A Nonsensical Jumble of Misused Words Requires Discussion
AP Photo/Charles Krupa, File
A Nonsensical Jumble of Misused Words Requires Discussion
AP Photo/Charles Krupa, File
Story Stream
recent articles

I know, right? Like you, when I first heard about it there’s been little else on my mind. The structural implications alone were such that any rational person would devote as much time and energy to figuring out all the nuances. The stakes literally cannot be calculated, even today. Scarcely has there been a more serious issue.

I’m writing, of course, about “regulatory arbitrage in the presence of non-harmonised re-hypothecation regimes.” Only partly tongue-in-cheek, the satire applies solely to the fact that very few humans on this planet could make much sense of what seems otherwise a nonsensical jumble of misused words. Hardly the topic for any mainstream conversation.

It really needs to be.

To begin with, ask any person about the 2008 crisis and ninety-nine out of hundred will tell you it was subprime mortgages, those greedy Wall Street bankers making stupid loans to American housing bubble buyers in no shape to borrow for even the most reasonably-priced property. The hundredth will simply say “they” crashed the system on purpose.

Challenged, this near-centenary might go further to allege that these ill-conceived mortgage loans, being so badly packaged and at times illicitly maneuvered, these obviously created huge losses for the banking system which provoked good-thinking people to remove their money before being drawn into the orgy as it inevitably imploded.

Like Lehman Brothers.

A classic case of currency elasticity in the 19th century mold; an ol’ fashioned bank panic.

There were, actually, very few cases of this; only isolated instances. These certainly made for good television, especially during an election year in the US, and they did serve to leave a specific impression about banks being banks and doing what banks always have done. Long lines of depositors desperate to convert their deposit claims into bearer currency, cash, just didn’t happen except for rare examples (like Northern Rock in the UK, or IndyMac in the US).

Lehman Brothers, by the way, didn’t even have depositors!

Of those big banks who did, like Citigroup, it is true they experienced huge losses. Tens of billions, but not because of subprime mortgages. These were proprietary write-downs (OTTI; other-than-temporary-impairment charges) as large warehoused securities they were holding, or were stuck becoming beneficial owners of, grew unstable due to severe disruptions in the marketplaces for them.

What had made these massive, complex securities markets so unstable? Furthermore, why were these disruptions spread out all over the world? US subprime mortgages should have been contained to a US subprime mortgage problem, instead it grew to become a gross, global bond and fixed income expurgation. While Lehman Brothers had been at the center of it, very few today understand what was the center of Lehman Brothers.

More to the point, why that still matters.

Just as the untimely unwinding of AIG is mistakenly put down as some issue with some derivatives called credit default swaps, in truth what brought AIG to the brink was largely the same thing which pushed Lehman Brothers over it. Securities lending practices, not trigger-happy depositors.

For one thing, Lehman Brothers Inc. was merely the US dealer of a global dealer network housed under a single parent with that name. Counterpart to the American Lehman was the London-based subsidiary Lehman Brothers International Europe. Both prime brokers serving a range of big financial customers, including other brokers and dealers, as well as hedge funds, the London sub had a huge advantage its American cousin couldn’t match.

Regulations and regulatory arbitrage; it was purposefully made much easier to do monetary business in the offshore network of which London’s Lombard Street had been the key node. British authorities long ago decided in order to be a player in the growing international currency regime of the eurodollar system they’d let international banks setting up shop in The City do a whole lot more of what they wanted so long as their customers weren’t British persons.

This meant, among other things, any of these “London” banks and subs could offer clients much better terms, so long as, in most cases, clients went along with the full particulars of this arrangement. Including, getting back to our beginning premise, what amounted to a non-harmonized rehypothecation regime.

Clients buying securities through Lehman Brothers Inc. may or may not have been aware that the end result was those securities actually being custodied with Lehman Brothers International Europe across the Atlantic. In most cases, they wouldn’t have cared anyway; the latter dealer offered much better terms, funding arrangements and other perks that cheapened the costs of doing financial business. All a form of leverage.

This leverage extended to Lehman, too. Because in the world of securities lending, and what today is called securities funding transactions, to get the best terms mostly means letting your broker secure them on your behalf.

Nobody buys securities; they borrow and claim to “own.” Repo. The hedge fund (client) says it wants to own XYZ US Treasury issue, puts up a minimal upfront investment, enough to cover some overcollateralization requirement, and borrows for the rest of the purchase price. In many instances, the broker is the lender as well as custodian.

