Ye olde (ironic) collateral crunch | FT Alphaville

Ye olde (ironic) collateral crunch

The Atlanta Fed has dredged yore (or at least some of it) to bring us a paper that goes to the Amsterdam Crisis of 1763 to find a shadow banking precedent for the collapse of Lehman and the subsequent policy responses.

They wanted to answer two questions: Would a different pre-crisis regulatory environment have increased market resiliency? And what if governments and central banks had displayed a lesser response to the Lehman failure?

But why late eighteenth-century Amsterdam? Glad you asked (emphasis ours):

It was replete with merchant banks offering securitization. To enhance the credit and liquidity of debt instruments, the Dutch substituted a borrower’s obligation with a debt guaranteed by a merchant bank. The borrowers were located all over the European trading world, but the credit hub was Amsterdam, so credit risk was concentrated there. The typical Dutch merchant bank financed itself by issuing debt before the original borrowers were paid, following a business model comparable to modern asset-backed commercial paper (ABCP) conduits. Merchant banks’ dependence on debt rollover made Amsterdam in 1763 as vulnerable to aggregate shocks as New York was in 2008.

And it succumbed to just such a shock:

The spark for the 1763 crisis was the Lehman-like failure of the banking house Gebroeders de Neufville. As occurred in 2008, de Neufville’s failure made creditors reluctant to purchase new debt from surviving banks that were thought to be following a similar market strategy. Our investigations indicate that the resulting shadow run may have been greater (relative to the size of the market) than that experienced in 2008.

(And at the time it went down, Gebroeders’ list of creditors included over 100 counterparties.)

A second parallel is in the Bank of Amsterdam’s response to the crisis:

As in 2008, access to central bank liquidity was expanded in an unprecedented and ad hoc basis. Differently, this expansion was relatively narrow in scope. The policy intervention worked through the Bank’s repo facilities to broaden the set of assets eligible for repo to include silver bullion. Liquidity also expanded via the traditional channel of repo transactions with trade coins.

Pfff, that’s a “mere” 40 per cent increase in liquidity over six months… and the bank’s minimalist approach was disproportionately felt in Amsterdam’s satellite markets, which experienced an almost complete shutoff in credit flows.

The authors argue that the crisis of 1763 confirms the model of a shadow bank as a financial firm that has to roll over its financing before the backing assets matures. Shadow runs are the sudden inability to sell new debt, as arrangements designed to make claims mature. Finally, the story shows how a shadow run was alleviated—if only partially—through aggressive repurchase facilities but without explicit bailouts or too-big-to-fail guarantees.

And in Amsterdam they were able to reconstruct both lender of last resort funding and the obligations pressing on shadow banks.

So where’s the collateral crunch, let alone the irony, you ask? Here:

The Treaty of Hubertusburg (February, 1763) concluded the war and spawned two shocks that diminished the value of the collateral (implicitly) backing Amsterdam’s bill transactions.

The first shock was a drop in the value of grain: prices in Berlin and Hamburg dropped by 30 percent between November 1762 and May 1763. Then, in May 1763, Prussia decided to dump its unused wartime grain supplies on the Berlin market, leading to a 75% drop in the local price of wheat…

The commodity price shock was compounded by a monetary policy reversal. During the war, Prussia conducted a series of debasements that moved its monetary standard (i.e., mint equivalent) from 14 Reichsthalers per mark of fine silver to 40 thalers per mark for some coins (Koser 1900, 341-351). The wartime inflation was extremely unpopular with the nobility, so in May 1763 Prussia demonetized the depreciated war coinage and reduced the mint equivalent of new Reichsthalers to a “transitional” level of 19.75 thalers per mark (Henderson 1962, 96). Prussian merchants holding debased wartime coinage saw the nominal value of their collateral cut in half, and they responded by funding immediate debts with new bills drawn on markets such as Hamburg and Amsterdam. They also sent the demonetized coins to the same cities in the hopes of finding higher value as bullion.

Pesky Germans devaluing their debt! You’d think they’d have more of a stomach for it today.

We were also delighted to see a mention of negative rates. A quick explainer of the Bank of Amsterdam’s operations first. The Bank’s funding “pipelines” involved the use of expensive, high-quality collateral, i.e., trade coins.

[P]eople could purchase existing Bank funds from other account holders without changing the balance sheet. This was done in an open outcry market held in front of the Bank every day in which (effectively) coin could be traded against Bank money (van Dillen 1964a). The market price was the agio, or gap, between two units of account: Bank money (the “bank” florin or guilder) versus the value of circulating money (the “current” guilder or florin).

And now to negativity via the agio:

But outside the Bank, de Neufville’s failure caused a sudden, extraordinary demand for coins. The market suddenly bid down the agio (premium) of Bank money, denominated in bank florins, against coin, denominated in current guilders. The next section will show that Bank funds were still in high demand to settle accepted bills of exchange that were now coming due, yet the agio fell to a discount of ½ percent on Saturday, August 6.  After two days and a central bank intervention (see Section 7 below), the agio bounced back up to positive territory, but the emergence of a negative agio was stunning development. It had been observed only once before, during the French invasion of 1672 (Quinn and Roberds 2010, 16).

And a quick seniority aside:

In Hamburg, claims against de Neufville amounted to around three million florins, spread over 38 counterparties (de JongKeesing 1939, 102). The bill market there was faced with virtual collapse. On August 4, a group of prominent Hamburg merchants sent a petition to Amsterdam, demanding a bankruptcy preference, and threatening a shutdown of their market for Amsterdam bills if this was not granted

We could keep going for a while but, at this stage, if you want more you may as well read the paper itself.

Related links:
We told you negative rates were a big deal – FT Alphaville
Eurozone seniority, needling du jour – FT Alphaville