THE liquidity routinely provided by central banks has for years been
extended by a daisy chain of derivative transactions.
The credit squeeze which is tightening its grip on the world economy
is the result in large part of that chain being broken.
The asset write-downs being forced on the financial system are truly
gargantuan, reaching $US620 billion ($740 billion) at last count, with
the meter still ticking fast, but it has been the loss of liquidity,
not asset value, that brought the pillars of the world financial
establishment tumbling.
Lehman Brothers was forced to file for bankruptcy because confidence
in its ability to repay its debts evaporated, and financial markets
refused to advance it money.
AIG, Merrill Lynch, Bear Stearns, Fannie Mae, Freddie Mac, Northern
Rock and HBOS all faced the same agonising financial suffocation
before their assets were seized either by governments or larger
competitors, with their shareholders left for dead.
The loss of confidence in counterparty risk and a desire by financial
institutions to accumulate as much cash as they can are part of the
reason for the worldwide shortage of cash that is forcing up interest
rates on interbank and term debt markets.
Central banks are doing what they can to counter this, providing as
much cash to markets as they believe markets will absorb. But
financial institutions have been relying not only upon cash, but on a
myriad transactions leveraged by securities to fund themselves. That
business has dried up and it is probably beyond the scope of the
central banks to replace it.
Director of the Melbourne Centre for Financial Studies Professor Kevin
Davis says it has been puzzling that through the boom years, the broad
measure of money supply, M3, which includes currency and deposits in
both the banking and non-bank sectors, grew at a brisk, but not
excessive, annual average around 10 per cent.
When the financial crisis hit last year, it soared to more than 20 per
cent as organisations that were no longer able to fund themselves
using securities returned to the conventional banking system.
He cites research by Citigroup London analyst Matt King, penetrating
the smoke and mirrors in the last accounts of the five big New York
investment banks.
This shows that while they had a combined $US1.6 trillion in finance
secured by collateral on their balance sheets, the total blew out to
$US3.5 trillion by the time off-balance-sheet transactions are
included. The off-balance-sheet transactions are mainly collateral
they have received in “repo” deals, but then on-lent to someone else
(repos, or repurchase agreements, are essentially short-term secured
loans).
King explains how this funding disappears from the balance sheet. The
investment broker sells a hedge fund $100 million of stock in Company
A, providing a margin loan to finance it.
The hedge fund then short sells $100 million of shares in Company B,
and uses the proceeds to pay off the margin loan. The investment bank
now records no change in cash and no net receivable from the client,
so there is nothing on the balance sheet.
The investment bank needs to borrow the second stock so that the hedge
fund can deliver on its short sale, so it pledges the first, which it
is holding as collateral. The investment bank makes a margin on the
transactions, coming and going.
The reality of the transaction may be more complicated, but King says
this is the principle that explains how the investment banks have been
able to fund up to $US7 trillion in open positions maintained by hedge
funds.
King says you would not worry if the repo operations were conducted
using highly liquid assets such as treasury bonds. If the funding were
to disappear, the asset could simply be sold. However, securities used
for repo loans have been a mix of equities and convoluted credit
products.
In the US, the major source of securities for this funding has been
the “custodian” banks like State Street, which hold securities on
behalf of funds managers, and is known as “tri-party repo”.
At the Federal Reserve’s Jackson Hole conference last month, chairman
Ben Bernanke said he was encouraging banks to reduce their reliance on
tri-party repo funding for overnight financing of less liquid forms of
collateral.
“In the longer term, we need to ensure that there are robust
contingency plans for managing, in an orderly manner, the default of a
major participant,” he added, with subsequent events redefining the
meaning of “longer term”.
On Thursday night, Lehman Brothers administrator PwC said that hedge
funds who had pledged assets to the investment bank could not expect
to get them back.
In Australia, fund managers have contributed to this quasi-liquidity
through the lending of stocks to hedge funds.
Repo operations are not nearly such a large part of the financing of
Australian financial institutions, but still make up more than $20
billion of Macquarie Bank’s balance sheet.
The money-go-round has now seized up, and institutions can no longer
fund securities with securities. As positions become mismatched, there
is a desperate need for cash.
The plans being developed by the US Fed and Treasury for a trust to
take over the unwanted debts of the US banking system may do much to
restore financial market confidence.
But they cannot stop the squeeze on liquidity resulting from the
unwinding of the leverage built into the market for securities, and on
which large components of the world financial industry, including
hedge funds and investment banks, is based.
Australian regulators were trying to create a more robust liquidity
risk management system for the banks when their endeavours were rudely
interrupted by the crisis.
Until the crisis, liquidity risk management was thought of as
particular to individual institutions. Regulators wanted to ensure
that there were contingency plans afoot so that if, for whatever
reason, an institution lost access to financial markets for a period,
the risk could be managed.
However, the financial crisis has thrown up the risk that markets may
close for the entire financial system. APRA is planning to release a
discussion paper before the end of the year.
For the moment, the four major Australian banks are among the handful
of AA-rated banks left in the world. The liquidity shortage is raising
their costs, but they still have access to the funds they require. But
the crisis is adding urgency to the regulators’ “what-if” scenarios.
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