It gets less attention than its credit-denominated relative, but the 2008 financial crisis actually sprung from a massive ‘collateral crunch’ within the shadow banking system.
Read Manmohan Singh on rehypothecation, or try to get your hands on Matt King’s seminal ‘Are the brokers broken?’ note. The Citigroup credit analyst warned just two weeks before Lehman’s collapse that “brokers’ and banks’ gross usage of repo, revealed in footnotes of 10-Qs, far exceeds that which shows up on balance sheet. Although in principle much of this is for clients (mostly hedge funds) it still makes their business as a whole much more dependent on the continued availability of repo funding than might otherwise be appreciated.”
No kidding. In 2008, the use of so-called toxic assets to secure repo funding very suddenly became unacceptable to other banks, causing financial meltdown.
Back then, the solution was for Fed chairman Ben Bernanke to say stuff like this: “We are encouraging firms to improve their management of liquidity risk and reduce over time their reliance on tri-party repos for overnight financing of less-liquid forms of collateral.”
Now we have that emphasis on the safest of collateral assets — government bonds, and especially US Treasuries. Some $4,000bn of these are currently used in the repo market, according to JPMorgan. Presumably, what you wouldn’t want is any further reduction in the amount of decent, liquid collateral available to a still nervous-financial system.
On that note — here’s a nice tidbit from Monday’s Financial Times:
Some of Wall Street’s biggest banks are preparing to cut their use of US Treasuries in August as a precaution against any turbulence that could follow if warring Republicans and Democrats fail to increase soon the US debt ceiling, a senior bank chief said.
One strategy, which bank executives only agreed to discuss without attribution due to the political sensitivities related to discussing Treasury debt, is to have more cash on hand to put up as collateral against derivatives and other transactions, decreasing the financial system’s reliance on Treasuries.
Combine a shift away from US Treasuries with everything else that’s currently happening in the collateral sphere. The Federal Reserve Bank of Chicago has a nifty new software programme to help banks estimate the amount of assets that may be needed once stuff like central counterparty clearing comes into effect. There’s been a worldwide shift towards collateralised lending just when upcoming Basel III rules for banks are busy redefining what can count as liquid or safe assets. And much more.
Now go back to that UST point, specifically.
JP Morgan managing director Matthew Zames warned back in April that:
A Treasury default could severely disrupt the $4 trillion Treasury financing market, which could sharply raise borrowing rates for some market participants and possibly lead to another acute deleveraging event. Because Treasuries have historically been viewed as the world’s safest asset, they are the most widely-used collateral in the world and underpin large parts of the financing markets. A default could trigger a wave of margin calls and a widening of haircuts on collateral, which in turn could lead to leveraging and a sharp drop in lending.
Shades of 2008, that.
Clearing vs collateral – FT Alphaville
‘A new era of Treasury price volatility’ – FT Alphaville
Which came first – the margin call or the commods mayhem? - FT Alphaville
Financial stability is getting difficult – FT Alphaville