JPMorgan Chase & Co. (JPM) and Bank of America Corp. are helping clients find an extra $2.6 trillion to back derivatives trades amid signs that a shortage of quality collateral will erode efforts to safeguard the financial system.
Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries (DEBPMARK) is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.
The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.
“The dealers look after their own interests, and they won’t necessarily look after the systemic risks that are associated with this,” said Darrell Duffie, a finance professor at Stanford University who has studied the derivatives and securities-lending markets. “Regulators are probably going to become aware of it once the practice gets big enough.”
Adding to the concern is the reaction of central clearinghouses, which collect from losers on derivatives trades and pay off winners. Some have responded to the collateral shortage by lowering standards, with the Chicago Mercantile Exchange accepting bonds rated four levels above junk.
The potential reward for revenue-starved banks is an expanded securities-lending market that could generate billions of dollars in fees. JPMorgan and Bank of America, which have the biggest derivatives businesses among U.S. bank holding companies with a combined $140 trillion of the instruments, are already marketing their new collateral-transformation desks, people with knowledge of the operations said.
The list also includes Bank of New York Mellon Corp., Barclays Plc (BARC), Deutsche Bank AG (DBK), Goldman Sachs Group Inc. (GS) and State Street Corp. (STT), said the people, who asked not to be identified because they weren’t authorized to speak publicly.
“Collateral transformation is a client service that does not hide risk,” said Jennifer Zuccarelli, a spokeswoman for New York-based JPMorgan. “It is a form of short-term secured lending, which has always been an important part of capital markets, subject to tight capital and liquidity rules, and fully transparent to regulators.”
Derivatives allow buyers to bet on the direction of currencies, interest rates and markets to protect their holdings, insure against defaults on bonds or lock in a price on commodities. More than 90 percent of the trades are privately negotiated, according to the Bank for International Settlements. That exempts them from the rules of futures exchanges, which require an initial collateral posting as a good-faith deposit to ensure bets are covered. Traders have to post more collateral, usually in cash, when positions move against them.
The new rules are rooted in the 2010 Dodd-Frank Act, passed in reaction to the near-collapse of the financial system in 2008, caused in part because derivatives contracts weren’t backed by enough collateral. American International Group Inc. (AIG) needed a $182.3 billion bailout from the U.S. government after the New York-based insurer failed to make good on derivatives trades with some of the world’s largest banks, according to a 2011 report by the Financial Crisis Inquiry Commission.
In response, Congress required that most privately negotiated derivatives trades, known as over-the-counter, go through clearinghouses. These entities, run by firms such as Chicago-based CME Group Inc. and London-based LCH.Clearnet Group Ltd., make traders provide collateral, including government bonds, that can be seized and easily converted into cash to cover defaults.
Estimates for how much extra collateral participants will need range from about $500 billion to $2.6 trillion, based on data compiled by Bloomberg. The top figure comes from Tabb Group LLC, which recently raised its forecast from $2 trillion to incorporate new reports on the size of the derivatives market, said Will Rhode, head of fixed income at the Westborough, Massachusetts-based consulting firm.
Analysts at New York-based Morgan Stanley estimated the shift to clearinghouses would force traders to post about $481 billion of collateral, or about 0.4 percent of cleared trades. As much as 75 percent of the $462.2 trillion of interest-rate derivatives, the most common type, may be cleared once the rules take effect, up from about half currently, the analysts wrote in an Aug. 23 report. Under a worst-case scenario, traders may have to post $1.3 trillion, or 1.1 percent, they said.
Either way, the amount is multiples of the collateral currently required, since most cleared trades now are between securities dealers, where the rate nets out to about 0.005 percent, the Morgan Stanley analysts estimated.
Adding to the pressure, new banking-safety rules will compel lenders to keep more cash and easy-to-liquidate investments on hand for emergencies. That may boost demand for high-grade assets by $2 trillion to $4 trillion, according to an April report from the International Monetary Fund.
Top-rated countries, including the U.S., Japan and European sovereigns rated AAA or AA, had about $33 trillion of debt outstanding at the end of 2011, according to the IMF report. There was an additional $2.4 trillion of U.S. agency debt. Most government securities are already committed to other purposes, such as central banks buying them to influence benchmark interest rates or sovereign-wealth funds and other investors counting on the government bonds as a reliable store of wealth.
Money managers, insurance companies and pension funds that use derivatives will be hardest hit by the change, said Josh Galper, managing principal of securities-lending consultant Finadium LLC in Concord, Massachusetts. Almost 40 percent of money managers and insurers in a July survey by State Street and Tabb Group said they’re worried about a collateral shortage once clearing becomes mandatory for more derivatives.
BlackRock Inc. (BLK), MetLife Inc. (MET) and the California Public Employees’ Retirement System, known as Calpers, probably will need more collateral to meet the new rules, according to regulatory documents, public statements by company officials and people with knowledge of the industry’s collateral needs.
“This is a client base that hasn’t had a need for securities financing,” Dave Olsen, JPMorgan’s head of over-the-counter clearing, said in an interview. “You take a typical life insurance company or pension fund, and they might have anywhere from a single-digit percentage to over 10 percent of their derivatives portfolio now required to be pledged to a clearinghouse.”
U.S. regulators implementing the rules haven’t said how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment.
Banks could be squeezed if they have borrowed the Treasuries that they’re lending as collateral, and the original lender suddenly demanded them back, said Duffie, the Stanford finance professor.
“We just keep piling on lots of operational risk as we convert one form of collateral into another,” said Richie Prager, global head of trading at New York-based BlackRock, the world’s largest asset manager.
Lenders also could suffer if a trader defaults and his collateral is seized. In that case, the bank loses its Treasuries and is left holding lower-grade bonds that the trader posted in the collateral transformation.
