Is Panic Inevitable?

Repos, Haircuts, and Rehypothecation

The real story of the present is the shadow banking system, the unstable and massive repo market, and the apparent daisy chain of hyper-rehypothecated collateral. It looks like the sound bite version amounts to the fact that the European banking system is on the leading edge of collapse for the whole system. These institutions are by all evidence now badly deficient of the three hallmarks of real banks--deposits, capital and collateral.

David Stockman (http://www.zerohedge.com/contributed/big-3-french-bank-assets-triplefrances-gdp-according-david-stockman)

This article discusses the possibility that panic is inevitable in the financial markets, in particular Eurozone sovereign debt, given that many owners positions in existing sovereign debt are funded through short term mechanisms. The banks and institutions that own sovereign debt do not fund the sovereign debt from just their own capital or from depositors, but from the Repo market: a source of short term funds (e.g. overnight) in exchange for collateral, (i.e. the sovereign debt securities.) The lenders in the repo market may Re-Hypothecate or use the collateral as collateral for loans or repo from a third party. This creates a daisy-chain of leverage, with an extremely high maturity mismatch. As the perceived risk of the underlying asset and counterparties increases, the size of Haircut increases, which is to say the borrower gets a loan of less than 100% of the value of the collateral. As the size of haircuts increase, collateral chains are shortening and deleveraging ensues. This is what happened to Lehman Brothers. The perceived risk of the underlying assets -- Lehmans repoed sub-prime and other mortgage backed securities -- along with the counterparty risk of Lehman itself increased and lending dried up. However the highly leveraged banks, by definition, will not have sufficient capital to cover the haircut. This leads to them selling assets, which can further drive down the value of collateral for repo or any other purpose, amplifying the capital needed to fund securities positions. A repo-run or institutional run on the banks occurs.

Repo Banks, to use a shorthand for financial institutions, buy securities and borrow against them on the repo or repurchase funding market. The repo market is essentially where a bank offers a security as collateral, and the lender lends money and takes possession of the collateral. Legally, the bank sells the security for a period of time, anywhere from 1 day to 90 days or in theory till the securitys maturity, and promises to buy it back within a certain period of time for a markup. The buyer gets a profit on selling back the security, and the seller collects the excess interest between what they paid the lender/buyer and what the underlying security pays out. If the lender lends less than the value of the collateral there is a Haircut. If the borrower got 90% of the securitys value, there is a 10% haircut. However for many AAA securities there is no haircut in liquid credit markets. If collateral is high quality there is little need for due diligence. The haircut measures

counterparty risk: the risk that borrower A cant repay, and the risk of lender B being able to find a buyer for the collateral from A, or lender B finding a lender C to lend to lender B till the security matures or can be sold at a profit. Firm will also do collateral swaps. A pension fund swaps their high grade securities for high yield ones. The investment bank can then repo the high grade securities with the central bank. This allows the investment bank to fund its high yield securities with cheap credit. (The Overnight Black Swan, Izabella Kaminska http://ftalphaville.ft.com/blog/2011/08/31/661311/the-overnight-black-swan/) Houses that are custodians for highly rated assets, would on the clients behalf repo out AAA assets and then invest the cash in repos for less rated assets. (Are the Brokers Broken, Matt King http://www.zerohedge.com/sites/default/files/images/user5/imageroot/2011/12/Are%20the%20broke rs%20broken.pdf p. 12.) Given that interest rates are at 0% - this encourages investing in risky assets. (Which is the point according Frederick Sheehan. See section Feds Deliberate Culpability http://www.scribd.com/doc/33050499/Report-from-the-Mises-Circle-Austrian-Economics-and-theFinancial-Markets-May-22nd-2010#outer_page_2) Repo funding is short term: analyst Dale F Gray writes that the average maturity of repo funding was 40 to 90 days and two-thirds of this funding was being rolled over each week (Modeling Financial Crises and Sovereign Risks, Dale F. Gray, p. 123 http://www.scribd.com/doc/45008658/ModelingFinancial-Crises-and-Sovereign-Risks) The repo market is a decentralized market for short term, usually overnight, collateralized borrowing and lending that uses debt as collateral.2 The repo market had an average daily trading volume of $7.6 trillion in the first quarter of 2008. (Repo, Haircuts and Liquidity, Tri Vi Dang, Gary Gorton, Bengt Holmstrm http://www.scribd.com/doc/75327365/Repo-Haircuts-and-Liquidity-Tri-Vi-DANG P. 2) While repo ties up cash from the point of view of the lender, the lender is still essentially in a cash position because the collateral is highly liquid and the lender will not be left holding the bag for an extended period of time. Lenders will often lend 100% of liquid collaterals value. It is as good as money in the bank. From the point of view of the borrower, the borrower collects the difference between the interest paid out to the lender and the interest paid by the security. If there is no haircut, theoretically the borrower can borrow an infinite amount and collect interest on infinity. However, "the very same features which are designed to make repo safe for cash lenders do tend to create risks for those who depend on it for their borrowing." (Are the Brokers Broken, Matt King http://www.zerohedge.com/sites/default/files/images/user5/imageroot/2011/12/Are%20the%20broke rs%20broken.pdf p.3) However the borrower is dependent on short term financing it must roll-over, often on a daily basis. On any day, its lenders can refuse to roll-over the repo. If the borrower cant rollover then its potentially bankrupt. In theory, you could just go out and sell the collateral and pay back the repo; but if there is a temporary drop in demand, i.e. the asset is illiquid, it is impossible to pay back the repo when the price has dropped. "Haircuts and daily variation margin further help to insure the lender against the effect of any price falls in the collateral." (Are the Brokers Broken, Matt King

