When safe assets return | FT Alphaville

When safe assets return

Like so many others, FT Alphaville has spent much of the past year thinking about collateral shortages in the shadow banking system and how safe assets function as a kind of currency.

But it’s about time someone actually calculated just how much money these assets might represent.

And so, courtesy of the same crew that brought you the unwanted mutant offspring of the most important chart in the world, we begin with this chart of private and public “shadow money” in the US:

That’s from the latest note on shadow banks from Jonathan Wilmot, James Sweeney and team at Credit Suisse, and it is superb — in this blogger’s opinion, the single best concise explanation of the collateral issue that we’ve come across.

There’s a lot packed into the ten pages and we can cover only some of it here, so we recommend a full read at this link.

In discussing the money-like properties of debt that functions as shadow banking collateral, three variables matter:

1 – Its value

2 – The haircut on the security when used as collateral

3 – Collateral velocity, represented in the shadow banking world by rehypothecation.

We’ve previously cited the work of Manmohan Singh, who looks at rehypothecated collateral to arrive at estimates of the “churn factor” of this collateral. (Churn factor is the amount of collateral received by dealers divided by the amount of source collateral.) Here is what happened between 2007 and 2010, from Credit Suisse:

[Singh] reports that, as of a year ago, total collateral was down sharply to $5.8 trillion with $2.45 trillion in source collateral, reflecting a significantly lower velocity of 2.4.

Less debt, lower value, higher haircuts, and reduced collateral velocity: in our view, this is an ongoing and significant monetary shock.

The monetary shock bit is key and we’ll have more on that in a minute.

As the Credit Suisse analysts are interested in a broader macro view, they’ve done something slightly different from Singh to calculate the total amount of private shadow money. They’ve counted the entire outstanding value of private and public debt, and adjusted by the repo haircuts of each type of debt security.

In doing so, they’ve combined the debt being used as collateral with debt that potentially could be used as collateral.

We’ll let them explain why:

Although only a portion of liquid debt securities are used as collateral, a much wider pool of debt can become “shadow money,” or securities that can easily be borrowed against. This broader concept is relevant because an asset holder always benefits when his assets become more money-like.

His improved ability to realize liquidity quickly means he need not hold the same amount of cash. In addition, his asset may appreciate in value because of a liquidity premium.

For example, if a bond is worth $100 and its repo haircut is 5%, then a holder of that bond can easily raise $95 of cash when holding that bond. The holder has $95 of shadow money, and this is likely to reduce his need to hold cash…

This is how they arrived at the chart above.

And it’s also why it makes sense to then combine this shadow money with the Fed’s M2 money supply data to arrive at measures of “effective” money:

“The idea is to calculate a broad measure of privately and publicly created money, or inside and outside money,” writes Credit Suisse.

Another way to think of public vs private effective money is that the former is money created by government liabilities and the latter is money created by banks.


– Public effective money is the value of publicly issued debt, adjusted for haircuts, plus the monetary base (currency plus reserves).

– Private effective money is the haircut-adjusted value of privately issued debt plus those parts of M2 (demand and savings deposits, retail money-market funds, etc) other than the monetary base.

Now then, we were saying something about a monetary shock…

Let’s review the story that’s told by these charts.

The crisis involved big increases in repo haircuts and calls for more collateral of the sort that led to Lehman’s collapse, and it was followed by negative net debt issuance and a huge decline in the market value of the debt (for some debt there was no market).

So between the end of 2007 and the end of last year, the outstanding value of private debt securities fell by $1.8 trillion…

Although the value of this debt has fallen each successive year, the amount of private shadow money, represented in the first chart, began recovering in 2009 and is now roughly back to pre-crisis levels (though not to pre-crisis trend levels). The reason for this is that haircuts began to come down and, more recently, there was new issuance in corporate bonds and to a lesser extent in non-mortgage ABS.

But that precipitous fall in private shadow money amounted to tremendous deflationary pressures.

