The Financial System Is Running Out of Quality Collateral

15 january 2013

Worry about the global economic slowdown and tumbling stock prices. Then, worry about the scarcity of the highest quality collateral( US, German, Swiss government securities) and the rising cost of finding them– and the resulting handcuffs being placed on monetary policy in helping   financial institutions to provide credit.

Give credit to Bob Smith, founder of Smith Capital, a  New York-based fixed-income investment manager, who has been right on the mark all year about  predicting deflation– not inflation– and as a result his institutional acconts– are up 7%-8% so far.  It is Smith who has been giving me a gritty tutorial about the threat to the banking system of the dire collateral shortage. He called me this afternoon to underscore just how dangerous this murky area of finance is becoming.

Yes, the rush to  safety has pusheed the 10 year Treasury  yield in the US to 1.47%– an alltime record low. In Germany the return is only 1.20%, hardly enough to buy lunch for the bankers.  The Swiss 2 year note has a negative yield; you pay the Swiss to hold their paper. This  development signals just how frightened investors round the world are today– as Europe seems primed to experience a painful deterioration in its economy anbd financial markets.

Another pressure point on bank profits is the haircut they must take on collateral they utlize to do their business. You used to be able to borrow 99.5% on the face value of  Treasuries.   Now you can only get 91 or 92% of face value. On corporates you used to get 95% of the value as collateral; now you only get 75%. And no one’s willing to utlize  the  huge volume  of securities  from  Fannie Mae or Freddie Mac as collateral anymore.

No one is taking Greek paper, and I’d bet the ban will be extended to Spanish and Italian debt. Who knows what it’s worth. In fact, Smith tells me the threat of the rating agencies’ downgrade of Spanish banks is driving up the cost of collateral in Spain by a multiple of 3x to 4x.  Smith’s conclusion; as collateral becomes scarce and the cost of using it rises arithmetically– the earnings at most banks will decline. D espite the low cost of money, obtaining collateral for use is becoming hugely expensive. The flight to quality costs money.

That rising cost together with the shortage of  safe bonds means the extension of crdit must naturally be reduced.  And the banks’ ability to play the interest rate curve to build capital will be reduced as well, stresses Smith.

Should Morgan Stanley‘s credit rating be reduced, it will  require the firm to immediately raise $2 billion to $10 billion more collateral, Smith feels. That’s why the firm is trying to move its $52 trillion nominal value in derivative transactions to its own bank– in order to get it off  the investment bank’s balance sheet.

In the UK British banks have leveraged security positions that amount in monetary terms to 48% of the entire GDP of the UK. Should their credit ratings be lowered, thee banks will face the precarious necessity of upgrading the collateral they are using.

Lastly, the shortage of collateral impacts the whole rehypothecation of securities in the global banking system, where collateral is used in one transaction like a repo or a swap, and then reused again for yet another transaction. This daisy chain– invisible to the markets and the public– could also be negatively affected by the shortage of high quality, highly rated securities in the world.

Today, Morris Offitt of Offitt Capital, another fixed income investment manager, put out a memorandum underscoring the difficulty of obtaining US Treasury securities despite the increase in their issuance the last 4 years to $15 trillion.  Investors trying to safekeep their capital, are scouring the world for US government securities. It is the most fantastic phenomenon in a dangerous world.