The sovereign bond crisis is going to play out in a way you don’t expect. It’s going to get you by the back door, just like the sub-prime loan mess did. In fact, the very same back door.
‘It’s all got to do with collateral, you see.’
There’s a joke around the office about certain statements which should never be used on a first date. And that one was a winning entry. But that doesn’t mean it is not all about collateral. The stock market, the bond market, the entire economy – they are all about collateral. At least collateral is the crisis trigger that keeps popping up to ruin your day. Here are some examples of how –
Mortgages failed in 2007 because the collateral in the lending agreement (the house) fell in value. The fancy pants creations from Wall Street, which repackaged those mortgages into investments for unsuspecting investors, failed because the collateral (the mortgages) failed.
Then the investment banks started to struggle because the collateral they used in their short term borrowing (the mortgage bundles) failed. The banks had to be bailed out by the governments, which made the governments’ financial position worse. So now the supposedly safest collateral the banks use to secure funding (sovereign bonds) is failing too!
That was a series of recent examples where it was all about collateral. Those events brought the world economy to its knees. But even Shakespeare’s Shylock was tricked by collateral. In The Merchant of Venice, Shylock agrees to lend Bassanio three thousand ducats so that he can woo his princess Portia who lives in Belmont. (Can you feel the first date being rescued?)
The collateral for the interest free loan is a pound of flesh from Bassanio’s mate Antonio, who is the guarantor for the loan. (Shylock only gets the pound of flesh if the money isn’t repaid.) Antonio’s business ventures fail and he can’t pay up for his mate’s expensive wooing endeavour. So Shylock wants his pound of flesh. Luckily, Portia happens to be a brilliant legal theorist and, disguised as a man, becomes the saviour of her now husband’s mate Antonio.
She argues that Shylock is entitled to a pound of flesh, but not a drop of blood, because the contract didn’t mention any blood. Shylock, unaware of the English legal principle of ‘implied terms’, is cleverly outargued and loses out on his collateral.
So collateral is the trigger for just about every financial problem these days. Fictional and non-fictional.
That’s odd considering the whole point of collateral is to reduce risk, not increase it. You have to wonder whether those whizz bang risk models that bankers use to evaluate their borrower’s risk include the risk of the collateral going down the toilet. Did the mortgage bundlers realise that house prices were a key ingredient in the investments they were creating?
It’s too late to go back now when it comes to housing and mortgage investments. But the same story is playing out with another crucial asset in our economy – sovereign bonds. These are as popular as they are because for banks they are a great form of collateral. And without collateral, you don’t get much done in the finance industry.
That’s because, rather than spending time evaluating the financial position of every single counterparty, the financial world simply requires collateral to be pledged. That makes the act of lending a lot less risky and time consuming. Rather than looking at the balance sheet of a potential borrower, you just require them to pledge a risk free asset that you get to keep if the lending agreement goes pear shaped.
Having dealt with the risk of default, the financial system has created a different risk though. One that it doesn’t seem to take much notice of. We’re not sure if the term ‘collateral risk’ has been taken yet by the academic world, but we’ll use it in the following sense: Collateral risk is the risk of the collateral in a lending agreement causing the lending agreement to break down.
On a system wide basis (systematic collateral risk), this means that the failure of a commonly used type of collateral can cause an entire financial system to fail. Suddenly, the counterparty risk you thought you had escaped by using sound collateral comes back to haunt you.
How does collateral risk work in practice? In 2007 and 2008, Lehman Brothers and Bear Stearns used AAA rated CDOs as collateral to secure short term funding. They would borrow money from lenders and hand over CDOs to their lenders as collateral in case they defaulted.
Those CDOs turned out to be bundles of risky mortgages, not worth a single A. And so lenders stopped accepting them as collateral. That made it impossible for Bear and Lehman to refinance themselves, because they had no other quality collateral to pledge. And that’s why they went bust.
The same thing is about to happen with sovereign bonds. With a twist. Sovereign bonds are considered such good collateral that they can be pledged with the central bank for loans. And the central bank is not just any old lender. Its whole purpose is to keep the financial system alive. That means it is willing to engage in some dodgy practices. Back to that in a moment.
All this collateral pledging can take on a life of its own. It can outgrow the actual point of having collateral in the first place – to secure lending agreements. With a financial system on life support, survival comes first. And survival means having access to the central bank. To do that, you need collateral. Which means having enough collateral to pledge for emergency loans has become even more important than the quality and amount of lending itself.
That has led to an absurd practice between central banks and the banks they are trying to keep alive. The cycle works like this: Sovereign bonds fall in value, making a bank’s investment in them disastrous.
To be rescued, the bank pledges collateral, in the form of sovereign bonds, to the central bank in exchange for a loan. But the more sovereign bonds held by the banks to be used as collateral, the worse the investment position of the bank gets, the more they need from the central bank. And to get more money, they need more sovereign bonds to pledge.
The cycle reaches absurdity when the central banks come up with this sort of nonsense, explained by CNBC:
‘… the Bank of England is lending short-term government bills to banks, which use the securities as collateral to borrow money from the central bank at a rock-bottom rate – about 0.25 percent – and then make loans.’
So the sovereign bonds go from the banks to the central bank in a normal loan for collateral agreement, then back to the banks so that the banks can have more collateral to repledge with the central bank for more money.
If they can play this game once, they can probably do it many times over. They simply borrow assets that can be pledged as collateral from the central bank and then repledge them again and again, getting more and more cheap money each time.
All this begs the question, can you use something pledged as collateral with you in another transaction?
That, Daily Reckoning reader, is the world of rehypothecation. It’s a lawyer’s wonderland, so we won’t be going there.
What is worth taking notice of is how devoid the financial system has become from any sense of reality. In our opinion, this springs from the fact that money is no longer an asset. It used to be a specified amount of something, like a pound of sterling silver or 1/35th of an ounce of gold. Now, it is a nothing. And you can do a surprising amount of odd things with a nothing.
Eventually, all this will break down. Then we’ll be back to ‘he who owns the gold, makes the rules.’
Until next week,
The Daily Reckoning Weekend Edition
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