“This is not a solution to collateral availability during market stress, but it is necessary to address the new rules’ unintended consequences that impact the safety of systemically important central clearinghouses,” JPMorgan’s Zuccarelli said.
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.
The new business resembles the existing $5.5 trillion repurchase market, known as repo, where banks and investors can temporarily pledge their bonds to other lenders or mutual funds in exchange for cash loans. The sudden withdrawal of some participants from that market in 2008, partly because of concerns about the quality of collateral, contributed to the near-collapse of Bear Stearns Cos. and led the Fed to create a $148 billion emergency-lending program to backstop other Wall Street firms that depended on the financing.
The demand for collateral could stoke Wall Street’s fee machine even as the industry faces shrinking profits from regulations that increase price reporting and competition in derivatives trading, according to consulting firm Oliver Wyman, a unit of New York-based Marsh & McLennan Cos. (MMC)
While the $170 billion of annual revenue that securities dealers get from trading may fall by 20 percent to 40 percent once derivatives clearing becomes mandatory, “new revenues in collateral and funding are likely to offset much of those lost” from executing trades, Oliver Wyman wrote in a March report.
The firm declined to estimate how much the banks might reap. Lenders and Wall Street dealers generate a combined $11 billion from clearing trades and managing collateral for clients, identified in the report as an industry growth area.
Bank of America has a return-on-equity target of 10 percent to 15 percent from its clearing business, where the collateral-transformation desk will be located, said Denis Manelski, head of short-term rates trading at the Charlotte, North Carolina-based company. The bank’s return on equity last year was 0.04 percent, after a loss in 2010.
One constraint may be new capital rules that limit how much lending banks can do, according to Raymond Kahn, New York-based head of over-the-counter derivatives clearing for Barclays.
“We’re doing the best we can to factor in all costs and capital charges that are related to clearing, and we are building that into our pricing,” Kahn said.
Executives at Bank of New York and Frankfurt-based Deutsche Bank confirmed that their companies plan to offer collateral transformation. Tiffany Galvin, a spokeswoman at New York-based Goldman Sachs, declined to comment.
Meanwhile, clearinghouses are lowering collateral standards. CME, owner of the Chicago Mercantile Exchange and Chicago Board of Trade, where U.S. interest-rate futures are traded, said in March it would accept as much as $3 billion of corporate bonds from each member firm, up from $300 million previously. The bonds must carry a credit rating of at least A-, four levels above junk.
The exchange decided to accept the corporate bonds because Wall Street firms are under pressure to build capital and probably will face constraints on how much high-quality collateral they can lend, said Kim Taylor, president of the CME’s clearing business.
“We are trying to be aware of the needs of the market and help alleviate the systemic bottlenecks,” Taylor said. “If it’s not something we can safely take, then no matter what the market wants us to do, we can’t take it, so we won’t.”
LCH.Clearnet, which says it clears more than half of all interest-rate derivatives, announced in April it would accept mortgage-backed securities guaranteed by Ginnie Mae (BGNMX), which in turn is backed by the U.S. government. The closely held company is owned by its members, which include representatives of JPMorgan, Goldman Sachs, Deutsche Bank and Barclays.
Since regulators have mandated clearing, they should support “some flexibility on collateral, where the clearinghouse can make a strong case that they can manage the risk,” said Andrew Howat, LCH.Clearnet’s head of collateral and liquidity management. “You can’t have all this over-the-counter clearing without collateral, so something needs to give.”
The life-insurance industry has pushed regulators to allow looser collateral guidelines. The American Council of Life Insurers said in an October presentation to staffs of the CFTC and Securities and Exchange Commission that “high-quality corporate bonds” should be allowed as collateral on derivatives trades. The industry has 42 percent of total assets in corporate bonds, compared with 14 percent in government bonds, the presentation shows.
Members of the trade group, including MetLife, Allstate Corp. (ALL), Nationwide Financial Services Inc. (NFS), Prudential Financial Inc. (PRU) and Principal Financial Group Inc. (PFG), declined to discuss whether they would sign up for collateral transformation.
“This is a level of detail that we wouldn’t be doing interviews on,” said Maryellen Thielen, a spokeswoman for Northbrook, Illinois-based Allstate, the largest publicly traded U.S. auto and home insurer, which had $18.7 billion of derivatives as of June 30.
Calpers, the largest state pension fund in the U.S. with $226.6 billion under management, would use “existing assets in the portfolio” to meet any extra collateral calls, senior portfolio manager Anne Simpson said in a voicemail message. The Sacramento-based fund has derivatives with a notional value of $30.4 billion.
“There’s discussion to be had around what would count as suitable quality, suitably liquid and unencumbered collateral for that purpose,” Simpson said.
The added costs of posting collateral or borrowing it from banks may push some derivatives users to stop trading them altogether, reducing liquidity in the market, said Charley Cooper, a senior managing director at State Street in New York. He said other traders may shift to futures exchanges, which require less than half the collateral needed to clear over-the-counter derivatives, according to CME.
The potential shortage of high-quality bonds to post as collateral is becoming its own risk, the IMF said in its April report. Investors, unable to obtain the Treasuries they need, may “settle for assets that embed higher risks,” according to the report.
“Safe-asset scarcity could lead to more short-term volatility jumps, herding behavior and runs on sovereign debt,” the report said.
The banks’ new lending business “smells like trouble,” said Anat Admati, a finance and economics professor at Stanford who studies markets and trading and advises bank regulators on systemically important firms.
“The point of the initiatives on derivatives was that derivatives can hide a lot of risk,” Admati said. “Now they’re going to just shuffle the risk around.”
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