Here’s how Credit Suisse explains the response:

A sharp fiscal easing then created a flood of safe collateral that caused the public shadow money (Treasuries, mbs, agencies) to soar, fully offsetting the contraction in private shadow money (corporate bonds, asset-backed securities, and non-agency mortgages).

Central banks, meanwhile, were lowering interest rates and finding ways to improve the liquidity, value, and moneyness of various types of public and private collateral through their balance sheet operations.

Public shadow money from increased government issuance replaced the loss of private shadow money and, in combination with other measures, mitigated the effects of these deflationary forces.

And yes, that does lead to an argument against tightening fiscal policy too quickly: fiscal consolidation tightens monetary policy also.

Especially when considering this:

We expect [private shadow money] to contract further in 2012, driven by negative net issuance of financial debt of nearly half a trillion dollars… Even this potential fall in 2012 is tiny compared to 2008, but it comes at a time when fiscal deficits are shrinking.

The blurring, or even absence, of the line between fiscal policy and monetary policy in the shadow banking system is often ignored.

It’s no longer enough to understand traditional monetary policy transmission mechanisms (money multipliers, federal funds rates, reserves); it is also necessary to understand how the shadow banking system (collateral supply, rehypothecation) affects monetary policy, and vice versa.

And this also seems like the source of the many challenges in working out how to regulate the sector.

Because one thing that’s clear from the note is that the shadow banking system represents a lot of money, and more specifically a lot of credit flowing through the economy. Regulating it won’t be as easy as saying bring it all on balance sheet or higher capital standards (though the latter is probably still a good thing).

How to define, for instance, the appropriate coordination between the central bank and fiscal policymakers when the outstanding Treasury stock affects monetary policy in this way? Or how to go about discovering the right balance between government readiness to respond (as it did in this case) vs the moral hazard it would bring?

One more chart…

… and summary from Credit Suisse:

Crucially, this chart and the shadow money perspective allows one to see that there has been

(1) a huge and necessary change in the composition of the effective money stock,

(2) a big reduction in the velocity of circulation of liquid collateral,

(3) a sharp reduction in the value of illiquid collateral (houses),

(4) an increase in the “haircuts” on illiquid collateral (higher LTV ratios), and

(5) a big increase in the precautionary demand for money by both firms and households.

The net result cannot be reasonably characterized as posing a major inflationary threat – at least until such time as financial system deleveraging is more complete, collateral values, especially house prices have recovered substantially, and overall private sector credit demand is growing strongly…

The public sector is still doing King Collateral’s work. How long it acts as Regent may be the central question for financial markets in the next decade.

Thoughts, questions, idle musings…

The note raises so many questions, as should be clear, and we have more of our own:

1) Surely for the world’s most important central bank there is also an international angle to explore; call it the Triffin Dilemma dilemma.

How would the “right” level of the above monetary aggregates change if there is a reversal of capital flows from developed countries back to emerging markets — in other words, some combination of a) the creation of safe assets by EM countries along with new savings vehicles for their domestic currencies, and b) less resort to the flight-to-quality trade in times of stress.

Recall that it was the pursuit of safe saving vehicles that had capital flowing from poorer to richer countries, a most unnatural state of affairs, that probably led the financial sector to “create safe assets from the securitization of lower quality ones, but at the cost of exposing the economy to a systemic panic,” as Caballero explained. (The safe assets being the senior tranches of MBS that accounted for such a large share of repo market collateral pre-crisis.)

2) The movement of M1 and M2 in recent years seems not to have told us anything helpful about inflationary prospects. Should the Fed finally ditch them and start concentrating on another measure, perhaps one that incorporates some of the items above? Or bring back M3 (which at least included such shadow banking elements as institutional money market funds and repo)?

3) Perry Mehrling, whose recent paper is cited in the Credit Suisse note, likes to say that the Fed became not just the lender of last resort in the crisis, but the dealer of last resort. And that the new paradigm for monetary policy is to think of “asset markets, not banking institutions; market liquidity, not funding liquidity”. In other words, include shadow banking, though he prefers the term “new market-based credit system”.

