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!