It used to be that lending was done on unsecured term durations, all the time.
Then we had the credit crunch, and unsecured term lending died.
Then everyone started lending on a collateralised basis. Term collateral rates became more meaningful than unsecured rates.
And then — eventually — the collateral rate became more meaningful on an overnight basis too, leading some countries to even invent collateralised benchmarks like Ronia — the UK’s Repurchase Overnight Index Average.
But along with all this came an important side development too.
The rise of the collateral swap. Also known as a long-dated repo.
The premise was simple. Prudent institutions flush with top quality government bonds (or even cash) wanted to secure a better rate of return — on a still relatively low-risk basis. We’re talking insurance firms, pension funds and other low-risk asset managers.
They weren’t keen to lend unsecured, that was for sure. But they were prepared to engage in collateralised swap deals with cash-strapped investment banks or the shadow banking industry (who were looking for cheap funding) — gaining extra yield on their low-yielding ‘safe’ securities by indirectly funding more risky investments elsewhere. The shorter the duration of the loan the safer.
The shadow banking community thus inadvertently got drawn into being an intermediary agent, acting as a go-between in the channeling of cash into higher yielding investments like junk bonds, mortgage debt and emerging market securities (and sometimes even peripheral European debt).
Though, even now, very little is known about the nature, popularity and size of such deals. But they do encompass many forms, that we know.
A draft paper by Dan Awrey entitled “Complexity, Innovation and the Regulation of Modern Financial Markets” and dated August 25, 2011 attempts to shed some more light.
As he notes, these so far are known to be the characteristics:
A collateral swap is essentially a form of secured lending whereby one counterparty transfers relatively liquid assets to another in exchange for a pledge of less liquid collateral. In a typical collateral swap, a bank holding a portfolio of ABS or other securitizations will transfer these assets to a pension fund or insurance company which, in exchange for a periodic fee, will deliver a portfolio of more liquid collateral such as high-grade government or corporate bonds.
The pension fund or insurer thereby receives a higher yield on its (ostensibly) safe investments, while the bank obtains access to a portfolio of liquid assets which it can then re-pledge to obtain funding from central banks and other sources which, in the wake of the GFC, have been less willing to accept ABS and other securitizations as eligible collateral. The development of collateral swaps is thus, in effect, an innovative response to both the post-crisis funding constraints on banks and the need to satisfy new liquidity requirements soon to be imposed under Basel III.
And these are the issues he identifies:
Collateral swaps contribute to the complexity of modern financial markets in at least three ways. First, the collateral swap market is extremely opaque. Nobody knows with any certainty, for example, how big this market is, who the major players are, or the size of the aggregate exposures. As a result, it is exceedingly difficult to ascertain the nature and extent of the attendant risks. Second, given the identity of the counterparties, collateral swaps seem destined to strengthen the interconnections between (1) banking markets and (2) insurance and pension markets. Finally, as described above, collateral swaps are a reflexive response to changes in the post-crisis market and regulatory environment.
Some commentators (among them FT Alphaville) have noted this is almost akin to the privatisation of liquidity ops.
Others go as far as to say, it’s the key reason why the Fed is likely to shy away from QE3. It’s depending on exactly these processes to get the money flowing into riskier assets.
After all, consider all those zero-yielding (or worse still, fee incurring) deposits currently being gathered at prudent and low-risk institutions. Eventually the need for yield will overcome capital preservation behaviour (is the hope).
As Perry Mehrling, professor of Economics at Barnard College, Columbia noted earlier this month:
Basically, the ZIRP provides strong incentive for carry trades of all kinds. If you can borrow at zero, and can roll your borrowing for two years, then anything with a positive yield looks good. If a hedge fund borrows at zero and buys MBS, that is QE1 private-style. If a hedge fund borrows at zero and buys long-dated Treasuries, that is QE2 private-style.
The difference is that, since the Fed is not doing the trade on its own balance sheet, it has no control over which trades get made. Private speculators can also buy yen or Swiss francs, and central banks intent on preventing currency appreciation are forced to take the other side of the speculation, so doing their own QE. And speculators can also buy gold, or indeed any other asset, so long as expected capital gains exceed storage costs.
Another difference is that private-style QE gets financed with private money expansion (private debt secured by the asset purchased) rather than public money expansion (Fed debt which is bank reserves). From this perspective, private-style QE3 looks like a repurposed shadow banking system. As everyone now knows, the collateral that stood behind the original shadow banking system turned out not to be the AAA credit it was claimed to be. But, at the time, demand for private money backed by that dodgy collateral was sufficiently strong that there were strong incentives not to look too closely.
Though, as and when things get riskier, there’s also a critical downside to this development. Private money has no obligation to keep funding. It can pull its money sharply and quickly.
What’s more, if and when it’s tempted back into the lending market the duration of such long-term collateral swaps is likely to get shorter. You’re still happy to lend for yield, just for a shorter duration.
Professor Lew Spellman, for example, has noted that in many ways it’s the development of a shorter, even overnight, term collateral swap market (especially when conducted with the shadow banking community) that could create an entirely brand new black-swan risk.
An overnight funding squeeze which emerges almost from nowhere, or what you could call a totally unanticipated overnight black-swan event. Demand deposit risk, squared.
Related links:
Now you see it now you don’t – collateral transformation – FT Alphaville
It’s stock lending Jim, but not as you know it - FT Alphaville
Collateral transformation services key to buyside clearing – IFR