And he explains the new kinds of exposure the Fed has taken on since the crisis because it’s had to think about shadow banking:

By adding short-term T-bill holding and long-term T-bond holdings to both sides of the balance sheet, and rearranging, three fundamental risk exposures can be distinguished: a kind of overnight index swap, a kind of interest rate swap, and a kind of credit default swap.

In all three dimensions, the Fed is operating to support market liquidity… In all three dimensions, the Fed can be seen as adapting to its new role as liquidity backstop for the emerging new market-based credit system.

We need to think about this a lot more, but should this framework be made explicit Fed policy? Would doing so require a Congressionally-legislated mandate?

4) Does this change how we think about liquidity traps? Izzy, citing the latest paper by Paul McCulley and Zoltan Pozsar, convinces us the answer is yes. The short version is that in a liquidity trap caused by widespread deleveraging, conventional monetary policy won’t work — and as McCulley and Pozsar explain…

… the public sector has to move in the opposite direction and re-lever by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.

Same concept as public shadow money filling the gap left by private shadow money, just using different language.

5) We used to think of quantitative easing as having at least one dramatic flaw. For all its benefits, it also served to drain the system of some of the debt needed as shadow banking collateral. Now we believe there’s a limit to this way of thinking.

A different way to think about this is that quantitative easing set the stage for there to be greater fiscal easing because of the signal it sent (commitment to lower rates). And the signal, rather than the asset purchases, is probably what had the most beneficial impact anyways.

There’s no way to be sure, but this is one possible explanation for why both QE1 and QE2 fizzled after initially having reflated the economy and lifting asset prices. In both cases, the time came when Bernanke could no longer credibly commit to pursuing easing for as long as would be necessary to substantially improve economic conditions; and once the signaling mechanism wore off, so did the effect. It was all about the expectations channel, and the asset purchases themselves were just there for reinforcement.

And lately, as Izzy also mentions in her post on the McCulley and Pozsar paper, the message sent by Bernanke with the new communications policy could be interpreted as Hey, pssst, US Treasury, I’ll keep rates low. Please issue whatever you have to and top up the goddamn system with collateral. At least until the financial sector is finished deleveraging or until an accelerating economic recovery naturally raises the outstanding value of collateral.

6) How does this understanding of the crisis jive with Gary Gorton’s theory of what happened? Recall that Gorton’s story wasn’t just about collateral values plunging and haircuts rising in repo markets. It was that certain types of debt used as collateral flipped from being information-insensitive to information-sensitive. And this flip wasn’t limited to subprime MBS, which would have caused only minor stresses.

His argument wasn’t about the relative safety of the collateral as its value fell. It was about the collateral going from safe to unsafe just because lenders in repo markets realised that it could potentially fall. So they pulled out en masse and hiked haircuts even when the collateral wasn’t subprime-related, and voila you’ve got a crisis. This was partly an issue of repo market transparency, but it also reflects a different, more binary understanding of what triggered the crisis.

7) We covered the peculiar aspects of money market funds, deposit insurance, and future regulations earlier this week, but here we’ll re-emphasise the point that it raises broader questions of how to think about money that flows back and forth between the traditional and shadow banking systems. And of the difficulties in getting the pricing right in any fee-based regulatory approach.

8) Does the shadow banking system’s relationship to monetary policy have any implication for the Smithian/neo-Wicksellian view, which awaits the natural rate of interest imminently rising to and exceeding the federal funds rate? Is there an equivalent for the shadow banking system — perhaps something related to collateral haircuts? What about the NGDP guys? The MMTers? The John Carney?


We don’t have answers to, or even suggestions for how to answer, most of these.

At some point the matter becomes too big for the mind of this basement-dwelling blogger with no formal economics training. Then again, from what we understand, a lot of this stuff hasn’t made it into the textbooks yet.

About time it did?

Related links:
Why QE is being mis-sold – FT Alphaville
The decline of safe assets
– FT Alphaville
Show me the collateral blogging – Brad DeLong
The balance sheet recession, charted – FT Alphaville
Jedi economics – FT Alphaville
The age of the shadow bank run – Marginal Revolution