Collateral Damage

I have become aware of new information about what may be preventing the REPO market from operating properly.  Despite emergency Fed intervention, the REPO market continues to have trouble meeting cash demands.  It may not be a liquidity problem after all, it appears to be a problem with collateral.

The following example from Fed Governor Jeremy C. Stein, back in 2013, is a helpful illustration.

“Collateral transformation is best explained with an example. Imagine an insurance company that wants to engage in a derivatives transaction. To do so, it is required to post collateral with a clearinghouse, and, because the clearinghouse has high standards, the collateral must be “pristine”–that is, it has to be in the form of Treasury securities. However, the insurance company doesn’t have any unencumbered Treasury securities available–all it has in unencumbered form are some junk bonds. Here is where the collateral swap comes in. The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade.

Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain them, it may have to engage in the mirror-image transaction with a third party that does–say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet.”

This illustration helps us understand the complexity associated with lending.  How multiple parties can be associated with one transaction and the importance of the collateral backing the transaction.  Concerns by REPO market lenders about who has title to collateral and/or the underlying quality of the collateral itself, appears to be causing securities lenders to step away from the market.  The REPO market deals in “Pristine” collateral.

It is important to understand banks participating in REPO transactions have visibility to the underlying conditions of our financial system.  Problems emanating from this market should be taken seriously.

It is entirely possible this episode will pass without a serious market impact.  But if a market surprise were to arrive, a problem emanating from debt markets is a likely candidate.  There is no need to panic but it is a good time to consider your mix of investment holdings and eliminate unnecessary debt.

The global economy requires credit growth to continue and expand.  As the end of a cycle is approached lending standards have been known to be loosened to meet credit issuance targets.  Think of “No Credit, Bad Credit, No Problem” loan commercials.  Eventually lower quality borrowers can have difficulty servicing their loan obligations.  Get enough of them in a market and pop, a debt bubble deflates.  It is not clear we’re are at this point.  Employment is strong and wages have been rising but something has spooked REPO lenders.

To put some of this in visual context, I offer the following charts from the FRED database managed by The Federal Reserve of St. Louis.

Student loans are growing at approximately a rate of $100 Billion per year.  The balance outstanding is currently $1.6 Trillion.  Up over $1 Trillion in he last 10 years.

Our debt to GDP ratio has not climbed much the last several years, but it remains stubbornly high relative to the last 50+ years.  There are other countries with even higher ratios.

On the plus side, Federal tax revenues through April of 2019 remain near all-time highs, despite tax cuts in 2017.

What you see in the above charts is also present in many states, counties and cities in the U.S.  An accumulation of more debt, a high debt to output ratio, and rising revenues.  It is a delicate balance.

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