Collateral Transformation: The Latest, Greatest Financial Weapon Of Mass Destruction

Tyler Durden's picture

Back in 2002 Warren Buffet famously proclaimed that derivatives were ‘financial weapons of mass destruction’ (FWMDs). Time has proven this view to be correct. As The Amphora Report's John Butler notes, it is difficult to imagine that the US housing and general global credit bubble of 2004-07 could have formed without the widespread use of collateralized debt obligations (CDOs) and various other products of early 21st century financial engineering. But to paraphrase those who oppose gun control, "FWMDs don’t cause crises, people do." But then who, exactly, does? And why? And can so-called 'liquidity regulation' prevent the next crisis? To answer these questions, John takes a closer look at proposed liquidity regulation as a response to the growing use of 'collateral transformation' (a topic often discussed here): the latest, greatest FWMD in the arsenal.


Submitted by John Butler of The Amphora Report,

Back in 2006, as the debate was raging whether or not the US had a mortgage credit and housing bubble, I had an ongoing, related exchange with the Chief US Economist of a large US investment bank. It had to do with what is now commonly referred to as the ‘shadow banking system’.

While the debate was somewhat arcane in its specifics, it boiled down to whether the additional financial market liquidity created through the use of securities repo and other forms of collateralized lending were destabilizing the financial system.

The Chief US Economist had argued that, because US monetary aggregates were not growing at a historically elevated rate, the Fed was not adding liquidity fuel to the house price inflation fire and that monetary policy was, therefore, appropriate. (Indeed, he denied that the rapid house price inflation at the time was cause for serious concern in the first place.) I countered by arguing that these other forms of liquidity (eg. securities repo) should be included and that, if they were, then in fact the growth of broad liquidity was dangerously high and almost certainly was contributing to the credit+housing bubble.

We never resolved the debate. My parting shot was something along the lines of, “If the financial markets treat something as a money substitute—that is, if the incremental credit spread for the collateral providing the marginal liquidity approaches zero— then we should treat it as a form of de facto money.”

He dismissed this argument although I’m not sure he really understood it; at least not until there was a run on money-market funds in the wake of the Lehman Brothers bankruptcy in November 2008. It was at that point that economic officials at the Fed and elsewhere finally came to realize how the shadow banking system had grown so large that it was impossible to contain the incipient run on money-market funds and, by extension, the financial system generally without providing explicit government guarantees, which the authorities subsequently did.

This particular Chief US Economist had previously worked at the Fed. This was and remains true, in fact, of a majority of senior US bank economists. Indeed, in addition to a PhD from one of the premiere US economics departments, a tour of duty at the Fed, as it were, has traditionally been the most important qualification for this role.

Trained as most of them were, in the same economics departments and at the same institution, the Fed, it should perhaps be no surprise that neither the Fed, nor senior economists at the bulge-bracket banks, nor the US economic academic and policy mainstream generally predicted the global financial crisis. As the discussion above illuminates, this is because they failed to recognize the importance of the shadow banking system. But how could they? As neo-Keynesian economists, they didn’t—and still don’t—have a coherent theory of money and credit.[1]


Time marches on and with lessons learned harshly comes a fresh resolve to somehow get ahead of whatever might cause the next financial crisis. For all the complacent talk about how the “recovery is on track” and “there has been much economic deleveraging” and “the banks are again well-capitalized,” the truth behind the scenes is that central bankers and other economic officials the world over remain, in a word, terrified. Of what, you ask? Of the shadow banking system that, I believe, they still fail to properly understand.

Two examples are provided by a recent speech given by Fed Governor Jeremy Stein and a report produced by the Bank of International Settlements (BIS), the ‘central bank of central banks’ that plays an important role in determining and harmonising bank regulatory practices internationally.
The BIS report, “Asset encumberance, financial reform and the demand for collateral assets,” was prepared by a “Working Group established by the Committee on the Global Financial System,” which happens to be chaired by none other than NYFed President William Dudley, former Chief US Economist for Goldman Sachs. (No, he is not the Chief US Economist referred to earlier in this report, although as explained above these guys are all substitutes for one another in any case.) [2]

In the preface, Mr Dudley presents the report’s key findings, in particular “evidence of increased reliance by banks on collateralized funding markets,” and that we should expect “[t]emporary supply-demand imbalances,” which is central banker code for liquidity crises requiring action by central banks.

