REITs are not the largest borrowers on the repo market

I have a nit to pick with Tracy Alloway’s recent reporting on the repo market. She writes:

What remains of the $4.2tn market is increasingly being taken up by non-bank entities such as real estate investment trusts (Reits), mutual funds and hedge funds . . . The growing use of repo has been particularly marked among Reits, which have overtaken banks and broker-dealers as the largest borrowers in the market, according to Federal Reserve data. To purchase long-term mortgage assets, Reits have increased their repo borrowings to $281bn, up from $90.4bn in 2009. Closed-end funds, which invest in assets ranging from corporate bonds to municipal debt, also have increased their borrowing in the repo market, from $2.74bn at the end of 2007 to almost $8bn now, according to Fitch Ratings data.

Her data is apparently derived from the flow of funds data, which states that in Dec 2013 REITS has $281 bn in repo borrowings and broker dealers had $135 bn in *net* repo borrowing.

If REITs had indeed “overtaken” banks and broker-dealers as the largest borrowers in the market with a share of $281 bn, it would be very hard to explain how the market could possibly be a $4.2 tn market. In fact, of course, the broker-dealers are using their own (government supported) creditworthiness to intermediate access to the repo market for their customers, who don’t have the credit to borrow directly on the tri-party repo market. For this reason, it is almost certain that broker-dealers remain the largest borrowers on the market. In fact on page 170 of JPM’s 2013 10-K we find that this one bank had $156 bn of borrowings in the repo market. GS 10-K has $165 bn in such borrowings (p 173).  In short, the fact that the broker-dealers are intermediating access to credit should not be used to obfuscate the fact that they are the largest borrowers on the repo market.

 

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What are the elements of a healthy financial system?

Gary Gorton argues that the repo and securitization markets that developed over the last quarter of the 20th century are healthy phenomena and that we really don’t have much choice, but to preserve them.  While there are many aspects of his analysis with which I agree, I draw very different conclusions from the evidence he cites.  The bullet points below are the conclusions of this paper (h/t Felix Salmon actually that should be h/t Richard Smith — my apologies for sloppy link-tracking — was too overcome by the debating spirit once I took a look at the paper in question).

•As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Regulation Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system. Securitization became sizable.

I have no argument with this narrative of financial evolution, but I think that Gorton is missing an important point.  Money market mutual funds (MMMFs) are banks that are exempt from capital requirements, because they are (in theory, if not in practice) not protected by deposit insurance.  Any regulation that puts traditional banks in competition with money market mutual funds is sure to result in an undercapitalized banking system — either because uncapitalized MMMFs take over the role of intermediation or because the banks find ways around traditional capital requirements.

In fact, I agree with many aspects of Gorton’s analysis:

Holding loans on the balance sheets of banks is not profitable. This is a fundamental point. This is why the parallel or shadow banking system developed. If an industry is not profitable, the owners exit the industry by not investing; they invest elsewhere. … One form of exit is for banks to not hold loans but to sell the loans; securitization is the selling of portfolios of loans. Selling loans – while news to some people—has been going on now for about 30 years without problems.

My difference with Gorton lies in the approach to MMMFs and securitization.  I think that MMMFs are uncapitalized banks and that securitization was the process by which traditional banks also became undercapitalized.  Thus both are a major source of financial instability.  Gorton, by contrast, believes that MMMFs and securitization have stood the test of time.

In my view, the fact that this predictable evolution occurred does not mean that it was a healthy development for the financial system.  The fact that it took 30 years for all the contradictions built into this brave new financial system to result in a crisis large enough to threaten the whole financial system does not mean that crisis was not inevitable from the beginning.

•The amount of money under management by institutional investors has grown enormously. These investors and non‐financial firms have a need for a short‐term, safe, interest‐earning, transaction account like demand deposits: repo. Repo also grew enormously, and came to use securitization as an important source of collateral.

Once again, I don’t see that the fact that securitized assets were used as an important source of collateral in repo as evidence that this phenomenon is either good or healthy.  In all likelihood, the bankruptcy reform act of 2005 (which expanded the priority status in bankruptcy proceedings of Treasury/Agency repo to virtually all repo contracts) precipitated the growth of low-quality repo and may (given the absence of repo data this is all but impossible to demonstrate) have been a proximate cause of the catastrophic failures of Bear Stearns and Lehman Bros.

It’s my impression — once again on the basis of very limited data — that the repo market currently has shrunk to depend mostly on the traditional high-quality collateral that underlay its growth over the last quarter of the 20th century.  And that the broker dealers have shrunk their balance sheets and changed their liability structure to adapt to this new environment.  This change is healthy, because high-quality assets are by their very nature protected from the 20% and higher haircuts that precipitated the repo crises of 2008.  In my view the growth of the repo market is not unhealthy, as long as the market is restricted to only the highest quality assets.

•Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately‐created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.

