More QEs, More Liquidity, and More Economic Downturn
It is an extended lesson in the outmoded way in which financial firms report themselves to the public, as well as the consequences of it. This isn’t in any way to assign blame to those institutions since they are simply doing what is required of them. The problem is, and has been for a very long time, that current accounting conventions are just not appropriate to properly illuminate the way things are done.
Those conventions are decades behind massive financial and monetary evolution. The current intellectual foundation is simply an anachronism.
I’ll start by giving you one specific example. Below is taken from Morgan Stanley’s latest annual SEC filing (10-K) for its calendar year of 2018. Pretty much boilerplate, it could have come from any of the big banks.
“The Firm receives collateral in the form of securities in connection with securities purchased under agreements to resell, securities borrowed, securities-for-securities transactions, derivative transactions, customer margin loans and securities-based lending. In many cases, the Firm is permitted to sell or repledge these securities held as collateral and use the securities to secure securities sold under agreements to repurchase, to enter into securities lending and derivative transactions or for delivery to counterparties to cover short positions.”
Buried way down in a blurb and accompanying table on page 121 of the notes, even the most sophisticated of stock investors will have trouble understanding what’s going on here. For the layperson, forget it. How about regulators? Put a pin in that one.
Morgan Stanley is laying out for you the parameters of its rehypothecation program(s). The amounts are not small. According to the published end-of-year numbers, the bank reported $639.6 billion in “collateral received with the right to sell or repledge”, of which $488.0 billion actually was sold or repledged at that moment.
Those quantities were up slightly from reported year-end 2017. For collateral received, it was an increase of a little more than $40 billion; for rehypothecated collateral during 2018, an increase of about $14 billion. The bank was proportionally much less pliant with collateral it could have re-pledged.
During the year before, 2017, it had been noticeably different. The amount of reported collateral it had received at year end had increased $38 billion from the last day of 2016. The balance of it repledged, however, had ballooned by more than $44 billion during that specific year. The bank seems to have been far more confident about re-pledging.
At this point, we probably need to stop and back up. What is being pledged by whom, and how does this re-pledging work? For what purpose or purposes?
I hate to say it, but the excerpt above actually does explain most of what’s taking place. As a regular part of its money dealing business, the investment bank piece has financial customers. These financial customers come to Morgan Stanley, as any other money dealer, seeking to satisfy specific financial needs.
Primary among them, leverage. Non-banks like hedge funds attempt to increase their returns by borrowing. Seeking the lowest possible interest cost in order to make these trades work, the hedge funds offer collateral on the leverage they obtain as well as make concessions about that collateral.
The hedge fund allows the dealer bank to “re-pledge” the asset it just posted for the dealer’s own purposes. This then permits the dealer to go into the money markets and finance itself also on the cheapest possible terms; whether specifically as a pass-through on that trade or, more often, on an aggregate level.
In other words, the hedge funds have a vested interest in helping the dealer obtain the best possible marginal funding terms – which is expected to be passed along, minus a small spread, to the hedge fund. If the dealer can use your collateral as its own to secure cheaper funding, everyone wins.
Thus begins what are called “collateral chains.” This is a concept first developed in detail by the IMF’s Manmohan Singh in 2011 (WP/11/256). Building further on the work of Gary Gorton and Andrew Metrick, who looked at the Global Financial Crisis (GFC) from the repo collateral perspective, as well as Adrian Tobias and Hyun Song Shin, Singh developed the framework for appreciating the phenomenon of collateral velocity.
Very much like the concept of money velocity, in collateral it begins with rehypothecation. Collateral often changes hands many times over the course of a specific period of time. These “collateral chains” therefore form the backbone of the repo market. Without them, collateral doesn’t flow and that can lead to serious breakdowns not just in repo but across the entire financial landscape.
The Autumn of 2008 was only the most extreme example of such.
What Singh did was match estimates for total collateral being pledged against those for where it mostly comes from. In addition to hedge funds, dealer banks also source collateral via “securities lending.” This is a much less transparent process rife for, shall we say, excesses. I’ve been writing about these a lot recently (transformation).
AIG’s securities lending in the Autumn of 2008 was, again, only the most extreme example of such.