He also makes specific reference to ‘collateral transformation’: when banks swap collateral with each other. This practice, he notes, “will mitigate collateral scarcity.” But it will also “likely come at the cost of increased interconnectedness, procyclicality and financial system opacity as well as higher operational, funding and rollover risks.”

Why should this be so? Well, if interbank lending is increasingly collateralized by banks’ highest quality assets, then unsecured creditors, including depositors, are being de facto subordinated in the capital structure and are highly likely to ‘run’ at the first signs of trouble. And if banks are holding similar types of collateral that suddenly fall in value, then they can all become subject to a run at the same time, for the same reason.

Collateral transformation is thus a potentially powerful FWMD. But don’t worry, the BIS and other regulators are on the case and doing the worrying. As a belated response to the financial crisis that they all failed to foresee, the latest, greatest trend in financial system oversight is ‘liquidity regulation’. Fed Governor Jeremy Stein explains the need for it thus:

[A]s the financial crisis made painfully clear, the business of liquidity provision inevitably exposes financial intermediaries to various forms of run risk. That is, in response to adverse events, their fragile funding structures, together with the binding liquidity commitments they have made, can result in rapid outflows that, absent central bank intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether. And fire sales and bank failures–and the accompanying contractions in credit availability–can have spillover effects to other financial institutions and to the economy as a whole. Thus, while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because, although they bear all the costs of this buffer stocking, they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure. It is this externality that creates a role for policy. [3]

Ah yes, wouldn’t you know it, that ubiquitous, iniquitous enigma: market failure. Regulators have never found a market that doesn’t fail in some way, hence the crucial need for regulators to prevent the next failure or, at a minimum, to sort out the subsequent mess. In the present instance, so the thinking behind liquidity regulation goes, prior to 2008 the regulators were overly focused on capital adequacy rather than liquidity and, therefore, missed the vastly expanded role played by securitised collateral in the international shadow banking system. In other words, the regulators now realise, as I was arguing back in the mid-2000s, that the vast growth in shadow banking liquidity placed the stability of the financial system at risk in the event that there was a drop in securitised collateral values.

In 2007, house prices began to decline, taking collateral values with them and sucking much of the additional, collateral-based liquidity right back out of the financial system, unleashing a de facto wave of monetary+credit deflation, resulting in the subsequent financial crisis. But none of this was caused by ‘market failure’, as Governor Stein contends. Rather, there is another, simpler explanation for why banks were insufficiently provisioned against the risk of declining collateral values, yet it is not one that the regulators much like to hear, namely, that their own policies were at fault.

In one of my first Amphora Reports back in 2010 I discussed in detail the modern history of financial crises, beginning with the 1980s and concluding with 2008. A pattern rapidly becomes apparent:

[Newton’s] third law of universal motion was that for each and every action there is an equal and opposite reaction. While applicable to the natural world, it does not hold with respect to the actions of financial markets and the subsequent reactions of central banks and other regulators. Indeed, the reactions of regulators are consistently disproportionate to the actions of financial markets. In sinister dialectical fashion, the powers assumed and mistakes made by policymakers tend to grow with each crisis, ?thereby ensuring that future crises become progressively more severe...


[W]as the Fed’s policy reaction to the 1987 crash proportionate or even appropriate? Was it “an equal but opposite reaction” which merely temporarily stabilised financial markets or did it, in fact, implicitly expand the Fed’s regulatory role to managing equity prices? Indeed, one could argue that this was merely the first of a series of progressively larger “Greenspan Puts” which the Fed would provide to the financial markets during the 18 years that the so-called “Maestro” was in charge of monetary policy and, let’s not forget, bank regulation...