To make this securities funding transaction as cheap as possible, the client will agree to allow the dealer to re-pledge or rehypothecate (for our purposes here, the language is interchangeable though in a legal and regulatory sense these terms can have different meanings) the very security the client is claiming to own.

What that means is the dealer acts as an intermediary rather than lending its own cash for the purposes of the client owning this particular security. Instead, the dealer will repledge that security in the repo market or to other dealers in order to borrow the cash ultimately used to “purchase” and then fund the transaction (rolling over) to its ultimate end. Not just a securities financing transaction, a whole series of them.

And this series becomes horizontal as well vertical; the already re-pledged security posted by the client’s dealer to the next dealer in line can be re-pledged again depending upon the conditions set forth between the client’s dealer and what is now the client’s dealer’s dealer. As you may already guess, the client’s dealer’s dealer may also be able to re-pledge – the same security – to its dealer; specifically, the client’s dealer’s dealer’s dealer.

In many if not most cases, there needn’t be the original client need for this chain of re-pledging, either. What I mean is, the first link in that chain doesn’t have to originate out of the client’s need to borrow directly; if permissible, the client’s dealer may re-pledge the client’s security(ies) for its own purposes, with the client being sufficiently incentivized.

Thus, a dealer who does this kind of business with many financial clients can build up a stash of usable collateral that it doesn’t exactly own; these securities belong to other firms and vehicles, but are more than useful for the dealer to fund and carry out its dealer activities as a whole because of these peculiar usage rights.

The permissibility of these kinds of doings is, and remains, much higher in the offshore domain (the non-harmonized part of these rehypothecation regimes). The more a dealer could do re-pledging for themselves, the better terms it would offer its customers; giving Lehman Brothers International Europe a serious leg up on Lehman Brothers Inc.

Net result, Lehman Brothers as a global firm had acquired a significant pool of collateral owned by its customers and custodied at Lehman Brothers International Europe which underlay a whole range of dealer activities carried out by Lehman Brothers Inc., including securities financing transactions in its own proprietary book as well as a creating a margin collateral cushion for a whole host of derivative transactions and potential counterclaims.

So, what happens when customers start to feel a little uncertain about these arrangements? Quite naturally, they may begin to wonder about what their exposure might be given how their securities are in London. In fact, this, not subprime mortgages, is what led to Lehman’s end.

Hedge funds and dealers as Lehman clients scrambled to change these prime brokerage agreements limiting Lehman Brothers Inc. from being able to transfer assets into Lehman Brothers International Europe, or demanding they be transferred back, having the effect of stripping Lehman of a huge chunk of what had been available collateral by which to supply its global operations.

The rest was typical, traditional bank run stuff; rumors of Lehman being shaky led to the initial customer collateral “run” which then made Lehman shakier leading to more customers running in and changing their brokerage language. Soon enough, bye bye Lehman.

It was a run, but it wasn’t like one Walter Bagehot or Benjamin Strong would’ve recognized. It sure hadn’t been something Ben Bernanke or any of his kind considered too important, either. The latter group, contemporary central bankers, focused instead on the level of bank reserves, even as the federal funds effective rate had plummeted and been undershooting for a year by then.

What’s truly maddening is that authorities in the official sector have, and had, all the data – and absolutely no idea what to do with it. They have access to confidential streams, call reports, can pretty much open any book like any bank regulator in the past has been able to examine. They lack, however, the frame of reference so as to properly interpret this data no else has access to.

And if you think this has changed over the decade, now dozen years since the first Global Financial Crisis, I’ve got some very bad news for you. Beginning with, obviously, March 2020.

The term “regulatory arbitrage in the presence of non-harmonised re-hypothecation regimes” is contained within a January 2017 piece wrung together by the Financial Stability Board which comes to the somewhat familiar conclusions other intermittent such papers had already during the years; this kind re-pledging stuff sounds really important, maybe we should look into it.

As I wrote a few weeks back, it’s 2020 and the Europeans have only begun a pilot program to trace some securities financing transactions being executed on a few exchanges. If regulators and central bankers don’t appear to be in a hurry, that’s because they aren’t.

They need to be. What happened in March 2020 was merely the latest. I had written about the collateral bottleneck, as I called it for years anticipating the very danger, so many times before; in many key ways, it’s like what’s described above regarding Lehman. Dealers are exposed when a significant chunk of their collateral pool might be at risk; what’s more, they know it!