Absolutely, “repo is money”.  And sound backing for the money supply is found (i) in a Central Bank that holds mostly government debt as backing for the money supply and (ii) in a banking system that is well capitalized.  If banks want to use repos for funding (which are collateralized, rather than protected by capital reserves like traditional loans) then they need to rely on collateral that is appropriate backing for the money supply — like Treasuries.  Allowing senior tranches of synthetic CDOs — in other words credit default swaps — to be used as backing for the money supply was madness.  And I sincerely hope that our regulators do not experiment again with the degradation of the money supply that took place in the late naughties.

•In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.

“Firm failures should not be caused by fire sales.”  This statement is just far to general.  If hedge funds fail because of fire sales, the appropriate regulatory response is:  “Sorry, folks.  Shit happens.”  Our regulators do not have a responsibility for ensuring that all markets are liquid all the time.  If they ever try to take on this responsibility, they will probably be as successful as the Soviet Union was in planning production.

Banks that play an important role in the monetary system are different matter, but even here the goal of regulators is not to prevent firm failures — the goal is only to protect the stability of the money supply.  Traditionally (see Bagehot’s reaction to the failure of Overend Gurney) the first bank is allowed to collapse and the central bank provides abundant liquidity to support the remaining banks through the fire sales.  Any bank whose capital is wiped out by the failure of the first bank to honor its liabilities is also allowed to fail (since it faces a solvency not a liquidity crisis).

When one remembers that the goal of regulators is not to protect firms from failure, but to protect the stability of the money supply, one realizes why it is so important for regulators to demand that repos be backed only by the highest quality assets.  Any other policy will force the central bank to take low quality assets onto its balance sheet in a crisis and undermine the stability of the money supply.

One also realizes that there is a strong theoretic foundation for the argument that banks should be small.  The failure of any large bank that holds more than 5% of the economy’s deposits can undermine the stability of the money supply — and may put regulators in a position where they are forced to conflate protection of the money supply with protection of an individual firm from failure.  I don’t think that the dangers created by government officials who believe that their job is to protect firms in a free market economy from failure need to be explained.

• The crisis was not a one‐time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.

Bank liabilities have a vulnerability — and banks protect themselves from that vulnerability by being well-capitalized.  The fact that securitization undermines a bank’s capital position is precisely the reason that it has come in for so much criticism.  When and if securitizations are structured as true sales with no implicit or explicit recourse to bank balance sheets, they will be a positive addition to our financial arsenal.  However, as long as securitizations just represent bank assets against which banks are not required to hold capital reserves, they weaken the financial system rather than strengthening it.

In my view the elements of a healthy financial system are:

(i) a central bank that stands ready to provide abundant liquidity in a crisis, but will not step in to protect individual firms from failure.
(ii) a well-capitalized banking system.
(iii) absence of pseudo-banks that face preferential regulation like money market funds.
(iv) regulators who understand the many ways in which banks underwrite “market-based” lending and who require banks to hold reserves to honor their commitments to such “market-based” lending programs.

What is to be done? #1-13

To address the systemic risks caused by collateralized interbank lending, it is important to discourage large financial institutions from borrowing on a collateralized basis.  For example, if large financial institutions are prohibited from entering into over the counter derivative contracts that require them to post collateral, then their counterparties will be forced to evaluate the credit risk of being exposed to them.  Since every counterparty will favor the more creditworthy financial institutions, market forces will once again function to encourage the growth of conservatively run firms.

Collateral is intrinsic to the market for repurchase agreements and this market is far too large to disrupt by prohibiting the participation of large financial institutions.  On the other hand after the recent turmoil, it should not be difficult to remove the safe harbor protection for repos of less liquid assets – effectively, it is advisable to repeal those sections of the 2005 Bankruptcy Act that apply to repurchase agreements.  The repo market functioned reasonably well for a quarter of a century and imploded shortly after it was enlarged to included riskier assets.  As the riskier assets were the first to be rejected by repo counterparties, the presumption must be that we are better off with the narrower privileges granted to repurchase agreements in 1984.

To those who would argue that collateralization is necessary in order for derivative markets to function, I observe that this claim is simply false.  Collateralization of over the counter derivative contracts was introduced in the early 1990s.[1] Thus, the market for interest rate and currency swaps grew to more than $10 trillion in notional value before collateralization of derivatives became common.[2] Clearly, collateralization is not necessary to the operation of derivative markets.

In fact, financial markets are likely to be healthier when uncollateralized contracts are the norm.  In an environment where the credit risk inherent in every contract is obvious, there will be very few participants who are willing to do business with an unsound counterparty.  When unsound counterparties are shunned, the business of well-managed firms grows and the business of poorly managed firms shrinks.  Thus in an environment with uncollateralized contracts the natural dynamics of the financial system will tend to reduce leverage and promote stability.  This stands in stark contrast to the dynamics generated by a financial system that relies on collateral.