By the late 1980s, a huge portion of the S&L industry was insolvent. The recession of 1990-91, made a bad situation worse. FSLIC funds were rapidly depleted. But a federal guarantee is supposed to be just that, a guarantee, so Congress put together a bailout package for the industry. A new federal agency, the Resolution Trust Corporation (RTC), issued bonds fully backed by the US Treasury and used the proceeds to make insolvent S&L depositors whole...


In retrospect, the entire S&L debacle, from its origins in regulatory changes and government guarantees, through the risky lending boom, bust, credit crunch and fiscal and monetary bailout can be seen as a precursor to the far larger global credit bubble and bust of 2003-2008: Just replace the S&Ls with Fannie/Freddie and the international shadow banking system. But there is no need to change the massive moral hazard perpetrated by incompetent government regulators, including of course the Fed, and the reckless financial firms who played essentially the same role in both episodes.[4]

Notwithstanding this prominent pattern of market-distorting interest-rate manipulation, guarantees, subsidies and occasional bailouts, fostering the growth of reckless lending and other forms of moral hazard, the regulators continue their self-serving search for the ‘silver bullet’ to defend against the next ‘market failure’ which, if diagnosed correctly as I do so above is, in fact, regulatory failure.

Were there no moral hazard of guarantees, explicit or implicit, in the system all these years, the shadow banking system could never have grown into the regulatory nightmare it has now become and liquidity regulation would be a non-issue. Poorly capitalised banks would have failed from time to time but, absent the massive systemic linkages that such guarantees have enabled—encouraged even—these failures would have been contained within a more dispersed and better capitalised system.

As it stands, however, the regulators’ modus operandi remains unchanged. They continue to deal with the unintended consequences of ‘misregulation’ with more misregulation, thereby ensuring that yet more unintended consequences lurk in the future.


In his speech, Governor Stein also briefly mentions collateral transformation, when poor quality collateral is asset-swapped for high quality collateral. Naturally this is not done 1:1 but rather the low quality collateral must be valued commersurately higher. In certain respects these transactions are similar to traditional asset swaps that trade fixed for floating coupons and allow financial and non-financial businesses alike to manage interest rate and credit risk with greater flexibility. But in the case of collateral transformation, what is being swapped is the principal and the credit rating it represents, and one purpose of these swaps is to meet financial regulatory requirements for capital and, in future, liquidity.

An obvious consequence of such collateral transformation is that it increases rather than decreases the linkages in the financial system and thus in effect replaces firm-specific, idiosyncratic risk with systemic risk, exactly the opposite of what the regulators claim they are trying to do by increasing bank regulatory capital ratios. Liquidity regulation is an attempt to address this accelerating trend and the growing systemic risks it implies.

Those financial institutions engaging in the practice probably don’t see things this way. From the perspective of any one institution swapping collateral in order to meet changing regulatory requirements, they see it as necessary and prudent risk management. But within a closed system, if most actors are behaving in the same way, then the net risk is not, in fact, reduced. The perception that it is, however, can be dangerous and can also contribute to banks unwittingly underprovisioning liquidity and undercapitalizing against risk.

Viewed system-wide, therefore, collateral transformation really just represents a form of financial alchemy rather than financial engineering. It adds no value in aggregate. It might even detract from such value by rendering opaque risks that would otherwise be more immediately apparent. So I do understand the regulators’ concerns with the practice. I don’t, however, subscribe to their proposed self-serving remedies for what they perceive as just another form of market failure.


Already plagued by the ‘Too Big to Fail’ (TBTF) problem back in 2008, the regulators have now succeeded in creating a new, even more dangerous situation I characterise as MAFID, or ‘Mutual Assured FInancial Destruction.’ Because all banks are swapping and therefore holding essentially the same collateral, there is now zero diversification or dispersion of financial system risk. It is as if there is one massive global bank with thousands of branches around the world, with one capital base, one liquidity ratio and one risk-management department. If any one branch of this bank fails, the resulting margin call will cascade via collateral transformation through the other branches and into the holding company at the centre, taking down the entire global financial system.

