And practical reality is precisely what the TBAC had in mind when it wrote the above presentation of stark caution, because no matter what one says, there is a $11+ trillion collateral shortfall at any given second. A shortfall that can and will be triggered the second the central banks lose control of the financial system which every single day rests on a thread of stability.
Because the thought experiment we presented earlier can be extended one further: assume tomorrow the real black swan appears and all the liabilities: traditional and shadow, promptly demand collateral delivery. Well, the $11 trillion shortage would mean that risk values of, for example the S&P, would be haircut by a factor of, say, 75%. Or back to the proverbial 400 on the S&P500.
Still think owning real high quality collateral, not of the paper but of the hard asset variety such as gold, is a naive proposition, best reserved for fringe lunatic, tin foil hatters and gold bugs?
Go ahead then: sell yours.