And, unlike central bankers and regulators, they don’t sit still waiting around to become the next Lehman – or actually believing, as the public is asked to, some Jay Powell-type might be able to bail them out with inert, useless bank reserves. If there’s a potential huge gap in their collateral pool, guess what? They’ll scramble and fight tooth and nail to fill it; including, like March 2020, bidding at outrageous premiums for any good, unencumbered collateral they might be able to secure.

While on the defensive, though, dealers won’t (can’t) do dealer things; the original problem of monetary incest, the procyclical core of GFC1. Once in danger, the dealer restricts its own activities because it has no other choice. If you don’t think you’ll have sufficient collateral, yours or others, to carry out the full range of money dealing activities, those are made to suffer while you hope everything gets sorted out.

Without Lehman to transact in these offshore, wholesale ways, it sure did (immediately) lead to problems with other dealers who then passed them along into more dealers as well as markets. Widespread liquidations. Fire sales. Contagion.

What doesn’t necessarily matter is if ultimately Lehman Brothers fails; or, if it manages to remain a going concern but out of necessity curtails its vital capacities anyway. So far as the system’s capacities, there isn’t any functional difference. It’s greatly diminished by either situation, monetary restriction and pro-cyclicality the result of both.

This seems to be the conclusion regulators and especially central bankers have gone out of their way to avoid as it pertains to the March financial crisis; there weren’t any Lehman-type failures this time around, so everyone must have done their job really well!

Meanwhile, the monetary system and the markets dependent upon them suffered massive dislocations even if there weren’t any headline-grabbing deaths or near-deaths. This included, importantly, the Treasury market itself; there hadn’t been too many securities for it, rather too few which restricted dealer capacities to do what dealers are meant to do (including intermediate selling in the Treasury market triggered in the first place by this global monetary implosion).

This is not strictly a US$ problem, either, though in the end the denomination matters very little. The eurodollar system is a monetary system made up of banks transacting in all major currencies, primarily the US$. Any irregularity/imbalance that might develop in a single currency bloc therefore negatively affects the whole (see: “Greek” debt crisis, 2010-12). Dealer impairment, especially where collateral availability might be concerned, is the monetary agent.

It's certainly not bank reserves; dollars or euros.

In fact, the way in which central banks create those reserves can have, and has had, negative effects on collateral. In Europe, a recent presentation (November 2020) given by Isabel Schnabel, Member of the Executive Board of the ECB, highlighted this non-neutral trade-off. In order to raise the level of bank reserves, any central bank must first purchase a security.

The net result is more bank reserves, less available collateral. The system, as usual, doesn’t stand idly by while central bankers pat themselves on the back over abundant reserves. The subsequent “safe asset shortage” can lead to, has led to, more securities lending activities to work around it:

“There are two other factors that have further alleviated collateral scarcity after December 2016. First, the set of securities eligible for APP purchases was expanded in January 2017. Second, anecdotal evidence suggests that the use of private securities lending operations has increased. The conference paper by Jank, Moench and Schneider (2019) investigates the re-use of collateral in response to scarcity induced by the Eurosystem’s large-scale asset purchases.”

She says these things like they’re positive developments!

When Ms. Schnabel refers to “alleviated collateral scarcity”, over here in reality what actually happened was that these workarounds only amplified the potential negative pressures which would arise of any bottleneck. More re-use and re-pledging, more securities lending, increasing the self-reinforcing destructiveness once the aggregate system collateral pool (in any currency denomination) comes under threat.

That was March 2020. Lehman Brothers II not required.

They have the data, they have numbers, and they have position reports we could only dream of obtaining. And they have no idea what they’re looking at. Further, authorities are in no rush to change this. Why would they be when bank reserves are, globally, “abundant” and no individual banks required official intervention even as global liquidations took hold anyway.

In the few studies and examinations which exist, in using Treasury securities it’s been figured these collateral re-pledging and rehypothecation chains average multiples of six to eight; meaning, that a single UST security might be reused for book and customer business six to eight times. Between 85% and 90% of all Treasuries taken on dealer books are re-used in some fashion. No wonder these banks might become skittish, and why Treasury (and similar collateral) prices remain the way they are.

The value in UST’s isn’t as an investment; it’s the liquidity premium demanded by a fragile global monetary system. These are balance sheet tools whose worth is derived from what central bankers and bank regulators (same thing) are in no rush to comprehend.

Currency elasticity is a time-honored worry. Here’s the thing, and it’s still the thing all these years later: just what is the currency which becomes destructively inelastic? Not what you’re led to think. Someone might want to check on bill prices recently. 

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

Show comments Hide Comments