A simple macro model of collateral

Regulators are pushing for non-centrally cleared trades to be backed by high levels of collateral, such as cash or government bonds. This is where the $10tn figure comes in. It is the amount of extra collateral that could be required according to estimates by the International Swaps and Derivatives Association.

Here is the full FT article.  It stresses that figure of ten trillion may be too high an estimate, but a separate lower estimate still runs at $2 to $4 trillion.

Let’s play out the scenario.  In some future world, what if most savings is done by corporations and also by traders at the clearinghouse, in the form of collateral.  Collateral, however, is not “smoothed” across assets but rather is an either/or decision.  They won’t take your sheepdog as collateral, nor will they take shares in small tech companies.  Most of the saving is done in the form of approved safe assets and the rest of the economy is somewhat starved for investment.

I call it the return of financial repression.  Let’s see how far it is allowed to go.


"They won’t take your sheepdog as collateral, nor will they take shares in small tech companies." ... Too bad about the former, as it's easy give a sheepdog a haircut. Also is repression always bad? You didn't sign the phenomena but it might read as negative, at least here. I thought finance was one of your under-regualed, on balance, sectors. What's your better ideas?


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'I call it the return of financial repression. Let’s see how far it is allowed to go.'

You mean counterparties being able to rely on deals being backed by reliable collateral is now represssion?

Well, we saw how far the other way went - or have we already forgotten about AIG?

'On September 16, 2008, AIG suffered a liquidity crisis following the downgrade of its credit rating. Industry practice permits firms with the highest credit ratings to enter swaps without depositing collateral with their trading counter-parties. When its credit rating was downgraded, the company was required to post additional collateral with its trading counter-parties, and this led to an AIG liquidity crisis. AIG's London unit sold credit protection in the form of credit default swaps (CDSs) on collateralized debt obligations (CDOs) that had by that time declined in value.[25] The United States Federal Reserve Bank announced the creation of a secured credit facility of up to US$85 billion, to prevent the company's collapse by enabling AIG to meet its obligations to deliver additional collateral to its credit default swap trading partners. The credit facility provided a structure to loan as much as US$85 billion, secured by the stock in AIG-owned subsidiaries, in exchange for warrants for a 79.9% equity stake, and the right to suspend dividends to previously issued common and preferred stock.[18][26][27] AIG announced the same day that its board accepted the terms of the Federal Reserve Bank's rescue package and secured credit facility.[28] This was the largest government bailout of a private company in U.S. history, though smaller than the bailout of Fannie Mae and Freddie Mac a week earlier.[29][30]'


Yeah, AIG wasn't repressed - but it did manage to end up with some collateral to make its counterparties good. That collaterial being us. Or better said, U.S. taxpayers.

It is not just "being able to rely...on reliable collateral", it is being forced to do so. That is what makes it repressive--it prevents voluntary decisions to take on risk. Of course that is necessary when taxpayers are implicitly on the hook for any major financial failure. But lots of us have arguing that we should not be on that hook.

'But lots of us have arguing that we should not be on that hook.'

And yet, we were. Before the 'repression' of counterparty collateral. And do read that information - AIG required collateral to keep the entire financial system from slagging, because no one dared repress it with requiring anything but its own word that its credit was good.

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The fact is that many of the counterparties to AIG were banks who had used these arrangements to put risky assets into their capital base, thereby "faking" the capital they had backing their statutory obligations. All of this was "overlooked" by the Fed because they wanted so bad to believe that "regulation" was getting in the way of some fantasy world of corporate "good will". Everybody got in bed with AIG and they never had the resources to back up their position. The Fed choosing to abdicate its regulatory authority allowed a single major counterparty to collude with the banks to falsify their capitalizations is what got us into this mess.

The point is that if AIG had been required to properly collateralize their positions they probably never would have been able to assume the role that they did. This would have forced the banks to either not get involved in these shenanigans to the extent that they did, or it would have forced the market to diversify on the long side and thus, hopefully, spread out the risk sufficiently that one firm losing its rating wouldn't have resulted in the whole market collapsing.

