At 174 pages, this is the most thorough, enlightening (and longest) financial and economic review and outlook I’ve run across.
If you’re put off by the size of this tome, the FT Alphaville blog focuses in on what it considers to be “the most important chart in the world,” which can be found on page 143 of the report:
[This chart] shows how the world’s outstanding stock of safe haven assets denominated in either dollars or euros has evolved, adjusted to account for the Fed’s purchases of US Treasuries and other assets in recent years as part of quantitative easing.
You can see just how impressive the decline has been since the end of the crisis, and we’d also note that if Credit Suisse had been feeling uncharitable, they would have been justified in excluding French sovereigns.
The chart helps explain much of what’s happening in global financial markets now, especially in Europe (not on its own, mind you — we said “helps” explain):
– Begin with the ongoing collateral crunch, and how the decline of safe assets is directly tied to the dramatic fall in the availability of high-quality collateral in European lending markets. So much of it is now encumbered via direct bilateral funding agreements or by sitting at the central bank drawing liquidity.
Now, if you’ve read your Manmohan Singh [Footnote 1] (or your Izzy Kaminska [Footnote 2] or your Tracy Alloway [Footnote 3]), you’ll know that this availability is the first of two parts of the collateral shortfall effect. The other part is the shortening of “re-pledging chains”, otherwise known as a reduction in the velocity of collateral and which Singh explains thusly:
Intuitively, this means that collateral from a primary source takes ‘fewer steps’ to reach the ultimate client. This results from reduced supply of collateral from the primary source clients due to counterparty risk of the dealers, and the demand for higher quality collateral by the ultimate clients.
And why does it matter? Singh again, emphasis ours:
The “velocity of collateral”—analogous to the concept of the “velocity of money”—indicates the liquidity impact of collateral. A security that is owned by an economic agent and can be pledged as re-usable collateral leads to chains. Thus, a shortage of acceptable collateral would have a negative cascading impact on lending similar to the impact on the money supply of a reduction in the monetary base. Thus the first round impact on the real economy would be from the reduction in the “primary source” collateral pools in the asset management complex (hedge funds, pension and insurers etc), due to averseness from counterparty risk etc. The second round impact is from shorter “chains”—from constraining the collateral moves, and higher cost of capital resulting from decrease in global financial lubrication.
When you hear concerns that the ECB has lost some control over monetary policy because of a liquidity-starved credit channel — or indeed when you hear Draghi himself say that he’s cognizant of the “scarcity of eligible collateral” – this is why.
– As was perhaps inevitable, the decline in safe assets has come at a time when investor demand for these assets has only climbed for them and as the deep freeze in European unsecured lending has meant a big shift towards collateralised lending. Hence the widening discrepancy in repo prices for different types of collateral (also noted by Draghi) and, in particular, the negative spread between Libor and the secured repo rate, on which Izzy superbly elaborates. For all but the strongest banks, i.e. those with surplus cash reserves, the ECB is increasingly the only shop still open.
– There are future policy considerations here as well. Back to Singh one last time:
Recent regulatory efforts will require significant collateral on many fronts—Basel’s liquidity ratios, EU Solvency II and CRD IV, and moving OTC derivatives to CCPs. Unless there is a rebound in the pledgeable collateral market, the likely asymmetry in the demand and supply in this market may entail some difficult choices for the markets and the regulators.
It stands to reason that the collateral grab has been exacerbated as financial institutions anticipate the onset of these regulations. This has already led to much talk about a burgeoning collateral transformation industry, though apparently there remain questions as to how big it will get and what kinds of unintended systemic risk could result.
– A somewhat obvious and related point here, but the loss of “safe” status for so much debt contributes to the deleveraging burden of European banks and their American subsidiaries; by definition it means higher risk weightings for these assets.
Declining asset quality is surely also one reason that European banks had trouble funding themselves in US repo markets, and the resulting stress in the currency basis swap markets as banks sought dollars elsewhere led to last week’s intervention.