http://www.zerohedge.com/sites/default/files/images/user5/imageroot/2011/12/Are%20the%20broke rs%20broken.pdf p.4.) One may object that some repos are to maturity, they dont end until the collateral matures. However this is the trade that bankrupted MF Global. So how could MF Global go bankrupt? The trade was a sure thing as long as the bonds did not default and they were all short term bonds just over a year. Apparently the counterparty could still somehow pull out or demanded more collateral. Presumably the bonds were not sold because there was a short term loss or the market was illiquid. The short term loss led to the repo financer demanding their repo ratio be established in line with the new lower market price, or they claimed that material conditions changed. Clearly even long term repos can create short term liquidity issues. (MF Global and the repo-to-maturity trade, Izabella Kaminska http://ftalphaville.ft.com/blog/2011/10/31/717181/mf-global-and-the-repo-to-maturity-trade/) If one party defaults in a repo, then the borrower keeps the cash and the lender keeps the security. So the lender is impacted by the risk that the security will be seen as lower quality, less liquid, and more risky collateral in the future: a run on repo cannot be a coordination failure. Here, a run on repo can arise if macroeconomic news causes IA-insensitive collateral asset to become IA-sensitive. There is a kind of regime switch. (http://www.scribd.com/doc/75327365/Repo-Haircuts-and-Liquidity-Tri-ViDANG) A borrower needing to repo may sell other assets not commonly repoed to raise funds to cover the haircut. This would keep up the price of repo market assets, while dropping prices of other assets, until crunch time came on repo assets. (Perhaps this is an application of Greshams law, acceptance of bad collateral drives out the good assets. Firms will also often try to repo their best collateral first to fund bad.) The repo market is usually highly liquid, and assumes assets and counterparties are of very high quality. Just as leverage on the upswing compounds profits, it also compounds losses on the downswing. Potential lenders, e.g. money market funds, dont want their cash tied up in long term investments. Therefore, they will get nervous if the quality of the assets or counterparty, i.e. the collateral and the borrower, are possibly deteriorating or perceived as unknown or indeterminate. (Typically collateral and borrower have a known quality and a high quality.) They dont want to be part of a potentially long term position, therefore they will want to get out first and park their money someplace safe.

Rehypothecation Apparently, the lender can then use the collateral as collateral for loans to itself from a third party. This is rehypothecation. This creates a daisy-chain of borrowers, all using the same securities as collateral. (It is not clear how this unwinds it seems like there are multiple owners for the security. If someone takes the collateral it seems like everyone else earlier in the chain who posted the collateral loses their shirt.)

US banks can rehypothecate 140% of the debit balance this is the difference between what a customer buying on margin paid in and the value of the securities. However in the UK there was and is no limit to it. So a bank or broker can rehypothecate all of their customers assets. Apparently many U.S. firms would do exactly that: by transferring assets to their London entity, e.g. Lehman and probably MF Global, and the broker would have language to that effect in the customer contract.