Am I exaggerating here? Well, if Governor Stein and his central banking colleagues in the US, at the BIS and around the world are to be believed, we shouldn’t really worry because, while capital regulation didn’t prevent 2008, liquidity regulation will prevent the scenario described above. All that needs to happen is for the regulators to set the liquidity requirements at the right level and, voila, financial crises will be a thing of the past: never mind that setting interest rates and setting capital requirements didn’t work out so well. Setting liquidity requirements is the silver bullet that will do the trick.

Sarcasm aside, it should be clear that all that is happening here is that the regulators are expanding their role yet again, thereby further shrinking the role that the markets can play in allocating savings, capital and liquidity from where they are relatively inefficiently utilized to where they are relatively more so. This concept of free market allocation of capital is a key characteristic of a theoretical economic system known as ‘capitalism’. But capitalism cannot function properly where capital flows are severely distorted by regulators. Resources will be chronically misallocated, resulting in a low or possibly even negative potential rate of economic growth.

The regulators don’t see it that way of course. Everywhere they look they see market failure. And because Governor Stein and his fellow regulators take this market failure as a given, rather than seeking to understand properly how past regulatory actions have severely distorted perceptions of risk and encouraged moral hazard, they are naturally drawn to regulatory ‘solutions’ that are really just plagiarised copies of an old playbook. What is that definition of insanity again, about doing the same thing over and over but expecting different results?


[1] Neo-Keynesians will deny this, claiming that their models take money and credit into account. But they do so only to a very limited extent, with financial crises relegated to mere aberrations in the data. The Austrian economic school of Menger, Mises, Hayek, etc, by contrast, has a comprehensive and consistent theory of money and credit that can explain and even predict financial crises.
[2] The entire paper can be found at the link here (PDF).
[3] This entire speech can be found at the link here.
[4] FINANCIAL CRISES AND NEWTON’S THIRD LAW, Amphora Report Vol. 1 (April 2010). The link is here.

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Xibalba's picture

blaming the 'gun' is like like blaming the beer for that drunk driver.

DoChenRollingBearing's picture

This is a great time to neither lend nor borrow.  Lending & borrowing are for optimists...  The Bank of Sealy should hold, say, three months of expenses if possible.

CPL's picture

In hard collateral assets.  After three months they should sell the clothes off their backs.

Stoploss's picture

All i know is if you want to know which market is going to crater next, find out which one involves the little CDO bitch, and there's your next mark.

jmc8888's picture

Except a gun is necessary and has an actual legitimate purpose.

Derivatives don't. Even the hedging answer is pretty much bullshit.

Derivatives were made to enable squeezing money out of people in a fun brand new way. 


The entire point about derivatives is to exploit others. 

So blaming derivatives is like blaming derivatives.  It's a fake product designed to screw.  So them being used to screw is not the same as beer.  Beer wasn't made for drunk drivers.  Derivatives were created to bankrupt everyone else.

That's why there was Glass-Steagall (to protect against any such thing), and why we need to return to it.

Glass-Steagall destroys everything the oligarch wants, and protects everything REAL that would be crushed, transferred, or otherwise bailed-in.

Derivatives are not beer, so yes lets blame the 'product' that was designed from the beginning to exploit.  They were never legitimate.

So lets skip the sophistry and actually address the issue. Derivatives were made to bankrupt you and me and everyone we know. Are we really going to argue that a product that was designed to do nothing but that somehow has a legitimate other purpose?  BS. 

Pass Glass-Steagall or you will be bankrupt.  They will take your money, to satisfy their derivatives claims.  No, they aren't legitimate.

Just like a rape-o-matic, if there was ever such a device to be created.  It would not have a legitimate use, since all it would do is rape.  So under such a scenario should we allow a rape-o-matic because it's the person using it, not the machine itself?  Or should we realize that there are only bad uses with no good coming from a rape-o-matic, and keep it from being allowed?

Well if we don't pass Glass-Steagall, you'll see how badly the derivatives will rape you.

sgt_doom's picture

jmc8888 makes a number of intelligent points; wish I could say the same for this blog posting!

This blog post does make a few intelligent points, but it also fails to state the obvious and comes off relatively obfuscatory and murky.