While unsecured interbank lending plays an important role in financial stability, it is appropriate to require collateral when dealing with an unreliable or an unproven business partner.  As long as some derivative contracts continue to require that collateral be posted, financial statements need to give the user an idea of how the collateral situation may change over the quarter.  For example firms could be required to report the maximum amount of collateral that could be called in two scenarios (i) the most adverse pricing environment and (ii) the most adverse pricing environment that was actually experienced over the past twenty-five years.

Furthermore, if Congress were interested in more thorough reform of over the counter derivatives markets, it could repeal the derivative and repo related bankruptcy amendments of 1984, 1990 and 2005, redefine repurchase agreements and swaps as securities and rely on the 1982 bankruptcy amendment to protect the interests of repo and swaps traders.  For this reform to work repo traders would have to form a Repo Trader’s Association and register with the SEC as a self regulatory organization.  Similarly, the ISDA – or an American offshoot of it – would have to act as a self regulatory organization subject to the supervision of the SEC.  Under this scenario repos and swaps would become regulated contracts like futures and options and receive the same protections – including safe harbor under the bankruptcy code – that other regulated derivatives receive.


[1] 1999 ISDA Collateral Review, p. 1  http://www.isda.org/press/pdf/colrev99.pdf

[2] The ISDA reports that by the end of 1994 there $11.3 trillion of currency and interest rate swaps outstanding.
http://www.isda.org/statistics/pdf/ISDA-Market-Survey-results1987-present.xls

Evaluating Collateralized Interbank Lending #1-12

The 2008 crisis demonstrated unequivocally that when the borrower is a large financial institution, collateralized lending does not protect the lender from losses.  Without the intervention of the Federal Reserve as a lender who was willing to accept collateral that nobody else was taking, many of the largest repo market participants would have been forced to sell this collateral in order to meet their obligations.  These forced sales would have driven asset prices far below those observed in 2008 – and all the major players in the repo market would have posted much larger losses than they did.

The case of AIG provides further evidence that collateralizing derivatives fails to protect the “in the money” counterparty from losses.  Collateral calls following a rating agency downgrade of the firm drove it towards bankruptcy and precipitated a bailout in the form of a loan from the Federal Reserve.  Notably $22 billion was passed from the Fed through AIG to counterparties in 2008.  It is abundantly clear that this collateral would not have been posted in the absence of government intervention and thus, if standard bankruptcy procedure had been followed, AIG’s counterparties would have been short $22 billion on their derivative contracts.

The 2008 crisis demonstrates that the only protection a bank has against the failure of a large counterparty is the intervention of the central bank.  Because of the fear of fire sales, collateral fell in value just when its protection was most important to lenders.  Similarly, large collateral calls themselves precipitated bankruptcies – with the result that without the help of the Federal Reserve the collateral would never have been posted.  In short, collateral was worse than useless throughout the crisis, because it served to destabilize financial institutions rather than to stabilize them.

The 2008 crisis raises this question:  Is collateralized interbank lending an inherently destabilizing force in a financial system? Three quarters of a century ago J.M. Keynes expressed the problem perfectly:

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities.  It forgets that there is no such thing as liquidity of investment for the community as a whole.[1]

The exemptions to the bankruptcy code for derivatives and the collateralized interbank lending regime that grew out of these exemptions are built on the fallacy that there is such a thing “as liquidity of investment for the community as a whole.”  Keynes also remarked on the most important cost created by ignoring the fallacy of liquidity:

The fact that each individual investor flatters himself that his commitment is “liquid” (though this cannot be true of all investors collectively) calms his nerves and makes him much more willing to run a risk.[2]

The collateralized interbank lending regime encourages banks to believe that their collateral is “liquid”, protecting them from losses in the event that a counterparty defaults.  Adherence to this fallacy has two consequences: (i) banks do not set aside reserves or hold capital to protect themselves against losses that they cannot imagine, and (ii) banks do not monitor counterparties carefully, because they believe that they are fully protected by collateral.  Both of these consequences are extremely detrimental to financial stability:  the financial system as a whole is undercapitalized and in the absence of screening for credit risk the weakest financial institutions end up interconnected with every other firm.  In such an environment, when one firm starts to wobble the whole financial structure can easily come tumbling down.

As last year’s Federal Reserve intervention demonstrated, collateralized interbank lending only protects lenders if the central bank is willing to intervene to prevent a fire sale of collateral.  But then, what is the role of collateral?  After all, the lender of last resort has a long tradition of protecting financial systems where interbank lending is unsecured.  Collateral serves only to create the illusion of a security that does not exist.  This illusion causes banks to reduce the capital they set aside to protect against unexpected losses and to cut back on monitoring the credit risk of their counterparties.  In short, the existing collateralized derivatives regime is inherently destabilizing:  It is not designed to function in an environment where a large financial institution can fail, it tends to reduce capital levels and increase lending to weak firms, and finally, because of the safe harbor exemptions, it all but guarantees that a run on a large financial institution will take place.


[1] Keynes, 1935, General Theory, p. 155.

[2] Keynes, 1935, General Theory, p. 160.