And it’s probably why US money market funds, worried about what the absence of safe asset holdings at European banks means for their stability, have continued retreating as a source of wholesale funding, and why the American subsidiaries of these banks are now liquidating their dollar reserves to make up for it.
– Another obvious and related point, which is that the ECB is now accepting everything but your dirty socks as collateral. Not much choice in the matter, we suppose, if it wants to ease the liquidity strains caused by the broken interbank market. What else can it lend against?
– Historically, a Triffin Dilemma — and that’s kinda what this is — leads to funky innovations in the shadow banking system and all the complications that such innovations bring. Will the whispers of new kinds of financial alchemy get louder?
– You can see in the chart that before the crisis, US Treasuries were an important but minority amount of the world’s stock of safe haven assets. Treasuries are now the vast majority of such assets. But this is because of the extraordinary decline in the other kinds of assets and because of quantitative easing by the Fed, not because the outstanding stock of Treasuries has increased by so much.
Issuance in recent years hasn’t been nearly big enough to make up for the decline in other kinds of safe assets or, certainly, to correct the imbalance between investor demand for safe assets and outstanding supply. We’re not saying it should have been — only that this further confirms how absurd it is that the US government has spent so much time this year bickering over deficits rather than economic growth, and that the US economy confronts a fiscal drag beginning next year.
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Footnote 1. Manmohan Singh, “Velocity of Pledged Capital: Analysis and Implications,” IMF Working Paper, November 2011.
Abstract: “Large banks and dealers use and reuse collateral pledged by nonbanks, which helps lubricate the global financial system. The supply of collateral arises from specific investment strategies in the asset management complex, with the primary providers being hedge funds, pension funds, insurers, official sector accounts, money markets and others. Post-Lehman, there has been a significant decline in the source collateral for the large dealers that specialize in intermediating pledgeable collateral. Since collateral can be reused, the overall effect (i.e., reduced ‘source’ of collateral times the velocity of collateral) may have been a $4-5 trillion reduction in collateral. This decline in financial lubrication likely has impact on the conduct of global monetary policy. And recent regulations aimed at financial stability, focusing on building equity and reducing leverage at large banks/dealers, may also reduce financial lubrication in the nonbank/bank nexus.”
Footnote 2. FT Alphaville, “Draghi: ‘We are aware of the scarcity of eligible capital,” posted December 1, 2011.
The ECB’s Mario Draghi gave a speech to the European Parliament on Thursday, making some of the following key points:
RTRS – DRAGHI-DOWNSIDE RISKS TO ECONOMIC OUTLOOK HAVE INCREASED
RTRS – DRAGHI-ECB TEMPORARY MEASURES ONLY LIMITED
RTRS – DRAGHI-ECB AWARE OF CONTINUING DIFFICULTIES ON BANKS
RTRS – DRAGHI-AWARE OF MATURITY MISMATCHES, STRESSES ON BANK FUNDING
RTRS – DRAGHI-CHANGES IN STRAINED COUNTRIES HAVE NOT YET HAD IMPACT ON FRAGILITY OF FINANCIAL MARKETS
RTRS – DRAGHI-CREDIBLE SIGNAL NEEDED TO GIVE ULTIMATE ASSURANCE OVER THE SHORT TERMAnother point also raised (but not flashed by Reuters for some reason) was that authorities are aware of the scarcity of eligible collateral in some financial segments. This in our opinion is a key issue and one which cannot easily be fixed by ECB purchases.
As Draghi noted:
Dysfunctional government bond markets in several euro area countries hamper the single monetary policy because the way this policy is transmitted to the real economy depends also on the conditions of the bond markets in the various countries. An impaired transmission mechanism for monetary policy has a damaging impact on the availability and price of credit to firms and households.
Furthermore, it echoes Draghi’s comments from November 18, when he said:
We are aware of the current difficulties for banks due to the stress on sovereign bonds, the tightness of funding markets and the scarcity of eligible collateral. We are also aware of the problems of maturity mismatches on balance sheets, the challenges to raise levels of capital and the cyclical risks related to the downturn.
