Cardiff Garcia wrote an incredible post on Money-Like Instruments over at the FT blog.
wh10 sent me a link today, but I was all over it a few days ago. Mr. Garcia’s post extends and fills in a vast amount of detail how the shadow banking system works. He takes much of the information from a Credit Suisse report, but also adds valuable information on his own.
I highly recommend reading both the post and the associated Credit Suisse report. It’s a must read if you are a geek.
Here’s a choice quote from the post:
In discussing the money-like properties of debt that functions as shadow banking collateral, three variables matter:
1 – Its value
2 – The haircut on the security when used as collateral
3 – Collateral velocity, represented in the shadow banking world by rehypothecation.
It should sound pretty familiar, because I did cover some of this in Money and Money-like Instruments Part I - which happened to be posted the same day as the Credit Suisse report! I don’t have access to CS’s reporting, so I guess it was something in the air back on the ides of March.
But there is data too, lots of great data:
“They’ve counted the entire outstanding value of private and public debt, and adjusted by the repo haircuts of each type of debt security.
In doing so, they’ve combined the debt being used as collateral with debt thatpotentially could be used as collateral.
We’ll let them explain why:
Although only a portion of liquid debt securities are used as collateral, a much wider pool of debt can become “shadow money,” or securities that can easily be borrowed against. This broader concept is relevant because an asset holder always benefits when his assets become more money-like.
His improved ability to realize liquidity quickly means he need not hold the same amount of cash. In addition, his asset may appreciate in value because of a liquidity premium.
For example, if a bond is worth $100 and its repo haircut is 5%, then a holder of that bond can easily raise $95 of cash when holding that bond. The holder has $95 of shadow money, and this is likely to reduce his need to hold cash…”
Wow. That’s fantastic work. And it gets better! It actually mentions Perry Merhling’s paper on the idea of fed becoming not just a lender of last resort, but a dealer of last resort too. This is important today, because:
“The new paradigm for monetary policy is to think of “asset markets, not banking institutions; market liquidity, not funding liquidity”. In other words, include shadow banking, though he prefers the term “new market-based credit system”.
Not only that, the shadow banking system blurs the lines between fiscal and monetary policy!
It’s truly a must read if you’re following what’s going on in banking.
And Mr. Garcia makes an explicit callout to John Carney:
Does the shadow banking system’s relationship to monetary policy have any implication for the Smithian/neo-Wicksellian view, which awaits the natural rate of interest imminently rising to and exceeding the federal funds rate? Is there an equivalent for the shadow banking system — perhaps something related to collateral haircuts? What about the NGDP guys? The MMTers? The John Carney?
Well, now you know what part II of Money and Money-like assets is going to be about.
- Natural Rate of Haircuts: The repo system is robust to inflation risk, but extremely brittle to re-valuation risk. Repos are always brittle to revaluation risk. I explain how/why below.
- Haircuts depend on both the credit quality of the collateral and the immediate credit rating of the counterparty.
During good times, low quality assets can trade like high-quality assets because there is a high chance of getting repaid. I’d lend 95% of face to Goldman on a repo of an MBS in 2007, even if I knew the thing was worthless. Goldman would repay and get the collateral back – they would never risk a non-resolution of the repo.
The loan is securitized by the collateral, but that collateral haircut can easily be overpriced if the credit quality of the counterparty is high.
But during the bad times, this dynamic totally changes. I don’t know if Lehman can pay me back, so I need to start considering the quality of the collateral as well.
The credit review of the collateral is triggered by the odds of the counterparty will default, and not by changes in the actual quality of the collateral. The collateral is information insensitive until the counterparty forces a review of this information.
We saw a dynamic like this in the recent MF global case, where they had a trade which was a guaranteed winner if held to maturity. “Money in the bank”, as someone might say. But then JP forced a MF Global’s credit rating down, and MF Global couldn’t hold the trade to maturity due to increased required collateral postings.
The Implied Put of Collateralized Lending
Remember, repos (like all collateralized loans) have an implied put. You can just walk away from the loan and let your counterparty keep the collateral. The valuation of this put doesn’t fit into a normal Black Scholes or lattice model because the exercise of the put can be extremely “costly” to the holder of the put. The holder of the put doesn’t want to exercise the option even when it makes money!
This cost to the holder isn’t entirely monetary. Walking away from a loan has an impact, but it’s not entirely based in money. The cost won’t even be realized in the trade itself. The cost of walking away from the trade happens later!
You can easily see what this implied put does to a collateralized loan, however. The value of the implied put remains at zero well past into the exercise price. It’s entirely possible to imagine getting a 5% haircut on collateral worth only 70% of face value, and wanting to pay back the repo, despite the quick 25% gain you would realize. If this was a 1 day repo, your annualized rate of return would be many thousands of percent – but you could never do another trade. You’d never consider exercising this put except under dire circumstances.
But here’s the catch, even though this option is “worth” zero in the collateralized option pricing model, the Intrinsic Value of that option is not zero. And while someone might not want to default, they may be forced to default.
Now, if I was a vampire squid like Goldman Sachs or JP Morgan, I’d be very aware of the difference between the market value of the implied put and intrinsic value of that same implied put. In fact, this evil Mike Sankowski would try to put himself into situation where I would get paid the intrinsic value of some puts, and had a large amount of control over the value of other implied puts though manipulating the credit rating of my counter-party.