The Financial Collapse of 2008 #1-11

This repo market instability became evident in March 2008, when rumors were swirling about Bear Stearns’ financial condition.  Counterparties did not want to risk holding collateral that could only be sold at fire sale prices in the event of a Bear Stearns’ bankruptcy – so they refused to lend to Bear against anything but the highest quality collateral.  Since Bear Stearns financed half of its balance sheet on the repo market, this withdrawal of credit was disastrous.  In the absence of credit drawn on repos Bear did not have the liquidity necessary to meet its short-term obligations.

In the case of Bear Stearns, fear of a bankruptcy filing precipitated a withdrawal of credit that made bankruptcy almost inevitable – and destroyed the firm.  In September 2008 Lehman Brothers collapsed when it too faced a bank run as fellow bankers withdrew credit and issued collateral calls.[1] At the time of the Lehman failure, Merrill Lynch was at risk of the same treatment and was saved only by Bank of America’s eleventh hour purchase.  Within days Goldman Sachs and Morgan Stanley were also at risk – exactly one week after Lehman filed for bankruptcy the Federal Reserve announced expedited approval for the transformation of these firms into bank holding companies with full access to the Fed’s support for commercial banks.[2]

In short, every firm that relied on repurchase agreements as an important source of funding – and did not have full access to the liquidity facilities of the central bank – faced a bank run and either failed or was rescued.  Safe harbor for repurchase agreements that are backed by securities of limited liquidity sets up an institutional structure that is prone to bank runs.  Whenever there is some small likelihood that a firm a might declare bankruptcy, counterparties protect themselves from the possibility of losses in a fire sale by withdrawing credit from the firm – and driving it into bankruptcy.  The repo markets we have now can only be described as fundamentally unstable.

The financial instability created by the run on Bear Stearns forced the Federal Reserve to take extraordinary action.  The Fed appealed to its authority under section 13(3) of the Federal Reserve Act to lend in exigent circumstances to financial institutions that were not commercial banks.  This authority was last exercised more than 50 years ago.

Using its emergency powers the Fed initiated two programs in March 2008:  the Term Securities Lending Facility and the Primary Dealer Credit Facility.  The Term Securities Lending Facility allows investment banks to temporarily trade highly rated private sector debt for Treasury securities.  In the Primary Dealer Credit Facility the Fed lends to investment banks against investment grade collateral.  Both of these programs were clearly designed to deal with the collapse of repo markets trading less liquid securities.  In addition, the Fed lent $29 billion to JP Morgan Chase to facilitate the purchase of Bear Stearns.  This loan was extraordinary because it was a non-recourse loan – in other words, JP Morgan Chase has the legal right to walk away from the loan leaving the Fed with only the collateral as payment.

As a consequence of the March 2008 collapse of the repo market, the Federal Reserve was exposed to private sector credit risk.  By the start of September it held as much as $100 billion of private sector assets that had been traded temporarily for Treasuries.  September was a disastrous month for the investments banks.  On September 14, the day before Lehman Brothers filed for bankruptcy, the Fed agreed to accept all collateral that had commonly been used in repo markets – including collateral that was not investment grade – in the Primary Dealer Credit Facility and extended the Term Securities Lending Facility to include all investment grade securities, not just those that were AAA rated.  (Lehman did not have access to these programs, because it did not meet the Fed’s criteria for a sound financial institution.)  By October 1st, the investment banks had borrowed almost $150 billion directly from the Fed.  This, in addition to $230 billion of private sector assets temporarily exchanged for Treasuries.[3]

In short, the collapse of the repo market in 2008 forced the Federal Reserve to intervene to protect the financial system by exchanging the risky assets that had been used as repo collateral for cash and Treasuries – the Fed chose in 2008 to act as a lender of last resort to the market for repurchase agreements.  As of mid-2009 these programs had shrunk to almost nothing, indicating either that the investment banks have found other sources of financing – possibly due to their new status as bank holding companies – or that repo markets have to some degree recovered.  Now that the crisis in the market for repurchase agreements is over, we can take the time to evaluate whether this is an appropriate role for the Federal Reserve or whether the repo market itself needs to be reformed.


[1] CARRICK MOLLENKAMP, SUSANNE CRAIG, JEFFREY MCCRACKEN and JON HILSENRATH, Oct 6, 2008, “The Two Faces of Lehman’s Fall,”  Wall Street Journal.

[2] Neil Irwin, July 21 2009, “At NY Fed Blending in is part of the job,” Washington Post, http://www.washingtonpost.com/wp-dyn/content/article/2009/07/19/AR2009071902148.html?wprss=rss_business indicates that Sept 18 is the date the New York Fed realized GS and MS were facing runs.  Federal Reserve Board, September 22, 2008 “Order approving formation of bank holding companies”
http://federalreserve.gov/newsevents/press/orders/orders20080922a1.pdf
http://federalreserve.gov/newsevents/press/orders/orders20080922a2.pdf
Gary B. Gorton, 2009, “Slapped in the face by the invisible hand” (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882) documents the withdrawal of credit from the repo market in the form of increasing haircuts – and discusses its similarity to a bank run.

