Here we go again. A December 30, 2011 article in Forbes by Robert Lenzner “The $18 Trillion Threat Of The Unregulated Shadow Banking System” savages re-hypothecation. Lenzner writes, “…Does this sound kosher to you in the wake of such a terrible financial crisis and meltdown in asset valuations? I’d vote for seriously curtailing this ability to repledge assets for uses that could threaten the stability of financial institutions….” He cites a November, 2011 IMF Working Paper by Manmohan Singh “Velocity of Pledged Collateral: Analysis and Implications” as corroboration of the damage repo, securities lending, and prime broker desks are doing to the financial system. Only the IMF paper really doesn’t say that. The IMF paper goes into great detail calculating the velocity of collateral and the changes since 2007; it went from 3 to about 2.4 in 2010. Finadium cited Singh’s work when calculating the impact to the collateral markets from the push toward CCPs. A link is here.
Singh is primarily writing a paper about measurement and it is very well done. He describes the sources and uses of the collateral in a clear and concise way. It is worth a read, if for nothing else than you’ll know when journalists who have only a vague idea what they are writing about cite it as evidence of the evils of repo and securities lending. Singh writes, for example, “…a shortage of acceptable collateral would have a negative cascading impact on lending similar to the impact on the money supple of a reduction in the monetary base…” That sounds to us like he is throwing up a cautionary flag about the reduction in collateral velocity. In all fairness, he also says “The size (including the length of chains) of the nonbank funding relative to the size of securities lending, repo, and related markets provides a gauge to the potential dislocation that may result from the unwinding of such funding.”
Yes, unwinding a daisy chain of financings can be messy. We’ve written about this before in our December 13, 2011 post “Re-Hypothecation is Now a Dirty Word”. But why does it feel like everyone forgets that these transactions are collateralized? You lend securities and get cash. The exposure is not the entire principal; it is on the mark-to-market deficit, if any.
Saying that re-hypothecation should be limited by broker/dealers is like saying the grocery store you buy a carton of milk from should be constrained from using the cash you give them to pay the wholesaler. And the wholesalers shouldn’t use the money to pay the farmer, and the farmer….well, you get the picture. Re-hypothecation is lubricant.
Lenzner writes “None of these regulators have the obligation of overseeing the re-use of this pledged collateral, which are being supplied by asset managers to other dealers or players who ‘mine’ this collateral for other purposes than were first intended.” The gap in regulatory oversight when institutions operate cross border is well known. The interplay between so-called “shadow banks” and regulated financial institutions is another area often cited as ripe for greater regulatory control. No problem from us there. But saying asset managers pledged the collateral and it ended being used “for other purposes than were first intended” leaves us wondering. Repo, prime broker, and sec lending contracts are pretty clear on what re-hypothecation rights are or aren’t included. And what are the alternative funding sources – unsecured deposits? Not so much. We refer you back to our post “Now Everyone is a Repo Trader”