Now, this isn’t exactly what Mr. Garcia was hoping to get, but I think it helps to think through the dynamic caused by money-like instruments. They cause a situation where the valuation of their implied put can move in highly discontinuous ways, jumping from zero to very high values in just a few days.
I hope to get to these topics when I have a bit more time:
- Money-like instruments create a new banking reality of asset-market driven lending (Perry Merhling)
- The repo market is something like the fed funds market for the private sector (More in another post!)
- There is real danger on the line between “sunshine and shadow”, where repo transactions happen with newly created money (More in another post!)
- Natural Rate…it’s my white whale!
“Walking away from a loan has an impact, but it’s not entirely based in money. The cost won’t even be realized in the trade itself. The cost of walking away from the trade happens later!”
)
Fascinating post Mike. Situations like this, I think, call for a strawman buyer.
However, since you don’t have a TBTF hall pass, my concern is that a preplanned “strategic default” would be considered fraud by the Federales (I’m assuming these are non-recourse loans) since you’re borrowing money with no intention of to ever paying it back, instead of, say, a garden variety put option (where both sides are clearly going in with their eyes open).
If I was a judge, I’d ask you as put option holder, so how much did you pay for your option? Isn’t the idea that the person with the obligation to act (in a put option, to buy) the one who walks away from option signing with cash in hand? Then I’d dismiss the case for some reason or another because you’re a good guy.
This is good stuff Mike. Cardiff’s post was awesome and very important.
What really is a “shadow bank”?
Previously, MMFs were mainly identified, but I’ve always wondered whether this is a correct description since MMFs cannot directly create horizontal money; they simply lend deposits (?). Perhaps, in some markets, the MMFs + banks as short-term funding/liquidity/securitzation agents act in concert as a shadow bank (e.g. ABCP, auction rate securities) but the MMF themselves are not. I’m not sure what happens in the repo market, but there doesn’t seem to be horizontal creation.
Put value.
For a non-recourse state, sounds like a good reason to flip houses!
“shadow banking system blurs the lines between fiscal and monetary policy! ”
Does it? If “shadow banking”=bank securitization, isn’t this just reserve-free lending? If so, I wonder if repo markets are required (i.e. how does Canada and other 0-reserve countries run?)
I didn’t go into this much here, but Mr. Garcia does over at the FT.
I did read the article (and the Credit Suisse report); I think I must be missing the main point.
To me, “shadow banking” doesn’t seem seem any different than regular banking, except it ignores everything learned from regular banking: “shadow banking system blurs the lines between fiscal and monetary policy” seems well-known in regular banking and that is why deposit insurance was created … the 1930s governments clearly saw that low interest rates was not enough and could not alone prevent a collapse in the banking system. In this regard, what distinguishes shadow banking is it is unregulated. I think the answer to Canada is: (1) regulation, (2) Bank of Canada as lender of last resort. (2) is particularily a problem for shadow banking as the rescue of the MMFs in 2008 as well as complete seizing of many ABCP and auction rate securities markets, but is a problem for private assets in general during market stress even highly liquid assets (1994, 2008 mortgages).
The blogosphere has spent a lot of time highlighting and asking whether “shadow banking” should be regulated.
I think it should, when shadow banking behaves like real banking. For example (re: rehypothecation mentioned in the FT article). If entity A uses its good balance sheet to loan money to a crappy company B via a repo, and then A in turn borrows from a bank, by rehypothecating it but negotiates a smaller haircut using its balance sheet + perhaps additional collateral, then this should be regulated. I.e. horizontal money is created. But, perhaps I’m getting the monetary ops all wrong.
This is all deliciously wonkish.
lol! Yes it is.
The good thing about a blog like this is we’re starting to build up articles which can be useful later.
At some point, I’ll make a transition to talking about spending more money and all that fun stuff. We need to spend more right now to improve the economy, no matter what’s going on in the world of money theory.
Speaking of such things, you mentioned the Delong-Summers equation could be combined with the TC rule— so combine it! It’d be interesting to see how that works out (and you could always send it along to DeLong and Summers for their feedback).
lol – thats for my beta level simulation to work on!
http://en.wikipedia.org/wiki/Technology_in_Revelation_Space#Beta-level
I’ll have to put several of my research assistants on it.
It seem like the house is going to jump into the deep end on economic theory.
H.R. 4180, which you can find on http://thomas.loc.gov/home/thomas.php
This from the bill translates into aggregate levels of private do indeed have a marco influence on the overall economy. I guess they do not read Krugman.
In general, an overly accommodative monetary policy inflates both asset prices and prices for goods and services. However, an overly accommodative monetary policy may sometimes cause a misallocation of capital that inflates asset prices disproportionately, creating unsustainable bubbles in asset prices, while prices indices for goods and services do not register significant price inflation. When asset bubbles burst, many investments must be liquidated at considerable cost to the U.S. economy in terms of lower real output and employment.
I think this site should change its tagline:
“What if we told you that we could make you feel “Monetarily Retarded” at least three times per week… would you feel surprised?”
ha! I’ll write something about the Trillion Dollar coin next!
Paul Brodsky had some good thoughts (re: my question/comment on what defines shadow banking or not)
http://www.ritholtz.com/blog/2012/04/on-shadow-banking/