[3] This may not represent the full extent of Federal Reserve lending to investment banks on October 1, 2008 as both Morgan Stanley and Goldman Sachs were now bank holding companies and could access liquidity facilities like the discount window and the Term Auction Facility.

10-6-09 update note: Corrected error regarding TSLF.

The Many Problems with Collateralized Interbank Lending #1-10

In addition to creating systemic risk and obfuscating financial reports, collateralized derivatives are not a good tool for hedging risk.  Let me be more specific:  derivative contracts can be perfect hedges as long as there is no risk that either counterparty will default.  Counterparty risk means that the derivative contract may be worthless and undermines its role as a hedge.  Collateralized derivatives are designed to address counterparty risk.  The problem with this “solution” is that collateralizing a derivative contract can undermine its use as a hedge, too.

First note that the standard analytic framework used to explain how derivatives serve to hedge risk assumes that both counterparties are money good.  In particular whenever a proponent of derivatives claims that they can be distinguished from other securities by the fact that they are “zero sum” and not subject to the losses that we see in asset markets, that individual is assuming that derivative contracts are not subject to counterparty risk.[1] It is true that, if one assumes away counterparty risk, derivative contracts can offset certain types of economic risk perfectly. An example is an airline that enters into a futures contract where the airline contracts to buy fuel three months in the future at today’s market price.  This airline has a perfect hedge against the risk that fuel prices will rise – as long as the airline’s counterparty honors his contractual obligations.[2]

One reason that the financial community developed the habit of assuming away counterparty risk when discussing derivatives is that, from the early years of the 20th century through approximately 1990, the vast majority of derivative contracts were exchange-traded.  When a derivative is traded on an exchange, the exchange is the counterparty to every transaction.  Because the exchanges put in place safeguards protecting them from losses, they are stable organizations and in the United States none has failed.  Thus, it is not unreasonable to make the assumption that there is no counterparty risk when discussing exchange-traded derivatives.

Over the counter derivatives differ from exchange traded derivatives because they are simply private contracts.  As a practical matter the only restriction on an over the counter derivative contract is that the two contract participants accept each other as counterparties.  Clearly counterparty risk can be a factor when dealing with over the counter derivatives.

In the event that a derivative counterparty defaults – and no collateral has been posted – the derivative contract no longer serves as a hedge.  Returning to our airline example, if fuel prices rise and the counterparty declares bankruptcy, the airline will be an unsecured creditor for the value of the contract at the date of bankruptcy.  The airline will be unhedged if fuel prices continue to rise after bankruptcy is declared and, like all creditors, the airline may receive partial or no recovery on its claim.  For this reason the credit risk of an uncollateralized over the counter derivative is more comparable to a financial asset such as a bond than to an exchange traded derivative – and uncollateralized over the counter derivatives are subject to losses due to default just like any other financial asset.

One way to mitigate the credit risk inherent in an over the counter derivative is to include a clause in the contract that requires the counterparty who owes money to post collateral.  This is comparable to the margin requirements used by exchanges, except that the terms of an over the counter contract are not standardized.  As late as 2003, the ISDA Margin Survey reported that only 30% of over the counter derivative contracts required that collateral be posted. Only three quarters of these collateralized contracts had terms that required both parties to post collateral.  Over time collateralized contracts have become the norm.  The 2009 survey reported that 65% of contracts included clauses requiring collateral.[3]

To understand how collateral works let’s use our airline example again and recall that the price fixed for the contract was the market price on the day the contract was signed.  If the price of fuel has fallen, so has the value of the airline’s contract – if the contract expired today the airline would lose money on it by paying a higher price for fuel than the market price.  In this case, the airline is “out of the money” and the airline’s counterparty is “in the money”.  (By contrast, if the price of fuel rises, the airline is “in the money” and the counterparty is “out of the money”.)  The purpose of collateral is to protect the “in the money” counterparty from the risk that the “out of the money” counterparty defaults on the derivative contract.

If the airline’s contract required collateral posting and the price of fuel fell steadily for the first month, then every day the airline would be required to post more collateral to cover the difference between the market price and the contracted price.  By contrast, when the price of fuel starts to rise, collateral will be returned to the airline.  And if the price of fuel exceeds the contracted price, the counterparty will post collateral to the airline.[4]

When there are no collateral requirements, the “in the money” counterparty to a futures contract faces credit risk.  When margin is posted, the “in the money” counterparty is protected from credit risk, and the “out of the money” counterparty must be prepared to post collateral well before actual payment on the contract is due.  Thus, a collateralized derivative contract protects against credit risk at the cost of creating liquidity risk (that is, the danger that liquid assets are not available to use as collateral) for the “out of the money” counterparty.  Futures exchanges have imposed margin requirements for over a century and, thus, have demonstrated that, despite the increase in liquidity risk, collateral is an effective way to protect the futures market from credit risk and guarantee its stability.

