By Bob Rinear
Whenever Wall Street is threatened, they have a fine habit of changing the rules. Each time some form of legislation is passed that might cramp their style, they come up with a work around solution so they can continue to play their game their way. Thus it was not surprising to me when Bloomberg finally reported on the new hot market trick... the "transformation of collateral". This is really pretty slick of them. Here's the deal....
According to Bloomberg, 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.
The new rules are rooted in the 2010 Dodd-Frank Act, passed in reaction to the near-collapse of the financial system in 2008, caused in part because derivatives contracts weren’t backed by enough collateral. American International Group Inc. (AIG) needed a $182.3 billion bailout from the U.S. government after the New York-based insurer failed to make good on derivatives trades with some of the worlds largest banks, according to a 2011 report by the Financial Crisis Inquiry Commission.
In response to the cries that most of the derivative market was handled via private negotiations, Congress demanded that they needed to see more of what was going on by declaring the majority of derivative trades to go through a clearing house. Well that caused a big rub. Why? Because while in private negotiations collateral requests could be of pretty arguable quality and certainly just a tiny fraction of the value of the trade. By making derivative trades clear through a central clearing house, there are minimum requirements for both the amount of collateral required and the quality of those assets deemed to be collateral.
Estimates for how much extra collateral participants will need range from about $500 billion to $2.6 trillion, based on data compiled by Bloomberg. The top figure comes from Tabb Group LLC, which recently raised its forecast from $2 trillion to incorporate new reports on the size of the derivatives market, said Will Rhode, head of fixed income at the Westborough, Massachusetts-based consulting firm.
Now one of the problems being encountered is that there's very limited supply of Treasury Bonds available for these traders to post as collateral. With Ben Bernanke buying up the lions share of Treasuries, the private market has precious little inventory. But Wall Street being the sly little fox it is, has created some work arounds for the situation. But, by allowing the banks to swap out low quality high risk assets and replace them with Treasuries, they have NOT reduced risk at all! Why? Because more times than not the Treasuries will be lent to provide that collateral. Banks could be squeezed once again if they have borrowed the Treasuries that they’re lending as collateral, and the original lender suddenly demanded them back.
See, the process allows investors who don’t have assets that meet a clearinghouses standards... to pledge corporate bonds or non-government-backed mortgage-backed securities to a bank in exchange for a loan of Treasuries. The investor then posts the Treasuries -- the transformed collateral -- to the clearinghouse. The bank earns fees plus interest, and the investor is obliged at some point to return the Treasuries. In effect, the collateral is being rented. Yes read that again...the collateral is Rented. What kind of true collateral is it, if it's rented? It's NO collateral folks.
Moving along, if a trader defaults and his collateral is seized, in that case, the bank not only loses its Treasuries but worse, is left holding lower-grade bonds that the trader posted in the collateral transformation. Do you see what's happening here? They aren't reducing any risk at all, they're simply shuffling the chairs on the deck of the titanic. But it gets worse as you might imagine. Along with a lot of the collateral literally being rented, the major clearing houses are also in the process of lowering the quality standards on the collateral itself. Here's a quote out of Bloomberg, that pretty much shows you the "wink and nod" going on here....
Since regulators have mandated clearing, they should support some flexibility on collateral, where the clearinghouse can make a strong case that they can manage the risk, said Andrew Howat, LCH.Clearnets head of collateral and liquidity management. You cant have all this over-the-counter clearing without collateral, so something needs to give.
Give? The whole idea of the legislation was to figure out some way to backstop the 700 TRILLION worth of derivatives floating around out there and prevent things like the AIG meltdown. If the markets lower the standards on the quality of the collateral, aren't we right back to where we started? We sure are.
The bottom line is that while on the surface it's going to look like the derivative traders have lowered their risk, backstopped it with good strong collateral and everyone has followed the legal interpretation of the legislation. But under the surface, they've simply shuffled the risk around, and an argument could be made that in the long run the risk has expanded. Oh and by the way, just how much collateral is required? Don't laugh, but here's another quote: Under a worst-case scenario, traders may have to post $1.3 trillion, or 1.1 percent of cleared trades". That's a worst case scenario, 1.1%?? Yes, because currently as most derivatives trade via securities dealers, the rate nets out to about 0.005 percent of cleared trades.
Is backstopping 1.1% of trades true collateral? On what planet?
The point here folks is this, do NOT believe the talking heads when they come out to tell you that they've solved the derivative mess, and the world can sleep safer knowing there can't be any more AIG disasters. They haven't solved a thing, they've simply shuffled the deck chairs around and made it look better. But all the decorating in the world wouldn't stop Titanic from sinking and this program of "collateral Transforming" is yet another smokescreen. But guess what? The big banks setting up these transformations are seeing big money in the fees they charge to set it up. Isn't that something? They get extra revenue for basically solving nothing. How perfect is that?
Here's Bloombergs view on it if you wish to see...