Example of Rehypothecation "the pledged collateral is not owned by these firms, but due to rehypothecation rights, these firms are legally allowed to use the collateral in their own name." (The (sizable) Role of Rehypothecation in the Shadow Banking System, Manmohan Singh and James Aitken, p. 9 http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf ) Rehypothecation is where collateral posted by a borrower or customer can be used as collateral by the lender or broker to get funding. For example Bank A does a repo with Bank B, posting Sovereign Debt as collateral. Bank B uses the sovereign debt as collateral to get loans from Bank C. This is rehypothecation. It creates a daisy chain. Some repoed assets cannot be re-pledged as collateral. ( Are the Brokers Broken, Matt King http://www.zerohedge.com/sites/default/files/images/user5/imageroot/2011/12/Are%20the%20broke rs%20broken.pdf.) In the case of margin trading rehypothecation may sound like industry practice: Retail Customer A buys on margin and posts cash collateral with Broker B, the Broker B uses the security as collateral to get a loan from Bank C. This is also rehypothecation. Many hedge funds are leveraged. So Hedge Fund A buys securities with Prime Broker B on margin, essentially getting a loan from the Prime Broker B instead of getting a real loan. Prime Broker B uses the securities as collateral to get a loan from Bank C. Bank C can hypothetically rehypothecate the collateral to get money from Bank D. However in many case the collateral may be purchased securities that clients presumably own outright, and perhaps outright cash. Hedge Fund A buy stocks or high grade bonds from Broker B and keeps them in an account with Broker B. Broker B uses the stocks or bonds as collateral to get a loan from Bank C. This is also rehypothecation. In return for this type of rehypothecation, customers pay less in fees or get interest. The broker gets a fat loan it can use to buy additional securities and repo out using the loan money to cover the haircut, making money on the spread. Firms will also cross repo and rehypothecate. For example Jefferies will sell collateral securities to other people in exchange for securities they want to hold. (http://newsandinsight.thomsonreuters.com/Securities/Insight/2011/12__December/MF_Global_and_the_great_Wall_St_re-hypothecation_scandal/)

At this point alarm bells may be going off in the heads of those familiar with the fractional reserve system, where banks lend out customers money leaving the vaults empty except for a fractional reserve and a pile of IOUs. With this last type of rehypothecation Bank C may demand the collateral posted by Broker B that Hedge Fund A thought it had clear title to. Customers may not really realize that their Brokers are lending out their securities. Once customers realize that the brokers may pose counter-party risk, there may be a run on the brokers as customers adopt the motto It isnt panicking if youre the first one out the door. Apparently this really happened to Lehman customers, who discovered all their securities were in London, and had been used as collateral by Lehman and had probably been seized by Lehmans counterparties. Re-hypothecation apparently did decline post Lehman as many hedge funds finally figured out that that broker-dealers were using hedge funds wholly owned assets as collateral for risky proprietary trades, not just financing assets for which the hedge fund had only posted margin. It is like discovering the casinos chips are worthless because they have taken the cash across the street and gambled it on roulette. The problem in all these scenarios is: what happens when Broker B or Bank B goes bankrupt and breaks the daisy chain? Lender Bank C can demand the collateral now and usually it is in their possession. However, Customer A also has a claim over the collateral. If it is a repo the claim is at a future date, and at least Customer A has cash. However if Customer A has posted a haircut, then they take a loss and their capital base suffers. It is not quite clear how rehypothecation worked with MF Global. One possibility is that the lender would move to seize the collateral which the customers thought they owned, leaving the customer trapped. Certainly this appeared to have happened with Lehman in the UK. Perhaps with MF Global cash was pledged as collateral. (http://newsandinsight.thomsonreuters.com/Securities/Insight/2011/12__December/MF_Global_and_the_great_Wall_St_re-hypothecation_scandal/)

Inherent Instability In the normal repo market for AAA securities, Banks can always find a short term lender. In many cases the banks would get 100% funding for securities they held, allowing the bank to collect the spread in the interest rate. What we have is a Maturity Mismatch a mismatch between the durations of the borrowing and lending. Banks lend long and borrow short. It should be clear by now that banks are funding their long term positions with other peoples short term money. Banks and other players dont seem to actually have any money to invest long term. The quality therefore of the assets is critical the underlying securities must be liquid, i.e. they can be easily sold without a loss. If the repo lenders wanted to invest long term in securities they couldnt easily sell they would have bought some.