In the money market, we see rising spreads between secured and unsecured segments, and a widening of repo prices between different types of collateral. Interbank activity remains subdued and concentrated in the very short-term maturities. This limited activity is reflected in increased recourse to our liquidity-providing operations, as well as to our deposit facility.
He’s trying to get a point across. Not only is the ECB arguably losing control, it’s trying to flag up that the chaos is the result of messed up transmission mechanisms in dealer markets more than the result of a changing view of Eurozone credibility.
No wonder the reaction in the German bund market has been as follows:
RTRS-GERMAN 5-YEAR GOVERNMENT BOND YIELDS FALL 6 BPS ON DAY TO 1.113 PCT
RTRS-GERMAN ONE- TO SIX-MONTH GERMAN TREASURY BILL YIELDS DIP FURTHER INTO NEGATIVE TERRITORY AFTER DRAGHI COMMENTS
Even if the ECB broadens the criteria on the collateral it acccepts — and remember it already accepts some of the poorest quality collateral in central banking circles — that won’t necessarily solve the problem in the public bilateral markets where only top quality bonds will do. And it’s what is happening in the bilateral and interbank markets which is determining the fate of the eurosystem.
Footnote 3. Financial Times, “Financial system creaks as loan lubricant dries up,” November 28, 2011.
Whoosh! That’s the sound of up to $5,000bn worth of collateral draining from the financial system. And it is not a reassuring one.
Large banks typically reuse securities handed over to them by big investors such as hedge funds, insurers or pension funds. They do so by pledging the assets out through the so-called repo or securities lending markets, generating a return for themselves and their clients but, in the process, also helping to lubricate the global financial system.
Since the financial crisis, though, these “chains of collateral” have become much shorter, meaning securities including government or mortgage bonds are not being recycled through the system as much as they used to be.
While that might help reduce overall risk, by limiting leverage, it has important implications for the way the system works and the global economy.
Some analysts believe that this fall in collateral use could actually serve to increase “hidden” risk in the financial system as the market devises new ways of tackling the shortage.
One reason collateral use has fallen is that market participants are more vigilant about the creditworthiness of counterparties and how business partners might use collateral sent to them.
Financial institutions are also increasingly trying to manage risk by taking “haircuts” – clipping some of the value on assets being traded to add a bigger safety cushion. That, in turn, limits the extent to which securities can be recycled just as the pool of available collateral is shrinking.
More collateral is also being tied up at the world’s central banks, and especially at the European Central Bank, as commercial lenders turn to them for financing. The ECB’s balance sheet has ballooned to more than €2,000bn as the region’s banks exchange their assets, such as bank bonds or bundled loans, in return for central bank funding.
The lack of financial lubricant has important consequences. It may, for example, be one reason why businesses and households have not felt the full effect of monetary easing by central banks, analysts say. Financial lubricant is needed to transmit rate cuts and boost the economy.
Regulatory reforms, including new capital rule for banks and moves towards central clearing of derivatives trading, are expected to intensify the chase for “decent” securities, potentially clogging the system further by locking up more collateral. One result of all this has been a boom in specialist collateral management services. So-called “collateral transformation” is being marketed to derivatives users as a way for them to obtain the cash or government bonds they will need for central clearing. Liquidity swaps, where banks exchange illiquid assets for more liquid ones, are also being used by banks to help meet the new requirements on capital.
These kinds of services may help to keep the world’s financial plumbing in good running order. However, many market participants still expect demand for collateral to exceed supply. Moreover, some argue that such services place a question mark over whether risk is being reduced or simply shifted around the system, potentially flowing into less regulated areas as it did before the 2008-09 crisis. The concern over such flows is that the effect, should there be another bout of severe market turmoil, could be similar to the rise of the “shadow banking system”, which thrived on leverage in the run-up to the financial crisis and helped cause the huge losses at Lehman and others.