Investors Want To Put All Their Run-Off-With-My-Money Risk In One Place

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One way I like to imagine the world is that there's sort of a constant amount of financial risk and entropy tends to increase, so that as time goes by everyone increasingly ends up facing the same financial risks as everyone else (though quantities and leverage vary) and idiosyncratic risk is a rare and beautiful flower and so I dropped a good portion of my net worth on Mega Millions this morning because what else can you do? Entropy increasers could include index funds, or converging bank business models, and I guess you could profitably ponder the fact that the big banks are now living on DCM fees until M&A comes back and what that could mean for a model of "we need to split up the big banks to avoid too-big-to-fail risk."*

One thing it could mean is get the hell away from banks. So for instance you could quite reasonably be worried about putting all of your money in collateral accounts with the banks who are your derivatives counterparties because hey MF Global just lost all the collateral you put with them, and so you are, reports the Journal based on the Fed's Senior Credit Officer Opinion Survey on Dealer Financing Terms:

Worried about what might happen to their funds in the event of a meltdown, hedge funds and institutional investors are asking to have their collateral held by a third party, the Fed survey found.

Fourteen out of the 20 dealers surveyed said their clients were more concerned about protecting their collateral and stepped up negotiations to have their money held by a third party. Two of those of dealers said that their clients' efforts to create more collateral protections have "increased considerably."

And if you weren't worried after MF Global, soon you will be, because your favorite bank will soon be downgraded:

Moody’s Investors Service, one of the two big ratings agencies, has said it will decide in mid-May whether to lower its ratings for 17 global financial companies. Morgan Stanley, which was hit hard in the financial crisis, appears to be the most vulnerable. Moody’s is threatening to cut the bank’s ratings by three notches, to a level that would be well below the rating of a rival like JPMorgan Chase.

Bank of America and Citigroup may also fall to the same level as Morgan Stanley, but those two are helped by having higher-rated subsidiaries.

And such a downgrade may or may not hit ratings triggers in those banks' derivatives CSAs, causing them to post more collateral, move trades to their commercial bank (which will be harder for Morgan Stanley because it still kind of looks like an old-school pre-2008 pure investment bank and has not yet converged to the universal bank business model but give it time / a Moody's downgrade), or get out of the business of bilateral derivatives altogether:

The downgrade could speed up the shift of derivatives trades to central clearinghouses, something that is being pushed by regulators.

“Moody’s may simply speed up something that is going to happen anyway,” said one senior Wall Street executive who asked not to be named because he was not authorized to speak on the record.

All very grim but also! That Fed survey is sort of boring in the sense that it asks 87 "how has X changed in the last 3 months?" questions and virtually all of the answers to most of them are "basically unchanged" but there are a few outliers and here is one:

So not quite the 12 somewhats - 2 considerablies that "How has the intensity of efforts by your institution’s clients to negotiate arrangements for the custody by third parties of collateral and margin posted to your institution changed over the past six months?" garnered but also not that far off, and again everything else is pretty unch'd so this does stand out. You could say it's a somewhat false positive, caused not by increased credit risk - after all, when's the last time a financial utility screwed anything up? - but just by increased movement of contracts to central counterparties rather than bilateral. To address regulatory changes and/or prepare for Morgan Stanley downgrades etc. So the increased focus on central counterparty credit is due not to increased credit risk by those counterparties but to increased gross exposure to those counterparties.

But, y'know, exposure is exposure, and greater notionals of exposure tend to lead, somewhere down the line, to greater worries about risk. So today we're hearing that - driven by recent scary glitches and potential ratings downgrades - investors are getting increasingly worried about their exposure to banks and are looking to move their collateral to third party custodians** or to central clearing. But the banks are getting increasingly worried about their exposure to those central clearinghouses, and it's not impossible that on that count they're just a bit ahead of the curve.

MF Collapse Spooked Big Investors, Fed Finds [WSJ]
Three Major Banks Prepare for Possible Credit Downgrades [DealBook]
Senior Credit Officer Opinion Survey on Dealer Financing Terms [Fed via WSJ]

* Right? Like, wouldn't you always, as a regulator, say "oh, yeah, good point, adding this business that is countercyclical or not-quite-synched-to-your-other-businesses is in fact risk reducing"? And so you diversify and embiggen, or reduce variance and increase kurtosis, or something.

** Viz., bigger banks!

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