The implication is that banks must decrease their assets because of insufficient equity. "This leverage is also an obstacle to rescue situations. When institutions are highly levered, small changes in assumptions about the value of their assets can have massive implications for the valuation of their equity." (Are the Brokers Broken, Matt King http://www.zerohedge.com/sites/default/files/images/user5/imageroot/2011/12/Are%20the%20broke rs%20broken.pdf p. 17 )

Housing Bubble This was the situation during the housing bubble crisis. Bank had large positions in mortgage backed securities. Since they were AAA rated securities and the banks seemed sound, the banks had no problem getting repo funding for them. Regulators during the housing bubble, as we know, encouraged the idea that the securities based on the loans were of high quality, even though in reality the regulators encouraged loosened lending standards (e.g. Ninja loans: No Income, No Job, No Assets). Financial models also assumed the price of the houses that were collateral would never fall. (Anatomy of a Train Wreck http://www.independent.org/pdf/policy_reports/2008-10-03-trainwreck.pdf) Now as a securitys rating decreases, Repo funding dries up. It is also harder to sell the security, and of course sales decrease the price in general, making the security worth less as collateral. This is what happened with subprime mortgages. People realized that the securities werent really high grade. This did not make the securities worthless per se, but made many of them worthless as collateral and illiquied. The initial subprime problem wasnt from financing the loans by selling the securities to long term investors, but by borrowing short term to finance the securities. There are two big issues. The first is maturity mismatch, long term debt is funded by short term funds. The second is illiquid structured credit without transparent values. Markets realize that liquid securities with apparently transparent values do not in fact have transparent values, making them progressively illiquid. The attempt by the banks to create returns with high leverage and little risk of capital fails in the long run.

The Sovereign Debt Crisis The situation with sovereign debt and banks is very similar to, if not exactly the same as, the housing bubble and banks. The banks that nominally own the debt dont have enough money to fund it all, and they borrow short term funds on the repo market. Everyone knows that the credit ratings will fall for sovereign debt. At a certain point the repo market will dry up for banks posting as collateral sovereign debt with increasingly

lower credit ratings. There is no reason to think that the sovereigns in the E.U. and well as the U.S.A. will do anything to improve their future credit ratings. Banks dependent on short term financing for their positions in sovereign debt will be faced with a reporun. As we saw repo markets depend on liquid securities, securities with high credit ratings and transparent values. Sovereign debt will be perceived as riskier over time, as credit ratings decline and their likely future value becomes anything but transparent. Acceptable collateral in the repo market is perceived to be as good as cash, i.e. stable in price and easily saleable, whereas the market for sovereign debt is becoming increasingly unpredictable. The symbiosis between banks and sovereigns appears to be breaking down. In order to fund debt, Banks need debt which is easily saleable and intelligible. Sovereigns need banks to fund them. The less intelligible the debt, the harder it is for bankers to fund it with short term money, and the harder it is to find more expensive long term lenders and buyers. If there is ever perceived inflation from ECB funding, interest rates will go up. This makes it even harder for Banks to fund their positions with repo funding. Blatantly printing the money, either directly loaning it from the ECB to sovereigns at 0% interest or loaning it to banks with no terms, gives the sovereigns absolutely no incentive to control spending and inflation. The system then runs the risk of the sovereigns and banks not being able to buy much of anything with the money they print, (e.g. Weimar Germany Marks, Confederate States of America currency, U.S. Revolutionary War expression not worth a continental, French Revolutionary Assignats.) The sovereigns need the banks to buy into the system. Help from the ECB is also problematic. According to Philipp Bagus Tragedy of the Euro, (http://mises.org/books/bagus_tragedy_of_euro.pdf p.72) the ECB only accepts high grade collateral for loans at the discount window, and it charges a higher than market interest rate to discourage borrowing. The ECB also demands a haircut it wont loan 100%. (If the ECB is forced to take the collateral and it tries to sell a security that dropped in price the ECB will take a loss.) If newer government debt is paying a higher interest rate than old debt, it creates a contradiction for the ECB to fund both debts. If it lends out a low rate, then a buyer of government debt depending on ECB financing makes a killing. If it lends out at a higher rate, then the owners of old debt cant cover their payments to the ECB with the interest from the government debt. So the obvious solution is for the banks to sell their bonds to the ECB, which it can legally buy. The problem of course is that it is pretty obvious to voters in harder money and lower deficit countries that the ECB is basically printing money to fund softer money and higher deficit countries to the detriment of holders of Euros. The deficit countries have no incentive not to accept the free money. (ECB may want a crisis to impose more controls to keep inflation from spinning out of control even if it leads to debt slavery of taxpayers.) With inflation from ECB funding at some point interest rates may go up? makes it harder for Banks to fund their positions with repo funding.

So the rules go out the window. But it may not happen fast enough. Markets may dry up and banks collapse first.