Bringing back sensible regulatory oversight makes total sense.

But also, the government was already involved in the financial system (particularly the mortgage system) in ways that implicitly promised they were the ultimate backers of the system. If that were not the case, then the financial institutions would have been less likely to take on those risks, without any additional regulation.

Faced with the prospects of a "Great Depression"-scale financial cataclysm, or even the overnight failure of a major, regional industry... every government that desires to avoid mass unrest has an implicit obligation to do what it can to do something.

In some cases, that is to provide a social safety net. In other cases, it is to make temporary exceptions to regulations, or to negotiate on the behalf of industry. In some cases, it is to provide financing and support.

But more than all that, the government has a job to ensure that markets are run in an efficient and risk diversified manner so that "overnight calamity" doesn't happen in the first place.

That's one of the reasons why we have anti-trust laws. It's one of the reasons we need to have appropriate capitalization requirements.

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"reliable collateral"

I think the argument is that the state(s) may be trying to mask the unreliability of this debt by boosting it's prices.

One thing I don't understand is how QE "removes" collateral from the market. Doesn't it *swap out* the bond with cash? Can't the banks use that cash as collateral? Or is there some bond-repo-haircut vs. reserve ratio distinction in the system?

Case 1. No QE:
1. Sell mbs in repo market, get cash after haircut (a relatively big one if there is a lot of uncertainty surrounding the asset)
2. Invest cash, retain x% as required by reserve ratio.
Result: There are two haircuts in play. The first imposed by the market, the second imposed by central banks.

Case 2. QE:
1. Sell mbs outright. Get market value in cash.
2. Invest cash, retaining required reserve.
Result: A single haircut = more money available for investing.

Moreover, the assets are "removed from the market" because the risk that MBSs will sour is preemptively removed from the market (if they do sour, the government would likely have been on the hook-out via bailout, so in this scenario they are simply biting the bullet sooner rather than later, boosting confidence in the solvency of the system sooner rather than later).

This is my pedestrian impression.

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Best first move is to end privileged status of derivatives in the bankruptcy queue...

The "privileged status" of netting agreements (not derivatives) in bankruptcy follows from two well-established principles of bankruptcy: offset and the privileged status of secured creditors. The suspension of the automatic stay follows from those two principles and reflects the true economic nature of the transaction. It achieves the (nearly) identical end result more efficiently. I say "nearly" because you could argue that in some circumstances the ability to immediately seize collateral makes the non-defaulting secured party superior other secured creditors of the debtor, who may not in every case be made whole in the bankruptcy process.

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This would be a great first step. Why do these contracts have ultra super-senior priority over other contracts?

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I don't think we can return to a stable financial system without higher levels of collateral or lower levels of leverage. Call it repression if you will -- it sounds more like responsible regulation to me.

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"Best first move is to end privileged status of derivatives in the bankruptcy queue"

So, now, every time I want to enter into a derivative contracts for a bit of speculation, I've got to double-check and triple-check the credit-worthiness of my counter-party, knowing that, if it is a financial company, its balance sheet means little to nothing, given the stuff kept off balance sheet... And that's when financial companies are already supposed to take seriously counter-party risk. They were meant to prior 2007, I bet they are a bit more careful now - but nowhere near as much as needed.

Surely, bringing things on-exchange would be less painful and might actually be better from a liquidity standpoint.

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No, no, see, this is a brilliant idea. This creates the demand for an additional $10tn of reserves, allowing central banks to print an additional $10tn of money without velocity or inflation increasing. All of this money can be used to purchase government debt, thereby helping governments deleverage. It's win/win!

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If I take out a mortgage, and the bank requires a downpayment, that is repression.

If I am a bank and want to take in deposits with an FDIC guarantee, and the government requires me to have collateral, that is repression.

If I trade on an exchange, and the exchange requires that I have minimum collateral to support my trades, that is repression.