Also, William Dudley, it should be noted, is a longstanding member of the Group of Thirty, the outfit which speaks on behalf of the speculators/banksters:

(take a close look at all the members at the site above, please)

founded by the Rockefeller Foundation in 1978.

Simply put, the entire housing/mortgage fraudclosure, while crucial as yet another tool of wealth theft/transfer, is almost besides the point:  it was ultra-leveraging, ultra-leveraged speculation and ultra-leveraged insurance swindles responsible for all this.

The top perpetrators can declare bankruptcy, shifting their debt onto the public, while the public can't declare bankruptcy, thanks to the Bush Administration's passage of that bankruptcy bill in 2005, the one with the amendment giving preferential treatment --- according them first right to assets --- to the bondholders, derivatives dealers, banksters, thereby dramatically increasing wealth concentration through wealth theft.

They can declare bankruptcy, shifting their (the banksters/hedge fundsters, etc.) debt onto the public, and then the Fed, via QEI, II, III . . ., can buy up their toxic assets (worthless credit derivatives), furthering shifting their debt onto the public.  (A bit more abstract, but essentially the same principle at work.)

Blog posts such as this forever avoid stating the real problem, instead act as a form of almost redirection or misdirection!

escargot's picture

Not a lot of chicks in that group of 30.  Talk about a sausage hang.  Cocktail weinies, methinks...

lordbyroniv's picture

Gotta admit...


I am fucking depressed of late.





CPL's picture

<manly internet hug>  

Two cannibals are sitting and eating a clown.  One turns to the other and asks "Does this taste funny to you?". 

Tinky's picture

John Kerry walks into a bar and the bartender says "Hey – why the long face?"

Dealer's picture

You guys are funny.

Jam Akin's picture

An Irishman, A Chinaman and a Cheesepope walk into a bar...

gtb's picture

Why the fuck would anyone be depressed?  We're in yet another recovery summer, the country will soon have gay marriage, and we're gonna grant amnesty to some 20 fucking million illegal aliens.  It doesn't get any better than this.

sgt_doom's picture

So, to sum it all up:  they are granting amnesty to millions of gay illegal aliens who are in recovery and may or may not be pro-choice and pro-gun control?? ??? ???

MeelionDollerBogus's picture

(Willy Mays voice): But wait THERE'S MORE!
Soon you can have your neighbors put in prison for ter'rism without evidence or charges,
they can do it to you too,
and you can all enjoy fresh hollow-points (instead of hollow comments) at your nearest FEMA camp care of DHS!
Call right now and you can get not one but TWO helpings of hollow-points! Offers valid while limited* supplies last!
(*if you call a billion rounds limited)

DeadFred's picture

We are living in a time of increasing international tension. Is there any evidence to suggest that regulators are even considering the possibility of a deliberate outside attack on the financial system? Most immediately if the fools in charge decide the US must impose freedom on the Syrians what can Russia and China do to the system that funds the war machine? This is beyond me to figure out but still I wonder.

sgt_doom's picture

Is there any evidence to suggest that regulators are even considering the possibility of a deliberate outside attack on the financial system?

Huh?  Dood!  Not to worry, all the attacks so far have originated from Ground Zero:  Wall Street!


The Invisible Foot's picture

The profit motive causes people to make these problems, why? because it pays too.

WonderDawg's picture

Nothing wrong with making an honest profit, that's what capitalism is all about, and whether you realize it or not, capitalism (free markets) was a critical mechanism in the evolution of civilizations and advanced societies. Desire for honest profits is a good thing. It's the mother of innovation. What we have, instead, is theft rather than honest profit-making, and it's based on moral hazard. The banking institutions keep the profits and tax-payers are forced to soak up the losses for their reckless and predatory practices. Big, huge difference between theft and profits.

disabledvet's picture

again "the call option" is when you dial Senator Schumer et al and "the put option" is when they ask for money back. of course if you get the busy signal i hope you have a Plan B. The Government has been very busy now cleaning up many other messes in addition to your own from "back when." And the American people really aren't happy campers right now.

smacker's picture

"But to paraphrase those who oppose gun control, "FWMDs don’t cause crises, people do."


