Kyle Bass presented us with a preview of what to expect in his monthly letter in a David Faber interview yesterday; today he delivers the full monty with his extended analysis of "shortening collateral chains" in his latest investor letter - a topic that we have been discussing broadly ever since we starting focusing on Shadow Banking two years ago (and why, as we have been pounding the table, it is the central bankers' primary prerogative to offset the collapse in the shadow banking system more than anything), and narrowly, since the realization of how tenuous the rehypothecation system is. The below analysis leads Bass to come to the one logical conclusion: "As European leaders press forward with failed attempt after failed attempt to suppress borrowing costs, control spending, reduce deficits and prop up what the markets have already told us is a broken monetary system, the data tells us that the citizens of the most troubled and profligate nations are losing confidence in the Euro dream. Trust has been lost, confidence in the system is being lost, and the ultimate consequence of this break down - sovereign defaults —are imminent. We continue to move ever closer to a great restructuring of sovereign debt."
Highlights from "Collateral Chains Shortening - Prima Facie Evidence Of Distrust"
The IMF released a working paper in November highlighting the significant decline in source collateral for large dealers in the Post-Lehman world. In other words, dealers' clients (sovereign wealth funds, asset managers, etc.) are not making their excess collateral available for use and re-use by their prime brokers for securities lending or repo activities. The author, Manmohan Singh, is particularly insightful with regard to the length of the collateral chains and how they have shortened over the last few years. This shortening effectively reduces the amount of "grease" needed to keep a highly-levered financial system operating smoothly and is undoubtedly closely connected to the de-leveraging that is beginning in the European banks. Basically, participants no longer trust dealers (which is not surprising, considering the behavior cif players like MF Global?) to re-hypothecate collateral. The chart below neatly displays the new paradigm with regard to collateral movements and the increasing awareness by financial markets participants that their excess collateral is safer in the hands of a third-party custodian than in the hands cif their prime brokers. This is quite a statement given that up to an incremental 200 bps can be earned on excess collateral kept at a prime broker. Some large European funds are even beginning to shun European banks in the OTC marketplace. This pre-emptive action by asset managers is, in part, a natural response to the European Banking Association's failure to conducted [sic] truly robust stress tests. Case in point: Dexia, a Franco-Belgian bank, passed a prior stress test with flying colors and approximately 90 days later failed miserably. In fact, 190 billion euros was needed for Daxia's bad bank alone. The most recent stress tests proved to be meaningless even sooner than last year's tests.
Below is an illustration provided in the IMF paper which shows the traditional flow of collateral (on the left) versus the structure currently employed by many large market participants. The reference to "churn" in the Chart refers to a dealers ability to re-use (i.e. risk) excess collateral to generate positive yield for themselves.
The recent announcement of a coordinated G7 central bank action to increase the availability of currency swap lines at cheaper rates was an attempt to put into place facilities that will act as airbags for a marketplace that will likely disintegrate into a formless void of investor action, once multiple sovereign defaults begin. We believe the timing of the swap facilities announcement was specifically designed to forestall the impending failure of a large Eurozone bank facing a funding crisis. The announcement provided temporary relief to the funding markets, and the mini-crisis was seemingly averted. However, this soft of relief simply allows Europe's banks continue to pick the flowers while allowing the weeds to grow, by preventing any failure and restructuring but forcing ongoing deleveraging across the systEm. The majority of "good" collateral is already posted at the ECB for repo funding, so facing a dearth of available collateral, what would you expect the ECB to do? Naturally, they announced an expansion of eligible or "Tiffany" collateral and provided some relief on the cost of the repo transactions. The constant lowering of collateral requirements has encouraged European banks to pledge lower and lower quality collateral to the ECB which, over time, has seen its balance sheet expand to provide more than half a trillion euros of loans; placing the ECB's tiny capital sliver of 5 billion euros at ever greater risk.
As European leaders press forward with failed attempt after failed attempt to suppress borrowing costs, control spending, reduce deficits and prop up what the markets have already told us is a broken monetary system, the data tells us that the citizens of the most troubled and profligate nations are losing confidence in the Euro dream. Trust has been lost, confidence in the system is being lost, and the ultimate consequence of this break down - sovereign defaults —are imminent.
We continue to move ever closer to a great restructuring of sovereign debt.
Full letter can be read and downloaded here.