Parting Thoughts

Collateral Transformation, or Doing the Laundry

By J.D. Neeson, President, Marine Parts Express

In will-they-never learn and where-the-heck-are-the-regulators department, J.P. Morgan, Bank of America, Barclays, Deutsche Bank, and State Bank are all setting up collateral-transformation trading desks. Due to the new financial rules that will begin in 2013, banks, hedge funds, and other traders have to increase the percentage of collateral they post when trading in the $648 trillion (yes, trillion, or 10 times the world GDP!) derivatives market.

Congress changed the law requiring most privately negotiated derivatives trades (called over-the-counter trades) to go through established trading houses and ruled that the collateral collected must not only be a bigger percentage of the trade, but of better quality and relatively easily convertible into cash. The theory being that if a derivatives trade went south, the clearing house would be able to cash in the collateral to cover the default and not require government help.

Herein lies the challenge for the poor derivatives trader. It is difficult to find enough high-quality rated debt to meet the new rules. The United States has about $11 trillion of high-quality treasuries out in the market, and if you add in the Japanese and European high-quality debt there is another $25 trillion available. There is a tremendous demand for these types of instruments from central banks, governments, and big institutional investors.

So the banks came up with collateral-transformation that allows the derivatives trader to “borrow” high-quality securities (mostly treasuries) from the banks by putting up as collateral for the loan of these high-quality securities, inferior or non-complying securities. At some point, the trader is supposed to return these good treasuries.

The derivatives traders take these loaned (or maybe rented is a better word) high-quality securities (mostly treasuries) to the clearing houses and use them as collateral for their derivatives trades. The clearing houses are happy because they have the good securities as collateral and meet the new regulations. The banks are happy as they charge the derivatives trader for doing the swap and charge interest for the loans of the securities.

And the derivatives traders are happy as they have completed the derivatives trades, and to pay for them the traders have effectively “laundered” their sub-par securities.

Who is not going to be happy is the government and, by extension, all of us. If the derivatives trader’s bet fails, the clearing house will liquidate the collateral to cover some percentage of the default and go after the bank for the rest (the trader’s sub-par securities are with the bank). The bank will have to try to liquidate the sub-par securities and to maintain the bank’s reserve ratio at the same time, but they don’t have their nice, secure, high-quality bonds anymore.

Does this scenario sound familiar? It should. The only aspect missing is some smart insurance company offering insurance for the bank collateral-transformation desk and we can have a default swap AIG-type debacle all over again.

It is a blatant attempt to get around the regulations, and I am sure the bankers (in the back of their minds) are thinking that if it all goes wrong, the government will bail them out again.

Categories: Economy, JD Neeson

Tags: bank, debt, Economy, finance, Marine Parts Express, trade

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