Over the counter derivatives, however, are sometimes very different from futures contracts.  Swaps in particular involve not just a single future payment, but repeated payments over an extended period of time.  Because the collateral posting requirements for a swap can involve summing over twenty or more separate payments, in some cases collateral becomes an onerous obligation.  The effect of a collateralized swap that by chance moves dramatically against one of the counterparties is similar to someone with a mortgage suddenly being called upon to have the full value of the house deposited at the bank.  Liquidity risk, when it involves large sums, can be a serious danger for derivatives investors.  This liquidity risk may undermine the swap’s effectiveness as a hedge.

To examine in more detail how collateral can undermine the use of a swap as a hedge, consider the example of a “plain vanilla” interest rate swap.  A university endowment has $10 million of debt on which it must pay the money market rate plus 3% for the next five years.  When the money market rate is 3%, the endowment will pay $50,000 per month and when the money market rate is 2% the endowment will pay $41,667 per month, and so on.[5] In order to protect itself from the possibility that interest rates rise, the endowment enters into an interest rate swap where it pays out a fixed rate of 6% per year (or $50,000 per month) and receives the money market rate plus 3% for five years.  Because the endowment receives from the swap exactly the amount that it needs to pay out on its debt, the swap is a perfect hedge for the endowment – if it is uncollateralized and the endowment’s counterparty does not default.

In the absence of a collateral agreement, the endowment has converted its adjustable rate debt into fixed rate debt – its liability is just $50,000 per month for five years.  If, however, the swap includes a collateral agreement and the money market rate falls and is expected to stay low for years, the endowment will be “out of the money”.  To illustrate what can happen to an “out of the money” swap counterparty, let’s look at the worst case scenario, where the money market rate falls to zero and is expected to stay there for five years:  in this example, the endowment pays $50,000 and receives $25,000 every month for five years.  Then the collateral the endowment can be asked to post is the present value of $25,000 a month for five years; when interest rates are close to zero, this approaches $1,500,000.  Thus, when a collateral regime is combined with a swap contract, it can have the effect of requiring a counterparty to have the means to prepay its obligations before they are due.

Because collateralized swap contracts involve large-scale liquidity risk, the only sense in which the endowment is hedged is on its balance sheet.  For the balance sheet the timing of the payments is irrelevant – all that matters is the total value of the firm’s claims and obligations.  On the balance sheet posting cash collateral is just a matter of moving the amount in question from cash assets to receivables.  Both of these items are assets so this change has a neutral effect on the financial report.

By any other standard, however, the endowment is not hedged.  In particular, there’s always the possibility that “cash assets” aren’t large enough to sustain the withdrawal of the cash needed for collateral.  In this situation, the endowment has a cash flow problem – just as a homeowner would have a cash flow problem if the mortgage lender had the right to demand that the full value of the mortgage be deposited at the bank.  “Liquidity risk” is a term that refers specifically to this problem.

The role of collateral is therefore to protect the “in the money” counterparty from credit risk at the cost of exposing the “out of the money” counterparty to liquidity risk.  For over the counter derivatives like swaps, it is far from clear that the gains from collateralizing the swap outweigh the costs.  Our example of an endowment was not entirely hypothetical.  Harvard University’s endowment faced precisely this situation – and, because cash flow was unavailable when needed, the University was forced to terminate the swaps, when their value was close to a nadir.  The University posted huge losses, but more importantly lost the hedge it had invested in over a period of years.  If the contract had not been collateralized, the University would have continued to make payments and in the event that interest rates rose again in the future, the University would have been protected.  Instead, the collateral terms of the derivative agreement were extremely risky – and cost the University its hedge.[6]

Interest rate swaps are not the only contracts that can require large amounts of collateral.  The terms of a credit default swap require the counterparty known as the protection buyer to make regular payments, and the other counterparty (called the protection seller) to make a much larger payment only if a specific firm defaults on its debt.  As the likelihood of a default by the underlying firm increases, the protection seller must post collateral.  Because the promised payment is large, the collateral requirement may also be large.  AIG is an example of a firm that failed due to collateral calls on credit default swaps – if the government had not taken over its obligations, it would have been forced to declare bankruptcy.

Not only do collateral requirements in some cases undermine the effectiveness of the contract as a hedge, but collateralized over the counter derivatives don’t necessarily provide effective protection against credit risk – despite safe harbor privileges.  The collateral necessary to cover the “out of the money” counterparty’s obligations changes every day with changes in the value of the asset or rate underlying the derivative.  In some cases these changes can be dramatic resulting in extremely large collateral calls.  Of course, it is precisely when price changes are dramatic that market turmoil and collateral calls are likely to cause the bankruptcy of a derivative counterparty.  Naturally, when a firm is bankrupted by collateral calls, then the firm’s counterparties will find that they are not holding enough collateral to cover the full amount due – and they will become unsecured claimants in bankruptcy court for the remainder.  In short, collateral requirements may not be an effective way to protect firms from losses due to market turmoil and sudden price movements.