There is repression all around us.

Let Lehnman be FREE. Free the S&P 500.

"If I take out a mortgage, and the bank requires a downpayment, that is repression."

Strawman on the field!

The point is that the bank will be forced to require a downpayment at gunpoint. Ofcourse a smart bank would require. But that is the bank's decision to make, not the government.

I guess everything is repression.

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As I see it, advocating for small emerging business, another entirely new level of Barriers to Entry, as only the established players will have sufficient capital, to meet the collateral requirements.

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Won't matter if the returns to providing the services of 'non-centrally cleared' financial trades don't increase as a share of GDP.

Collateral is everywhere. Dealer financing. Trade financing. An agrarian bank will take my sheepdog as collateral. That's the whole point.

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Maybe someone can explain how this would work.

Derivatives are used in hedging, so take an example. A friend is involved in a business venture where they buy natural gas and produce urea for agricultural purposes (I think). They contract with JP Morgan for gas purchases, a set price and quantity over a set time. JP Morgan as intermediary, would contract with producers and distributors on the supply end. They hedge their risks in the transaction, anywhere from the buyer going bankrupt, to the producer not being able to produce, the price fluctuations, shortage, supply infrastructure failure, etc., by a derivative of some sort that would increase in value if the core transaction decreases. If all goes to hell they stay solvent by gaining on the catastrophe to cover losses created by the catastrophe.

So who has to put up the collateral? JP Morgan doesn't own any gas, or surely doesn't want to at any point. They are acting as intermediaries in the marketplace and providing a stable price in an unstable market. Do they essentially have to put up collateral equal to the value of the contract?

If that is the case, the arrangement will disappear. My friend the buyer would have to make his own arrangements and hedge the risk himself. So would the producers, etc. All that would mean is the price of urea would increase, your food prices would go up, and the bureaucrats in Washington would pat themselves on the back for saving the world.

Further, essentially the risk is transferred from JP Morgan's derivative structures and counter parties, to the equity holders in all the companies from the producers, distributors and users. The reason why derivatives are used at all is so that the buyers and sellers can structure their business to minimize the risk, for a price. If the price is too high, as it would necessarily become if all the intermediaries have to post collateral, they won't.

Oddly this reminds me of a story from British Columbia a few years ago. Someone was opening a bar/restaurant, and the provincial sales tax department required them to remit upfront their expected tax receipts for month as a condition of doing business.

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The effect of the regulation would almost surely not be to tie up vast amounts of safe assets in collateral. Instead, it would be to force all big transactions and all transactions by people who are not well heeled to be centrally cleared, while allowing parties like commercial money center banks that have large volumes on safe assets on hand and available to plege as collateral to conduct moderate sized side deals outside of the central clearing forum.

Securities laws effectively do this already with stocks and bonds. While the law doesn't require all securities subject to the scope of securities regulation to be traded on regulated securities exchanges, in practice, the stocks and bonds of virtually all economically material companies required to make regular securities regulation disclosures are in fact traded on regulated securities exchanges, because this is a more efficient way to cope with securities regulation on a transaction by transaction basis than doing private side deals. The derivatives rule may need a few more exceptions (and may have exceptions that haven't received attention already). But the "sky is falling" analysis in the quoted material misapprehends how the derivatives industry participants would be likely to respond to the relevant regulation.

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Two things:
- this will add a transaction cost that may well result in much lower outstandings in the future
- it offers an insight into what the implied costs were of the previous regime where, in my own experience there was quite a bit of purely speculative activity with dealers competing for market share (and their self-interested employees on flawed formulaic incentive packages) with a small amount of own capital at risk and a free, unlimited option to put the firm to the gvt...

ISDA was the main culprit in the sorry saga that saw us get Basle II: banking as a popular utility and replace it by a hedge fund with a service business attached, structured in such a way that any substantial dip in the business cycle leads to illiquidity> ;arge capital write downs>involuntary gvt intervention.

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