Streetwise Professor

September 11, 2012

You Read It Here First

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 6:01 pm

Bloomberg’s Brad Keoun has out a long piece today highlighting the risks of collateral transformation, a development driven by Frankendodd’s clearing and collateral mandates:

Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.

Keoun quotes Darrell Duffie and Anat Admati raising concerns about the systemic risk that collateral transformation creates.  And bully for them, because they’re right.  As I pointed out in this post from July, 2011, and in several others in the months since (as well as in a paper in the J. Applied Corporate Finance.)  Anat argues that clearing and collateral mandates are resulting in the shifting of risk, rather than its reduction as promised by Frank ‘N Dodd and Gigi and Timmy!:

The banks’ new lending business “smells like trouble,” said Anat Admati, a finance and economics professor at Stanford who studies markets and trading and advises bank regulators on systemically important firms.

“The point of the initiatives on derivatives was that derivatives can hide a lot of risk,” Admati said. “Now they’re going to just shuffle the risk around.”

I wrote that mandates would result in a substitution of new forms of credit exposure and leverage for the credit exposures and leverage eliminated from derivatives via collateral in this July, 2010 Cato Policy Analysis (see especially p. 25).

So although these consequences were unintended, they were foreseeable and foreseen.

But even though these developments have been in train for months, and although they are pregnant with systemic significance, regulators are ignorant of the potential risks.  In the most shocking but not really part of his piece, Keoun writes:

U.S. regulators implementing the rules haven’t said how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment. [Emphasis added.]

But Congress and the regulators pinky swore that Frankendodd would make the system safer!  Trust us on this, they said.  We know what we’re doing!

Uhm, I don’t even think they slept in a Holiday Inn Express before taking on the wholesale reshaping of the vast derivatives markets.

Gensler and Geithner are particularly culpable here, because both pronounced repeatedly that Frankendodd, and specifically its collateral and clearing mandates, would reduce the interconnectivity of major financial institutions.

Not exactly.  Out with the old, in with the new: new interconnections, and arguably more fragile ones, are being forged to replace the old ones.  Again, predictable and predicted.

And they continue to assure the world that Frankendodd has made the world safer-even though the analysis necessary to support that claim has not even been done.

Think about it.  It is widely recognized that shadow banking, including quite specifically repo, was a major source of systemic risk that contributed to the severity of the financial crisis.  Collateral and clearing mandates have essentially resulted in the development of a new form of shadow banking.

This is an improvement?  Maybe it is.  But inasmuch as key regulators haven’t even acknowledged the development, and haven’t analyzed its systemic consequences, their pronouncements are not credible.

And make no mistake: this will not be the last big unintended consequence of Frankendodd that will tend to undermine the intent of the act.  And take fair warning: regulators are likely to be well behind the curve in understanding and reacting to these consequences.  Meaning that, to paraphrase Anat Admati, the systemic risk hasn’t gone away, it’s just been shuffled around.  That includes, mind you, the systemic risk resulting from the regulations and the regulators.

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  1. I expect prime brokers to come out with a comprehensive collateral management product that will maximize leverage for their clients for a fee. (Hedge funds worry a lot less about custody than they should.) The only entities left standing after a systemic event will be the clearing houses. Everything else will blow up in a mushroom cloud of perverse incentive counter-party credit risk.

    Comment by Highgamma — September 11, 2012 @ 9:05 pm

  2. @highgamma – either that will occur, or, more likely, another bail out of the clearing houses. This would disguise a bailout of parrticipants (political contributions, anyone?). The particular issue is that the use or extension of collateral risk means that at times of high stress the volume of trading in the “safe” collateral will spike dramatically, and probably overwhelm the markets ability to absorb it. Then we will be back to the same old crap that the lender of last resort has always done – lend on stuff no one can buy due to lack of liquidity. Same excrement, differetn bag, that is all.

    Comment by Sotos — September 12, 2012 @ 8:19 am

  3. […] will collateral transformation create a bubble? Ah, let’s not think about it. Obama’s Dodd-Frank Made Us […]

    Pingback by Fishy films, London whales, and Mike trouts « Rhymes With Cars & Girls — September 13, 2012 @ 10:13 am

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