Collateral requirements on credit default swaps are particularly difficult to manage.  In a credit default swap the protection seller owes nothing until a credit event occurs and, once the credit event occurs, the seller may owe tens of millions of dollars.  Thus, by their nature default swaps involve sudden changes in value.  Since protection buyers want to protect themselves from the credit risk inherent in such contracts, they use the cost of replacing the swap or the price of the referenced bond to estimate the likelihood that a credit event will occur.  Unfortunately, credit default swaps and the bonds they are written on often trade infrequently and may be difficult to price.  For example, when AIG faced collateral calls in late 2007, Joseph Cassano complained in a memo summarizing those calls:

[T]he prices we have received are all over the place and everyone we talk to has openly admitted that the bonds we are referencing have not, and do not, trade … As you can see where we do have more than one level they are never that close.  As a few examples, Goldman priced Dunhill at 75 and Merrill priced it at 95:  Independence V is subject to collateral call from both ML and GS, but the former calculates a price of 90 and the latter is using 67.5.[7]

As the AIG memo indicates, when there is no objective way to determine a fair price for a credit default swap, collateral calls are made without a clear foundation.  Thus, credit swaps have the particular problem that it is often difficult to determine how much collateral should be posted until a credit event actually takes place and full payment is due.

These two factors, that sudden price changes can render collateral inadequate and that for some derivatives it is very difficult to determine appropriate collateral requirements, mean that collateral may fail to protect the “in the money” counterparty from losses.  Thus, yet another problem with collateralized derivatives is that they can create the illusion of protecting a firm from credit risk without actually protecting the firm – particularly in a tumultuous market when protection is most needed.

Finally it is possible that, in the event of the failure of a large financial firm, the safe harbor provisions will actually serve to increase credit losses.  At the moment that a large firm declares bankruptcy many counterparties will simultaneously seize and sell collateral.  This process of exercising safe harbor privileges can generate the sudden sale of a large number of assets and have the effect of reducing the value of the collateral that was posted.  It may even be the case that these losses are just as large, if not larger, than the losses from having the collateral tied up in bankruptcy court for a few weeks.

In 1998 Long Term Capital Management, a hedge fund with a massive balance sheet, was heading towards bankruptcy and a fire sale of collateral loomed.  At the behest of the Federal Reserve Bank of New York, the major investment banks – who were also the hedge fund’s largest creditors – intervened, effectively taking over the hedge fund.  While a fire sale of assets was averted, the danger was acknowledged by everyone in the financial community.  In 1999 the ISDA published its first collateral review and found that cash collateral was “less commonly used”.[8] From that date forward the survey clearly documented increasing use of cash collateral in derivatives contracts.  In 2009 this trend culminated in cash accounting for 84% of all derivative collateral. [9] The reasoning behind this trend seems obvious:  cash collateral is the only form of margin that cannot lose value in the event that there is a fire sale.

Nowadays, it is repurchase agreement counterparties who worry that safe harbor provisions will result in a fire sale of collateral.  This is, in part, due to the nature of repos – they are always secured by a financial asset that can be sold – but also due to the fact that in 2005 safe harbor was granted to repos of less liquid securities like investment grade debt.  Of course, less liquid securities are far more likely to lose value dramatically in a fire sale, than, for example, government bonds.  For this reason repo markets that (i) trade in securities of limited liquidity and (ii) are granted safe harbor are inherently unstable.


[1] See for example the testimony of Richard R. Lindsay before the Senate Agriculture Committee on October 14, 2008.  http://216.40.253.202/~usscanf/index.php?option=com_docman&task=doc_download&gid=50 This is a commonly held view of derivatives.

[2] Of course, if fuel prices fall, the airline is locked into the higher price – this is the nature of a futures contract.  An airline that wishes to protect against a possible rise in prices without giving up the benefits of a fall in prices must pay an upfront fee for an option contract.

[3] ISDA Margin Survey, 2009, http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2009.pdf
ISDA Margin Survey 2003, http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2003.pdf
In 2009 one quarter of collateralized contracts only required one side to post collateral.

[4] For simplicity of exposition, I am assuming that the collateral agreement is bilateral and that both parties have a zero threshold for posting collateral.

[5] When the money market rate is 3%, (3% + 3%)/ 12 months = 0.5%.  Thus, each monthly payment is 0.5% of the principal or $50,000.  When the money market rate is 2%, (2% + 5%)/12 months = 0.4167%.

[6] Richard Bradley, 2009, “Drew Gilpin Faust and the Incredible Shrinking Harvard”, Boston Magazine.
http://www.bostonmagazine.com/scripts/print/article.php?asset_idx=251494

[7] http://www.cbsnews.com/htdocs/pdf/collateral_b.pdf

[8] 1999 ISDA Collateral Review, p. 9  http://www.isda.org/press/pdf/colrev99.pdf

[9] 2009 ISDA Margin Survey.  While cash collateral has increased in recent years, even in 2003 70% of collateral was cash.