Why Panic is Inevitable The incentives are to keep risk indicators low for as long as possible. (Policy makers often confuse symptoms and causes. If prosperous countries have low interest rates, let us just force interest rates down. Confusion of correlation with causation leads to confusion of causation.) When reality finally hits home, there is no buffer for the undercapitalized banks. Because sovereign debt funding is dependent on maturity mismatch small changes lead to escalating problems. (Not just default risk. There is financial system risk as ratings start falling.) Sovereigns were given plenty of chances to reform, but they did nothing. All Eurozone sovereigns are violating the spirit and letter of the treaty by running larger than permitted deficits. Indicators are eventually perceived, correctly, as not as meaningful, e.g. securities rating and stress tests. Sovereigns continue not to put their financial house is order, as it is politically unpopular, while the system tries to buy time. There is a feedback loop. Prices decline making it harder to sell more bonds. Sovereigns find it politically difficult to slam on the brakes and eliminate deficits. However in the markets rapid moves can happen, especially with leverage. Leverage and short term funding makes things non-linear, while also making funding initially cheaper. Even more exciting is that if the government is responsible for bailing out the banks it creates another feedback loop. If governments are perceived as being forced to take on additional debts from bankrupt banks holding sovereign debt, when their own deficits are out of control, this will force their credit ratings lower. Lower credit ratings will further dry up the repo market, bankrupting more banks that need bailing out, further increasing government deficits. When markets lock up it can be impossible to sell or fund securities. After all, if the people with money dont want to fund the debt short term, why would they buy it?

NOTES:

Lehman Repo 105 Lehman actually put AAA liquid assets in there. Repo 105 was a way to move assets and more importantly the fact that outside parties were funding them off balance sheet. This improver ratios. (If you own two houses with mortgages and you move one of the mortgages off balance sheet your debt to cash ratio looks better. Also how does the cash from the sale positively affected the

balance sheet.) Leverage during Lehman blow up became a prime indicator of risk, and Lehman couldnt sell the assets it owned. Old Cash Asset Debt 10 100 90 New 10 50 40

Off Balance Asset Future Payment

50 50

Articles read The original article is Matt Kings Are The Brokers Broken. However a copy was not obtained until after this was written. Are the Brokers Broken, Matt King http://www.zerohedge.com/sites/default/files/images/user5/imageroot/2011/12/Are%20the%20broke rs%20broken.pdf, http://www.scribd.com/doc/76464153/Are-the-Brokers-Broken Modeling Financial Crises and Sovereign Risks, Dale F. Gray. http://www.scribd.com/doc/45008658/Modeling-Financial-Crises-and-Sovereign-Risks Haircuts, Gary Gorton and Andrew Metrick. http://research.stlouisfed.org/publications/review/10/11/Gorton.pdf The (sizable) Role of Rehypothecation in the Shadow Banking System, Manmohan Singh and James Aitken. http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf Repo, Haircuts and Liquidity, Tri Vi Dang, Gary Gorton, Bengt Holmstrm. http://www.scribd.com/doc/75327365/Repo-Haircuts-and-Liquidity-Tri-Vi-DANG The Collateral Crunch. Tracy Alloway. http://ftalphaville.ft.com/blog/2011/06/13/592161/the-collateralcrunch/ Tragedy of the Euro, Philipp Bagus. P. 72. http://mises.org/books/bagus_tragedy_of_euro.pdf Why The UK Trail Of The MF Global Collapse May Have "Apocalyptic" Consequences For The Eurozone, Canadian Banks, Jefferies And Everyone Else. Zero Hedge, Tyler Durden 12/7/2011. http://www.zerohedge.com/news/why-uk-trail-mf-global-collapse-may-have-apocalypticconsequences-eurozone-canadian-banks-jeffe

MF Global and the Great Wall St. Re-Hypothecation Scandal http://newsandinsight.thomsonreuters.com/Securities/Insight/2011/12__December/MF_Global_and_the_great_Wall_St_re-hypothecation_scandal/ Kyle Bass Hayman Capital Letter of 12/14/2011 http://www.scribd.com/doc/75784106/HaymanCapital-Letter-Dec-14 MF Global and the repo-to-maturity trade, Izabella Kaminska http://ftalphaville.ft.com/blog/2011/10/31/717181/mf-global-and-the-repo-to-maturity-trade/ The overnight Black Swan, Izabella Kaminska http://ftalphaville.ft.com/blog/2011/08/31/661311/theovernight-black-swan/ MF Global 2008 parallels like you wouldnt believe, Tracy Alloway. http://ftalphaville.ft.com/blog/2011/11/02/722161/mfg-2008-parallels-like-you-wouldnt-believe/ Effectively Controlling Assets, MF Global edition, Lisa Pollack http://ftalphaville.ft.com/blog/2011/12/08/786771/effectively-controlling-assets-mf-global-edition/