Counterparties: Unintended collateral

September 11, 2012

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Financial reform was always going to be accompanied by unintended consequences. And Bloomberg’s Bradley Keoun has found a great one, in his piece on the rise of “collateral transformation” at big banks.

Under the Dodd-Frank Act, most derivatives deals — the things which sunk AIG, remember — are meant to be forced into public clearinghouses. The idea is to bring the opaque, hard-to-price derivatives onto an open forum, with each party setting aside safe collateral in case things go sour.

The problem is, good collateral, like those once-pristine sovereign bonds FT Alphaville has extensively cataloged, is in short supply. Enter banks like JPMorgan, BofA, Goldman Sachs and Barclays. Never ones to let an unintended consequence go unmonetized, they’re now offering clients services that take these assets and magically transmogrify them into safer ones:

The process allows investors who don’t have assets that meet a clearinghouse’s standards to pledge corporate bonds or non-government-backed mortgage-backed securities to a bank in exchange for a loan of Treasuries. The investor then posts the Treasuries — the transformed collateral — to the clearinghouse. The bank earns fees plus interest, and the investor is obliged at some point to return the Treasuries. In effect, the collateral is being rented.

This is pretty much the opposite of what was intended. Loaned collateral only serves to increase complexity of the derivatives market, and will likely make it harder to unwind contracts when things go bad. “The point of the initiatives on derivatives was that derivatives can hide a lot of risk,” finance and economics professor at Stanford told Bloomberg. “Now they’re going to just shuffle the risk around”.

A better regulatory approach, for people Harvard’s Kenneth Rogoff; John Kay; the Bank of England’s Mervyn King and Andy Haldane; and our own Felix Salmon, is that less is more. In a buzzy speech at Jackson Hole late last month, Haldane made the case for a financial regulatory regime “which is less rules-focussed, more judgement-based”. As Haldane put it, “As you do not fight fire with fire, you do not fight complexity with complexity”:

Dodd-Frank rulemaking in the 12 months after its enactment covered thirty  new rules or less than 10% of the total.  A survey of the Federal Register showed that complying with these new rules would require an estimated 2,260,631 labour hours every year,equivalent to over 1,000 full-time jobs. Scaling this up, the compliance costs of Dodd-Frank will run to tens of thousands of full-time positions.

In this world, rather than adding things like layers of executive branch oversight, banks would be rewarded for simplicity. — Ryan McCarthy

On to today’s links:

Tax Arcana
All $1 trillion of America’s tax breaks, charted – WaPo
Barclays just doesn’t feel right making tons of money providing totally legal tax avoidance advice anymore – FT

The Fed
How low rates are crushing savers – NYT

Yes, the AIG bailout worked and it is profitable – Sorkin

Must Read
The greatest GIF guide to the US jobs crisis and Fed policy you’ll ever see – Mike Konczal

Nothing to see here: China’s next President disappears from public view without explanation – NYT

Words spoken by a human: “We’re all about glocal right now” – Kevin Roose

EU Mess
Greece’s worst tax evaders? Its professional class – Guardian

Cut the Check
UBS whistleblower gets $104 million reward, while serving 40-month sentence for felony conviction – WSJ

Welcome to Adulthood
“Internships are pretty terrible” – Washignton Monthly


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