Despite popular perception, the financial industry isn’t actually made up entirely of “investment bankers” but rather of a whole range of people from those who work for months on years to close deals with $100mm fees that are pure profit, all the way down to people who do overnight lending of treasuries to make a spread that, annualized, is in the low-single-digit basis points. I sat somewhere in the middle and, while the M&A hitters usually had better suits, I had a suspicion that the guys shaving basis points for funding had to be more important.
Jon Corzine maybe disagreed. His prepared testimony for his filleting this afternoon has five pages talking about his ill-fated European sovereign bond bets, which conclude with a little note that all of those supposedly ill-fated bonds are doing fine, not that you cared. Then there’s some other stuff. Then there’s a page and a half about what people bought tickets for: the $1.2bn of missing customer money, which he calls by its colloquial nickname, “unreconciled accounts.” Here’s what he has to say about that:
1. “I simply do not know where the money is,” and
2. Can you blame me?:
As the chief executive officer of MF Global, I ultimately had overall responsibility for the firm. I did not, however, generally involve myself in the mechanics of the clearing and settlement of trades, or in the movement of cash and collateral. Nor was I an expert on the complicated rules and regulations governing the various different operating businesses that comprised MF Global. I had little expertise or experience in those operational aspects of the business.
With no clear answer we’ll just have to continue speculating among ourselves. The plausible speculation goes something like this: MF Global was so excited to have lots of customer cash and securities that it spirited them all away to London, where brokers are allowed to rehypothecate any customer collateral they can get their hands on, and went on to lend them away to finance its business.
If you live in some of the tonier precincts of the financial internet, you’ve probably been exposed to the notion that supplies and flows of collateral are the most important thing in the world. Much of that is due to the fascinating work of two IMF researchers, Zoltan Pozsar and Manmohan Sing,* who have together and separately written papers with sexy sexy names like “Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System” and “Velocity of Pledged Collateral: Analysis and Implications.” The core aim of a lot of this work is to understand, explain, and measure how the shadow banking system operates and whether it is likely to blow up the world.
Today Kelly Evans at the Journal calls attention to their latest collaboration, called “The Nonbank-Bank Nexus and the Shadow Banking System.” Go read her account of the paper, which starts with the notion that the shadow banking system exists to support “reverse maturity transformation” – as Pozsar and Singh put it:
Institutional demand for safe, short-term, liquid instruments (or money) mainly arises from the day-to-day management of long-term savings in the modern asset management complex. Even though asset managers invest households’ long-term savings into long-term instruments, their day-to-day management and return mandates—absolute or benchmark—effectively requires them to transform a portion of these long-term savings into short-term savings. This in turn drives the money demand of asset managers. This reverse maturity transformation occurs in spite of the long-term horizon of households. Reverse maturity transformation gives rise to large, centrally managed cash pools within the asset management complex.
Those cash pools are not especially well suited to being held in traditional money forms, like FDIC insured bank deposits or stacks of hundred-dollar bills or collectible gold coins. Instead they get put into money-like things – money market mutual funds, repos, etc. – which, because they’re not government guaranteed, have to be supported by collateral for the managers of those cash pools to trust them with their money. But there’s only so much collateral. Pozsar & Singh discuss “collateral mining,” a term that I like because it fits well with the general faux-blue-collar attitude of the financial industry:
Dealers obtain (or “mine”) collateral from asset managers through various means. From the levered (or hedge fund) accounts they mine collateral through the provision of funding via repo against collateral, and the prime-brokerage related borrowings via margin loans against collateral. From the unlevered (or real money) accounts, dealers mine collateral directly from their custodians; in these transactions, unlevered accounts and custodians act as principal and agent securities lenders, respectively.
Once you’ve mined this collateral, it can be used on a quasi-fractional-reserve basis to create more collateral, just like once you’ve mined gold it can be used on a fractional reserve basis to create more money (ducks). They estimate that at the end of 2010, there was $2.4 trillion in source collateral supporting $5.8 trillion in total collateral in the financial system, down from $3.4tn and $10tn in 2007.
This kind of freaks them out, since it’s a way of ratcheting systemic leverage up and down that is lightly regulated and non-transparent. It freaks out Kelly Evans too. She points out the irony that the Fed stopped tracking broad measures of the money supply in 2006, even as shadow banking was exploding:
In recent years, the Federal Reserve has considerably narrowed its study of the money supply (referred to by economists, depending on the breadth of the definition, as M1, M2 or M3), relegating it to more or less second-class status in the world of economic indicators. This, it turns out, may have been precisely the wrong thing to do.
What the 2008 financial crisis so violently revealed was the tremendous amount of financial activity taking place in the shadows outside the traditional banking system and measured economy. … If nothing else, it would seem a timely window into these broader money conditions would be one of the most important things the Fed could offer. … Pozsar and Singh in their paper identify how “collateral chains” lengthen as the financial system levers up; the first step towards measuring this behavior in order to prevent future systemic crises is to at least measure the underlying stock of collateral as part of the money supply in the first place. And the need for better measurement here will only grow as regulators crack down on banks and effectively push more activity into the shadow-banking world, Pozsar and Singh note.
If you’re the sort of person who gets freaked out by this stuff – and, I mean, that does seem kind of a sensible way to be, no? – the Corzine testimony ought to worry you. Even though, y’know, GOLDMAN CONSPIRACY EVIL, MF Global wasn’t actually the central node in the shadow banking system. But it was obviously a node. And it’s a classic collateral miner: asset managers and households come to MF Global with their precious, precious collateral, which they’d scrimped and saved over a lifetime, and trusted MF to keep it safe – just like they’d trust their local savings bank to keep their money safe.
But there are big differences between MF Global and your local bank. Some involve backstopping: your bank is FDIC insured, your Jon Corzine isn’t. Some involve regulation: the rules about what MF Global could do with your collateral were maybe in hindsight just a touch lax. Some involve transparency: the Fed does a better job of tracking savings deposits than it does of tracking shadow banking money creation.
But the difference that gets to me is one of attitude. The CEO of a classic, pre-Glass-Steagall-repeal bank views his job as taking in customer money and lending it out. The spread that he makes on borrowing short and lending long is his business. That and ATM fees. It’s hard to imagine an old-timey bank CEO saying “I just didn’t pay attention to that whole deposit thing. Seemed kind of boring.”
That’s kind of what Corzine said. He just didn’t perceive the focus of his job as being taking customer collateral and making a spread on lending it out. It wasn’t: MF made most of its money on commissions, and on principal investing and trading. But those businesses – even principal trading, really – aren’t the kind of businesses that pose big systemic risks, and they’re not the kind of businesses that, when they blow up, take a billion dollars or so of customer money with them. The shadow banking sideline that MF Global was running turned out, when MF was on its deathbed, to be the most important thing about it. And the CEO knew nothing about it.