"When Collateral is King": An Important Research Paper from Credit Suisse

How could a paper called “When Collateral Is King” not attract our attention? It is from Credit Suisse’s Global Strategy Research, published on the March 15, 2012 (a/k/a the Ides of March). The paper deserves a careful reading. The research looks at the impact that the financial crisis had on the “moneyness” of collateral – essentially how much cash could be borrowed from the asset — as well as the velocity of collateral. Post-crisis there was a huge need for liquid collateral to fill the vacuum created by the impairment of less liquid markets; this offset deflationary pressures and allowed the markets to deleverage safely.

The authors examine what happened to the mix between private assets (corporates, money market, asset-backed and non-agency mortgages) and public assets post-Lehman. They track the fall in the value of private assets, which was further exacerbated by the higher haircuts extracted to finance these assets (e.g. the fall in “moneyness”). The demand for collateral in the financial system didn’t just disappear although it did shift in favor of safer assets. Offsetting the decline was where the US Treasury and Federal Reserve came in; the massive rise in public assets was necessary and probably saved the economy from a depression.

The research is not only about financial assets. It makes excellent points about households and their collateral and “moneyness”. The impact on the outright fall in value of (as well as the capacity to borrow against) homes closely parallels what happened in the markets for financial asset leverage.

The paper looks at the private assets in the context of shadow banking. The concept of “shadow money” is defined as “…securities that can easily be borrowed against…” and “…based on the total outstanding value of various classes of debt, adjusted by each market’s average repo haircut.” The paper goes on to say “The surge in the demand for bank deposits and safe securities from 2008 was closely related to the collapse in private shadow money, which was caused by negative net debt issuance, falls in the market value of debt, and sharp increases in repo haircuts.”

By looking at the relationship between public and private assets, the authors make the point that the shadow money world is not some parallel evil universe, but complimentary with the public asset world. The paper cautioned against legislators and regulators who don’t understand the relationship between public and private and seem to be on a campaign to constrain the shadow money world without realizing the consequences.

There is a lot to think about in this paper and it is definitely worth a read.

A link to the paper is here.

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