Those who misuse the destructive power of a gun are subject to the Rule of Law.

Those who misuse the destructive power of FWMD apparently are not subject to the Rule of Law. They get taxpayer bail-outs instead.

SKY85hawk's picture

See jonnie corzine and his friends at the CFTC!


Whiner's picture

The Fed's 200 plus economists led by Bernankie Book Boy missed the tsunami of 2008, but they got our backs now. Love the vigilance. Do these men sup with Gods?

beaker's picture

So where do we hide????

Downtoolong's picture

That’s the real beauty of gold. Not its luster, but how it eliminates all black swans but one. That would be some amazing alchemist actually figuring out how to make it out of junk.

The central bankers of the world only think they’ve done it.    







SKY85hawk's picture

Inverse etf's have interesting charts in summer 2010, 2011 and 2012  Look at ERY (short energy) FAZ (short Financial).   I'm working on switching to the long side ERX & FAS when the shorts bottom.  The longs have been in charge since May 2009.

For right now, the longs peaked at 5/21/2013.  Will the POMO continue annnnd suceed?

MeelionDollerBogus's picture

before you do that open up Libreoffice or excel, go to and add all the related symbols to one chart.
Download the data (harddisk platters icon), build yourself a scatterplot graph.
Make sure you can measure the decay time frame (looks like a falling leaf tracing through the air) reliably on the graph.
This shows you the true "value" of an inverse ETF. The less it wanders the steadier the value. The value itself would be computed from the best-fit curve.
The best-fit curve keeps "moving" over time with bad decay.
That's why inverse ETF's can be a trap. Often -4x slope is detected short-term with vxx vs spy for example.
HOWEVER, over a longer time a +11x (not negative!) happens as the slope drifts. This means instead of getting inverse gains over months or years you actually get vxx down no matter what spy's performance is.
These kinds of charts are critical to make the right choice (which may be to stay out).
My scatterplot is out of date because I haven't been accumulating any.
I still may but I will re-chart it before I decide how much gain is possible & therefore how much risk should be put on the table, if any.

Given what I already expect of SPY (s&p500 closely correlated) I think we could buy at lower prices & see big gains only after those (vxx)lows (from SPY near 180):

SKY85hawk's picture

I am reminded of the Doctoring profession.  They're all PRACTICING medicine.  I want a Medical Advisor that KNOWS WHAT THEY ARE DOING!

-           The effectiveness of monetary policy was last discredited in the 1970s. The persistent attempts to revive growth with easy money led to stagflation.  The real world has turned to be opposite to the favored positions of the economics profession: the financial market is not only inefficient but systematically bubble-prone. 

Trying to bring back yesterday through monetary growth will eventually bring inflation, not growth.  This is what the Gov’t wants in order to ‘pay off the Debt’. 


Who remembers the 70's? 

It was a time of Stagflation.

The 'Bob Hope" generation entered their 'spend less-save more' life stage.  OUR Parents!

It should be clear that the baby-boom is in the same life-stage.

Not one Politician will admit they are helpless to restart Economic Growth! 

They will wait this thing out, just like before.

Even if it takes 11 to 15 years!

Perhaps much longer, if the gummint doesn't stop choking the life out of human initiative.

Sigh,  ,     ,       .

msmith9962's picture

Reading When Money Dies right now.  Lots of scary parallels.

Seal's picture

my definition of insanity is doing the same thing over and over expecting THE SAME  result

akak's picture

Does that mean that masturbating is insanity?

akak's picture

Why, did you spit out the first one?

msmith9962's picture

You two work well together.

ebworthen's picture

A guy walks into a bar.
He asks the bartender for a shot of whiskey.
The bartender asks 'Why?' The guy responds and says 'I got my first blow job.'
The bartender says 'In that case I'll give you two shots of whiskey.'
The guy says 'No, I just want one to get the taste out of my mouth.'  "

ebworthen's picture

One need only look to the 20% spikes in home prices in cities that absolutely got crushed in 2008 to see this is Bubble II.

