Our financiers have found a new way to blow themselves up. Their stockpile of explosives is starting to look like the U.S. – U.S.S.R. inventories at the peak of the cold war.
The new one is a collateral swap.
Here is how it goes. Our financial institutions used to make all sorts of (often very very short term) loans to each other with no collateral. Sort of like if you walk into a pawn shop, and they lend you $100 and you don’t have to secure it with your .2LR derringer, or your best costume jewelry. Well now, people are want the gun and the bling.
So now there are some people out there who need loans, but they don’t have anything to put up: they are firearm and blinged out. There are also other people who, for safety reasons are required to hold onto a lot of very safe assets (U.S. Bonds, AAA rated bonds, etc.) that do not make very much interest.
So the people with the bling let the people without the bling use their bling for collateral: for a fee. The people with the bling still own the bling, and they can show their government regulator that they have lots of very safe bling, and they also get to make extra money off their bling.
I am presuming you can see where this might be a problem.
The rise of the collateral swap. Also known as a long-dated repo.
The premise was simple. Prudent institutions flush with top quality government bonds (or even cash) wanted to secure a better rate of return — on a still relatively low-risk basis. We’re talking insurance firms, pension funds and other low-risk asset managers.
They weren’t keen to lend unsecured, that was for sure. But they were prepared to engage in collateralised swap deals with cash-strapped investment banks or the shadow banking industry (who were looking for cheap funding) — gaining extra yield on their low-yielding ‘safe’ securities by indirectly funding more risky investments elsewhere. The shorter the duration of the loan the safer.
The shadow banking community thus inadvertently got drawn into being an intermediary agent, acting as a go-between in the channeling of cash into higher yielding investments like junk bonds, mortgage debt and emerging market securities (and sometimes even peripheral European debt).
Though, even now, very little is known about the nature, popularity and size of such deals. But they do encompass many forms, that we know.