Insurance companies and pension funds are the primary sources for securities lending purposes. Each holds substantial pools of otherwise idle financial instruments. Always seeking to enhance returns, they “rent” out these assets to dealers who then re-pledge them as part of their dealer business.
Sometimes the re-pledged assets themselves get re-pledged, and re-pledged again. Only the one time for each bank that does this does it show up on financial statements, a partial disclosure buried in all the notes.
This is the collateral velocity, essentially the length of collateral chains. The longer they are, the more collateral has been re-pledged, the more fluid the repo system – on the collateral side. And that meant, at least before the crisis, plentiful monetary and funding resources for a whole lot of purposes, not all of them ended up as being wise.
What happened in the wake of the 2008 crisis was that these chains all shrank. As dealers became shy and nervous for obvious reasons regardless of the soundness of the collateral itself, the less it was re-pledged throughout.
So, in addition to securities becoming less available in the first place, hedge funds shied up and insurance companies curtailed their securities lending, the repo market transmitted that shock to the global system in the form of a multiplication function gone in reverse. Repo itself experienced a near-complete shutdown in the first weeks of October 2008, fails skyrocketing to more than $5 trillion for a couple of them.
But that repo crisis wasn’t a one-off as far as collateral rehypothecation has been concerned. Instead, there has been a lasting impact captured by Mr. Singh’s velocity concept.
According to his original figures, there had been $10 trillion in total pledged collateral for 2007. Of that, $3.4 trillion could be identified by source; half from hedge funds, the other half due to securities lending. Therefore, the velocity or approximate length of collateral chains was a ratio of 3 to 1.
By 2010, however, the amount of pledged collateral had been cut to $6 trillion. Hedge funds and securities lending together provided $1 trillion fewer securities than in 2007, meaning the velocity ratio declined to 2.5 to 1. It was actually the lower general tendency to re-pledge that accounted for the most serious reduction in repo collateral usage and therefore the catastrophic monetary shortfall of what had become this GFC.
Singh wrote in his original paper:
“This decline in leverage and re-use of collateral may be viewed positively from a financial stability perspective. From a monetary policy perspective, however, the lubrication in the global financial markets is now lower as the velocity of money-type instruments has declined.”
Given the scale, a lower bound estimate of $4 trillion, it made the Fed’s first couple of QE’s seem positively small and inadequate (even if not misdirected into bank reserves). Particularly given the fact that those QE’s themselves actually reduced the availability of collateral that much more by source, the bond buying programs taking more securities out of the potential marketplace and locking them up in SOMA.
The repo market’s curtailment because of questions surrounding the whole dynamics of collateral played a major role in first the crisis and then the lack of recovery from it. One need only look at bond yields to see the effects of collateral and monetary tightening no matter how many times QE was repeated to whatever ultimate cumulative total in bank reserves.
Starting in 2016, however, things collateral-wise began to pick up for the first time. According to updated estimates from Manmohan Singh, the total volume of pledged collateral grew modestly from $5.8 trillion in 2015 to $6.1 trillion. But with the 2017 introduction of the slogan “globally synchronized growth” and consistent official emphasis on it, the aggregate exploded to $7.5 trillion – an increase of 23% for this money market that hadn’t really seen any kind of growth in nearly a decade.
Of that two-year change, sources of collateral had jumped by $600 billion meaning the velocity also ticked up (to 2.0 from 1.9) accounting for most of that $1.7 trillion rise.
Dealers were back to repledging again! Maybe not in the way they had been before 2008, but certainly over and above the seven years following the crisis.
More importantly, I believe, the sourcing of collateral. The vast majority of it came from the “securities lending” side of things, $400 billion more in 2016 and 2017 compared to $200 billion due to hedge funds.
And these are just rough estimates. Despite an increasingly compelling and widening academic investigation about the importance repo and more so repo collateral, these remain outside of the mainstream. Certainly outside of most if not all monetary policy considerations. Collateral still, to this day, does not factor for people like Jay Powell.
No one bothers to track this stuff, and you really can’t come up with more than a rough guess from the accounting statements. They provide only a temporary and brief glimpse while offering no relevant details besides top-level reporting.