There is no self-sustaining recovery or Food Stamps and debt would not be at all time highs.

There is no "there" there; just more leveraged trades.

buzzsaw99's picture

It would get very interesting if rates did somehow rise significantly with all the IR swaps and other interest rate manipulating derivatives out there. For that reason it will not be allowed to happen, but still, it would be fun to watch.

Bastiat's picture

Thanks very much for this.  I've been trying to figure out the repeated references to "It's all about collateral."

This risk seems to be this: the "pricing" of the swaps i.e. haircutting the inferior collateral, is based on assumptions that are either a) not realistic because of the need to hide impaired institutions (with a wink and nod from the CBs, of course) or b) vulnerable to fat tail risk, where the risk collateral spreads blow up in a crisis.

One question: are these swaps actual changes in title to the collateral or are they like flex repos with mark to market provisions and other covenants?

Thanks again.


Bastiat's picture

Essentially it's just a matter of over leveraged banks loaded with bad paper playing an elaborate shell game. 

Paracelsus's picture

All that toxic MBS crap that the FED has on their books is gonna explode if interest rates rise.Some of that crap will be commercial MBS like shopping malls and such.With a major downturn in consumer spending,those shopping malls will be empty.The FED like other institutions needs to mark to reality on this stuff.But to do that would be getting the worlds biggest haircut.Simply put,when a major European bank goes south,the FED won't be able to help.Endgame....

MeelionDollerBogus's picture

Already empty. REIT's & private investors are already scrambling to fill spaces, cut painful deals to get occupancy & are still facing taxes and repairs. They can kiss goodbye revenue for the next 2-5 years at least.

Stuck on Zero's picture

Aaaarrrgh! We can't have free market allocation of capital.  Who would loan $780K to vagrants to buy mansions?  Who would drop $12.6 trillion into insolvent banks run by gangsters?  Who would loan $260K to a student who wants to study gangsta rap?  Oh the humanity.


Atticus Finch's picture

Ok, so it was the regulators who caused the financial crisis. I get it!

blindman's picture

economic growth, there that term again.

q99x2's picture

Banks need banks. People don't.

theprofromdover's picture

Just re-assert the fact the a CDO is not an enforceable contract, just a business arrangement.

That'll take the heat out of the shadow banking system (might turn it into a smelly liquid tho')

Captain Willard's picture

This article confuses a feature with a bug.

The collateral shell game is a means for the Fed and the financial system to keep bank profits up and to avoid de-levering of balance sheets in the aggregate. I cannot believe an author this sophisticated doesn't realize that the Fed understands this issue perfectly.

Ever since the Lehman "Repo 105" fiasco, every bank analyst and Fed regulator is aware of collateral transformation.

Of course, with $3 trillion of high-quality collateral on the Fed balance sheet, I would suggest they're well in charge and I wouldn't be surprised to see them lend this collateral to their favorites if any problems should arise. This will not end with a bang, as the author suggest, but a whimper. Despite all the shadow lending, this corrupt system simply cannot produce growth.


flow5's picture


Nobody at the Fed understands.  The reference to the origins (1980-90's S&L debacle) was wrong.  It began with the 1966 S&L crisis.  No, it began with Keynes himself - in almost every instance in which Keynes wrote the term bank in the General Theory it is necessary to substitute the term financial intermediary in order to mke his statements correct.

Remember the caveat is: POMOs between the FRB-NY & the CBs create reserves, & POMOs between the CBs & the non-banks create new money. I.e., if you lower IOeR, then the CBs will buy securities from the non-banks (as they always did between 1942 & 2008).

In other words the eligible securities the "desk" bought were owned by the CBs (not the NBs). Ergo, the NB's ownership of wholesale funding was largely transferred to the CBs before the Fed acquired any SOMA securities - or the NBs funding sources couldn't be renewed or matured, etc. (that's dis-intermediation, not deleveraging). I.e., directly or indirectly, the NBs assets fell by c. 6 trillion while the CBs assets have offset roughly half that decline (grew by c. 3.6 trillion).