The Collateralized Lending Regime: An Under-reported Shift in Capital Structure #1-9

As noted above in addition to their effects on systemic risk, the safe harbor exemptions are unfair because they give preferential treatment in bankruptcy to derivative counterparties.  This problem is exacerbated by the fact that financial reporting has not yet adapted to a world with derivatives.  Safe harbor creates a class of asset that is exempt from bankruptcy – and thus senior to all other creditors.  However, because reporting is quarterly and does not include details about the potential for near-term collateral calls, unsecured lenders have no way of knowing what fraction of assets reported will be seized by counterparties at the moment of bankruptcy.  Without this knowledge, bond and shareholders have no way to evaluate the assets on which they have a claim.  Furthermore, one can no longer expect a firm’s financial statements to be comparable from one year to the next, because derivatives that simulate bonds and other assets have effects that are not reflected in financial statements.

Let’s think about an example of how derivatives can affect the meaning of financial statements.  A firm can sell preferred stock to an investor and at the same time enter into a total return swap with the investor.  The terms of the total return swap require the investor to pay the total return (i.e. any cash flows) on the preferred stock; in return the firm pays the investor the money market rate plus some spread and compensates the investor for any losses on the preferred stock (in case of bankruptcy).  The net effect of these two transactions ­is that the preferred shares are just a smokescreen to put on the balance sheet.  In fact the firm has used a self-referencing derivative to issue secured adjustable rate debt.[1]

In this example, the firm’s financial reports show an increase in equity.  The market value of the total return swap will be reported initially as zero (because the income from the investor perfectly offsets the cashflow to the investor) and later as a financial asset or liability depending in part on the movement of the money market rate.  The firm reports an increase in equity, when the economic reality is that the firm has increased its debt load.  Note also that secured debt generally pays a lower interest rate than preferred stock, so the firm reduces its cost of funding by using derivatives in this manner.

The problem of course with this example is that the true state of the firm’s balance sheet is invisible to existing shareholders and bondholders.  When they review the firm’s financial statements, they will see an increase in equity and the increase in secured financing will remain hidden.  Of course, the more a firm funds itself with secured debt, the lower the recovery that both shareholders and (unsecured) bondholders can expect to receive in the case of bankruptcy.

Derivatives, as they are currently reported on financial statements, can be used to obscure the true nature of a firm’s liabilities.  While self-referencing derivative transactions may under certain circumstances be fraudulent in the United States, a legal note dated March 2009 concludes that they can be used – with caution.[2] Furthermore, because over the counter derivative markets are unregulated and not subject to reporting requirements, there is no way of knowing to what degree this is a problem.  In other words, there is no way of evaluating the inaccuracy – or accuracy – of financial statements.

Even in the absence of self-referencing derivatives, heavy reliance on derivative contracts can obscure the recovery that is available to shareholders and bondholders.  While the accounting rules for netting derivative and collateral exposures are strict,[3] reporting only takes place on a quarterly basis and there is no requirement to estimate or report collateral calls to which the firm may be subject in the near future.  Because large financial firms have significant exposures to derivatives, it is likely that, as a firm’s financial condition deteriorates, the same contracts that are generating losses will also generate collateral calls.  Furthermore many derivative contracts use credit rating downgrades as a trigger for collateral calls; this, too, means that a firm in deteriorating financial condition is likely to experience a sudden change in collateralized lending.  Currently shareholders and bondholders do not have the information needed to estimate the level of collateralized lending at the time of bankruptcy.

The current crisis illustrates the problem of changes in the level of collateral posted.  The ISDA Margin Survey reports that collateral posted tripled from 2007 to 2009.  The average amount of collateral posted per respondent was $4 billion in 2007 and $18 billion in 2009.  Furthermore because most of the collateral posted is delivered by the largest firms, firms that reported executing more than 1000 collateral agreements posted on average $16 billion in 2007 and $53 billion in 2009.  In short, the amount of collateral posted against derivative contracts can change dramatically from one reporting period to the next.  For this reason investors should be given information about potential future collateral calls whenever a firm trades in derivatives.

This information shortage regarding future collateral calls may mean that losses to shareholders and bondholders in the current crisis will end up being much more severe than expected.  If the losses experienced through the current downturn do indeed turn out to be excessive, firms may find it difficult in the future to finance themselves using bonds and other forms of unsecured lending.  In short, preferential treatment in the bankruptcy code for derivatives may completely change the capital structure of firms.


[1] I thank “A Credit Trader” for this example.  http://www.acredittrader.com/?p=219

[2] Linklaters LLP, New York, March 12 2009, “Synthetic debt repurchase transactions and other transactions utilizing self-referencing exposure” http://www.lol.se/pdfs/publications/us/090311_SyntheticDebtRepurchase.pdf

[3] FASB Interpretation No. 39