Remember how a week ago people went around bothering themselves about Bank of America’s derivatives? Specifically how if they get downgraded, as seems plausible, they will have to come up with a zillion more dollars for derivative collateral? And how earlier this week they did the same for Morgan Stanley?
Anyway we talked about it a bit and I put up a table that I figured I’d update when it was complete and now it is so here it is. Also a JPMorgan downgrade, which looked hilariously unlikely 25 hours ago, looks more likely so I guess this is relevant even where it wasn’t before. So here is how much cash various banks will need to stump up – to post as collateral on OTC derivatives or to clearinhouses, or to pay on termination of trades – if they are downgraded two notches:
I occasionally entertain myself thinking about this set of puzzles:
(1) It is good for financial regulators and probably, let’s say, the world, if creditors are slow to pull money out of banks that run into trouble. In particular you don’t want everyone to want to move first and get their money out well before there’s a problem, because them getting their money out creates, or let’s say at least exacerbates, the problem.
(2) Banks also want that, since going bankrupt for no reason seems sort of harsh.
(3) But creditors want their money back – and being first out the door is a good way to ensure that that happens.
And since, when things go pear-shaped, there’s always some risk either that the rules won’t let the creditors move as fast as they want, or that the rules will change, it’s good to get your money out before there’s a problem. The best way to do that is just to keep your money to begin with, or only to give it to people who won’t get into trouble, but failing that, you want to get your money back when there’s a hint of trouble but things are still mostly fine. For some reason credit ratings used to indicate that state, since they worked so well last time, so a downgrade from nice investment grade to less-nice-but-still-investment-grade is a good time to check in with your money and see if it might miss you and want to spend a bit more time with you.
On the other hand, if you are a bank and you agree to terminate or collateralize lots of contracts upon a downgrade, you tend to have to come up with lots of cash at exactly the wrong time. So it is probably smart practice to mostly not agree to that sort of thing. But life being what it is you can’t win them all, so you agree to have some trigger-on-downgrade collateralization in some of your contracts, and you just push for those triggers to be as few and as far away from your current ratings as possible.
The gnomes at the Bank for International Settlements have produced a particularly gnomish paper called “Collateral requirements for mandatory central clearing of over-the-counter derivatives.” Wait! It might be important! Hear them out. (There’ll be charts …)
Their goal is to measure how much more cash collateral the big dealer banks will need to encumber to make the transition to central clearing of derivatives (specifically interest rate swaps and CDS) under various forms of central counterparty regime. If you’re interested in that sort of thing, and some people are, then this provides you with much fodder for chewing ruminatively. It sort of reads like an econometrics final exam that, speaking only for myself here, I would fail, so I can’t really say how ruminatively you should chew it. You could clearly make different choices at many, many different points, and while each individual choice seems thoughtful enough you wonder whether the accumulation leaves you with a toy paper at the end.*
Now, if you’re not particularly into the constraints on cash that would be driven by central clearing of derivatives, you can still get something from this paper. Specifically, this gives you a sensible look at how much damage the Financial Weapons Of Mass DestructionTM can do at any one time. Because “margin” is a proxy for something else, specifically likelihood of a big loss. Here’s how they do their math: Read more »
I am always afraid to wade into the world of collateral and repo and rehyp and whatnot because it is big and complicated and smarter people than I splash around in it, but this week has had some good stuff so let’s talk about it for a bit. NBER’s weekly dump of things you could read if you wanted to yielded up a trove of Gary Gorton, including a Gorton-Lewellen-Metrick paper about how much of our economy has historically been composed of safe assets (answer: 33%! weird) and a heavy-sledding but apparently good Gorton-Ordonez paper modelling financial crises as the effect of people deciding that “information insensitive” collateral should be information sensitive. There’s also an interesting paper by Krishnamurthy, Nagel and Orlov (let’s go with K-N-O) that maybe illuminates that point. It’s called “Sizing Up Repo,” and if you’re not already into this sort of thing, here is a picture describing exactly how clear the rest of this will be:
Heheheh no really. Anyway, the basic gist of this whole realm of literature goes something loosely like this:
1. Humans put money in banks and banks lend this money to companies and fulfill their basic role of financial intermediation.
2. Also, there’s a whole lot of other stuff that isn’t “banks” but serves some of the same role, that is, intermediate between human savers and companies that need money.
3. That other stuff is looooooooosely “shadow banking,” and a lot of it consists of humans – and corporations, endowments, etc. – putting their money into things – like money market funds, mutual funds, etc. – that then lend money to each other or the banking system via short-term money-like instruments that sort of fill functions similar to bank deposits. A lot of these instruments take the form of very short-dated loans backed by financial instrument collateral, roughly speaking “repo.”
4. Something broke in that system and helped cause the financial crisis.
The K-N-O paper is a contribution in that vein, and here is the point where I felt like I could stop reading because I had learned something: Read more »
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: