FT Alphaville: One man’s haircut is another man’s unsecured risk

In a November 25, 2011 post in  FT Alphaville,  Izabella Kaminska points out that there is a flip-side to the collateral conundrum: excessive over-collateralization. The post notes that according to Richard Comotto, author of the ICMA bi-annual repo survey, over-collateralization gives the provider of collateral/borrower of cash unsecured exposure and that this is a “notable and under-appreciated risk”. In other words, if in a bilateral repo there is 10% haircut (e.g. $90 of cash vs $100 market value of bonds) to the extent there is over-collateralization (in this case the $10), that exposure is unsecured. Raise the haircut and the unsecured exposure goes up. If the cash lender goes bust while holding onto the paper (forcing the repo trades to be unwound in the cash markets) the collateral provider may not have enough cash to buy the paper back and has to reach into their pocket to make up the difference. We think the analysis may be a hard sell.

Repo haircuts (or in the derivative world initial margin) is there to absorb risk once a default has happened and everyone is rushing to unwind the trades. Market moves can be pretty violent then, as we’ve seen many times (post-Lehman immediately comes to mind).

We think they the post is missing a couple things in the analysis. First, in repo, it is the cash provider who gets to call the shots since they are exchanging a non-volatile asset for a volatile one. Second, higher volatility should mean higher haircuts. It is really as if a cash lender, by seeking a higher haircut, is asking the cash borrower to have more skin (i.e. capital) in the game. Complaining about cash borrowers not being able to leverage themselves enough will likely fall on deaf ears these days. Third, in bilateral securities lending, where the trade is driven by the need for securities, there is typically over-collateralization on the cash side. In other words, there might be $105 cash exchanged vs $100 market value of securities (so the exact opposite of what the post noted). In CCP cleared sec lending and repo trades, each side puts up initial margin — equivalent to both sides being haircut.

Finally, think about when when counterparties tend to go bankrupt. It usually happens when asset values are declining precipitously. For the entity receiving the cash, falling securities prices — post a counterparty default — will reduce their exposure. They may even end up with a windfall when buying back the securities at lower prices. For there to be an exposure problem linked to haircuts, the entity holding the collateral would have to go bankrupt when assets they borrowed are worth more than the cash they lent — in which case, why did the entity go bust? Yes, if in a bankruptcy haircuts exceed the fall in price of the security lent, then there will be unsecured exposure. But it is not a likely scenario unless haircuts increase well beyond current market levels. The one permutation that could end this way is a flight to quality that results in one asset class going up in price while others fall (combined with being very unlucky). But that argues more for diversified books of business than lower haircuts.

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