Streetwise Professor

November 9, 2011

Procyclicality in Action

Ironically, in financial markets positive feedback loops are typically a very negative thing.  Self-reinforcing spirals in tightly coupled systems like the financial markets are usually downward spirals.

Margining and collateral mechanisms are the most important positive feedback mechanism in financial markets.  AIG and MF Global are two examples of how these mechanisms turn high flying financial firms into smoking holes in the ground.  They suffer losses, counterparties demand more collateral, that puts further stress on the firm, they lose customers, counterparties demand even more capital, and before you know it–impact with the ground at high speed.

Procyclicality of margin can work at the level of the market too.  We are seeing the first signs of that with respect to Italy today.  LCH.Clearnet SA (the French arm, and not RepoClear) raised margins on Italian government debt today.  This will tend to induce some sales of leveraged Italian bond positions, which will reduce prices further.  Similarly, increasing haircuts will tend to reduce liquidity, which will also tend to put downward pressure on prices.  Lower prices and lower liquidity put further pressure to raise haircuts.

So–lookout below!  The spiral has begun.  Keep eyes on RepoClear.  I imagine it will be under tremendous pressure to avoid jacking up repo margins.  And who knows, since the 450 basis point  margin raising trigger* is based on the spread over an average of German, French, and some other countries’ debt, maybe RepoClear won’t have to raise margins on Italian bonds because French yields are rising too, due in large part to French banks’ holding of $400 billion in Italian bonds.  The looking glass world of Europe . . . .

Another comment, following on the previous post.  There will be tremendous pressure on CCPs to accept riskier collateral in the clearing mandate world.  Sovereign debt has been a primary asset for margining purposes, and the assumption has been that this collateral is low risk.  But we now know that is a fiction.

Pressure to expand collateral pools, combined with the risk that said collateral can decline in value, and precipitously, creates another positive feedback mechanism.  Markdowns in collateral held at CCPs (or indirectly, via collateral transformation services) will induce fire sale liquidations of margined positions, or of other assets in order to raise cash to offset the decline in the value of collateral.

Geithner, Gensler and others have touted collateral as the elixir for all derivatives market ills.  No.  In some circumstances the elixir is really a deadly poison.  Positive feedback mechanisms destabilize financial markets, and collateral mechanisms are among the most important sources of positive feedback in these markets.  We are moving to a regime in which more collateral is being required, collateral mechanisms are being made more rigid and less flexible (e.g., reducing hypothecation) but the supply of safe collateral is contracting–or at least not growing commensurately with the demand.  This will be a major source of fragility in the system, and one that has been built into the system all in the name of making it more robust.  Another gift from the sorcerer’s apprentices.

* The term “trigger” is hardly comforting in this context.

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  1. Go, Prof.

    On top of all that, US money-market funds are being guided away from lending overnight to euro banks. Hence the french banks’ dollar scramble. Dollars are backing up all over the streets of Manhattan. Shadobbie. All this chitter-chatter, chitter-chatter … to live in this town you’ve gotta be tough, tough, tough, tough … what does it matter … velocity’s collapsing … it’s in tatters … shattered … shattered.

    Comment by markets.aurelius — November 10, 2011 @ 6:47 am

  2. I try, MA. Nice musical tastes . . . suggests we’re contemporaries. And nice tweaking of the lyrics. Well done!

    The ProfessorComment by The Professor — November 10, 2011 @ 7:33 am

  3. What people are beginning to realize, as you pointed out in a prior post is that collateral has costs – what this seems to be is that the cost of collateral will be how this crisis is made manifest: as thing go to hell in a hand-cart, fails will occur that cause the lender of last resort to prop up another part of the system. The ability for more collateral posting by an insolvent party is limited, and those limits can be reached quickly/ As the collapse of SIV and some conduit ABCP issuance was the opening bell of the latest fiasco after Lehman fell, so haircuts and fails will be for this one. To carry the analogy further, there will be a razor haircut so close that a number of throats will be cut.

    by the way, did anyone notice that Government Sachs is selling another piece of its ICBC stake at discount? I wonder why?

    Comment by Sotos — November 10, 2011 @ 1:36 pm

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