According to Singh, what then happened in 2018 was encouraging; total source collateral remained equal to 2017, while the total volume pledged increased to $8.5 trillion (+13% from 2017). Velocity therefore ticked up to 2.2, the highest since 2012.
Writing in the Financial Times this past May, Singh projected:
“Although central banks are embarking on a tightening cycle, an increase in collateral velocity may ease financial conditions.”
It doesn’t quite seem that way in 2019, does it?
We might instead look at the migration into 2018 from 2017 a little differently, particularly in the context of the potential for problems due to “securities lending.” As we would given the way the bond market has behaved going back to late in 2018.
What if 2017’s big jump in repo re-pledging sourced mainly from securities lending practices was predicated on a shaky foundation? What if dealers were betting that globally synchronized growth was an actual thing and not just a marketing campaign made up to overhype small, temporary economic improvements in order to get increasingly hostile voters off the backs of beleaguered central bankers and Economists who couldn’t explain anything past the date of August 9, 2007?
Rather than being encouraging, the velocity in repo could have represented instead a potential weak spot. Let me be clear, it isn’t anything like the scale and depravity of the pre-crisis period, particularly 2004-06. But it does represent enough of an increase that if it had been done for shaky reasons and it did start to unwind this bulge could become more than a minor, slightly annoying issue.
In other words, rebounding collateral sourcing and velocity may not have been a good thing. Like the middle 2000’s, it may have opened up the possibilities of doing too much the wrong way; inappropriate risk-taking, especially, in my view, as it might have related to EM issues.
In 2018, that is likely what become more apparent. Longer collateral chains were the consequence of collateral sources souring. Especially if those sources were further questionable in terms of the potential for transformation within them. That’s ultimately the biggest blind spot in all of this; we have no idea what kind of collateral is the true source for the sources (both hedge funds as well as securities lending).
To the repo market, they may look like Treasuries or even re-pledged Treasuries. But we have to consider how there is and very likely was other kinds of collateral behind them closer to the source(s) of dubious current value. In that case, velocity would be a bad thing – slightly longer collateral chains mean more of the system would be subject to any kind of rethinking source terms.
And isn’t that what this year has been? Globally synchronized growth slowly transformed in 2018 into 2019’s globally synchronized downturn. Everyone may be optimistic and relieved lately because of central bank “stimulus” and the appearance of “trade deals”, but the truth is across the globe economic conditions are somewhere between uncomfortably bad and nasty.
There are a lot of places that look more and more 2009-ish, and the list of them is growing.
If the collateral source and rehypothecation processes in 2017 were predicated on the one, synchronized growth, and it has become the other, synchronized downturn, you might then understand why the strong worldwide demand for safe assets materialized pretty early on in 2018 and has only been strengthened and maintained in 2019; even now despite this deluge of “positive” news.
There is and remains the potential for serious repo problems.
Manmohan Singh’s estimates haven’t gotten that far. Pity because they are sorely needed as is a much higher quality to them. This is by no means a criticism of Mr. Singh; far from it, a rebuke instead of authorities who refuse to pay any generalized attention to the repo market until they are forced to by “unexpected” repo events.
Faced with that as well as ongoing repo problems, Jay Powell and the FOMC have tried to address it with collateral? Nope. More bank reserves. That part, at least, is just like 2008. They’ve learned absolutely nothing. Proving as much this week, FRBNY announced yesterday even more scale-up repo operations (that don’t touch the repo market).
Collateral remains, in my view, the primary liquidity risk, not bank reserves. That much you can see in the prices and stubborn price behavior of the safest bonds (which so happen to be the best collateral) whose prices were once slated to fall (interest rates had nowhere to go but up – until they went down, way down).
We don’t yet know how it will turn out this time, of course, but what I wrote on the last business day of 2017 seems an appropriate reminder:
"This was the year “globally synchronized growth” was going to overtake all the past decade’s persisting problems and lead to something unmistakably better. It hasn’t quite worked out that way, and in some cases, more than just UST collateral repo, it’s worse now than at any point since 2008. The former merely follows the latter."
Two years later: more liquidity operations, more QE’s, more downturn. More of exactly the same, still none of it properly accounted for.