Notwithstanding the U.S. debt deal—which takes default off the table— dollar money markets remain queasy, and longer term capital markets show clear signs of flight to safety, as market rates on the best stuff fall and rate spreads to the next best stuff widen.
Most people seem to be reading this as Wall Street reaction to changed expectations about the fortunes of Main Street. Economic slowdown in the real economy is coming, probably globally, and consequently there is a premium on safe assets to ride out the storm.
Maybe that is part of the story, but there seems also to be an important dynamic internal to the financial system that most commentary is missing. We see this best when we focus not on the price of the 5 year Treasury but rather on the price of overnight general collateral repo, not on the capital market but on the money market.
Andy Haldane’s recent “Haircuts” speech (see notices here and here) posits pro-cyclical haircuts for securitized lending as a mechanism through which the financial sector amplifies economic fluctuation. From a money view perspective, Haldane is talking about what Ralph Hawtrey used to call “the inherent instability of credit”.
Hawtrey was of course talking about trade credit in a bank lending system. (My favorite Hawtrey reading is “The Art of Central Banking” published in his 1932 book of the same name.) What Haldane is pointing out is that the very same inherent instability is a feature of the modern capital market credit system. But the mechanism is quite different.
The problem is that our monetary policy apparatus has evolved, and also been designed, to handle instability of the Hawtrey-type, whereas the instability that we actually face is of the Haldane-type. Here is Haldane:
“In the model, one of the key channels for contagion is the secured financing market as banks hoard rather than lend liquidity when haircuts rise. The liquidity feast then turns to famine as secured and unsecured financing markets dry up. The system switches to a low-liquidity equilibrium. These liquidity droughts were perhaps the defining feature of the financial crisis during 2007 and 2008.”
Haldane is not, I suppose, denying that there was a solvency dimension to the financial crisis—let it be stipulated that there was a lot of bad underwriting—but rather emphasizing that the liquidity drought is what turned a minor subprime mortgage collapse into a global financial crisis.
From this perspective, the recent queasiness in money markets speaks volumes. As during the financial crisis, the problem is in secured credit markets and the mechanism is haircuts on repo lending.
Haldane’s talk references a paper in which he and co-authors explore possible policy responses to haircut procyclicality, mostly designed to constrain upward instability. Authorities might, for example, impose minimum haircuts, say 20%. Or they might require compensating increases in liquidity balances whenever haircuts are reduced.
Upward instability is not our current problem. The problem we face today is how to buffer downward instability, which seems poised for quite a run. We have seen where that instability can lead, and the massive intervention required to put a floor on it once it gets going. Let’s not do that again, please.
In the emerging market-based credit system (now out of the shadows) funding liquidity is mostly about secured lending, which requires collateral. The value of collateral however depends on market liquidity, especially market liquidity in derivative contracts that reference the securities used for collateral.
Here is one way to understand what is happening. Suppose a shadow bank holds risky securities and also a derivative credit insurance contract that references those very same securities. When the value of the securities falls, the value of the derivative hedge rises, and vice versa, leaving total assets unchanged. But if those assets are funded using the securities as collateral, then when the value of the securities falls, or even just threatens to fall, haircuts rise and funding dries up. Liquidity crisis.
It doesn’t have to be that way.
Consider an asset manager, holding the other side of the various shadow bank exposures, writing credit insurance to get risk exposure and holding its assets in repo. When the value of the securities falls, the value of the manager’s contingent liability falls, and that loss is recognized as a fall in the value of the customer capital entrusted to the asset manager. In effect, that customer capital is the capital of the market-based banking system.
That means that it makes no sense for the asset manager to refuse to roll his repo lending, simply because of worries about the collateral behind that lending. The asset manager himself has insured that that collateral! The problem is that he can’t see it, because his counterparty for both the repo and the derivative is not the shadow bank itself but rather some financial intermediary.