Bonds Stop Flowing as Collateral Gets Stuck at ECB: Euro Credit

The chains of loaned securities being pledged and re-pledged in the so-called wholesale money markets are growing shorter, as collateral piles up at central banks where it can’t generate additional borrowing.

Rehypothecation is the financial alchemy that transmutes $2.45 trillion of assets into $5.8 trillion of collateral at the 14 largest securities dealers, down from a peak of $10 trillion in 2007, according to Manmohan Singh, senior financial economist at the International Monetary Fund in Washington. Once collateral is parked at the central bank, it can’t be recycled, and may become hard to find in times of need.

At the end of last year, banks turned each dollar of securities into $2.40 of collateral, Singh says. As banks grow wary of lending to each other, those assets are being pledged instead to the European Central Bank in one-time transactions that mean the securities can’t be recommitted.

“The system is collapsing onto the balance sheet of the most-solid member of the system, which is the central bank,” said Perry Mehrling, professor of economics at Barnard College, Colombia University in New York. “The central bank is on one side of the market only. The bonds are flowing in and they’re not flowing out again.”

The disappearance of the unsecured credit markets as the sovereign debt crisis deepens has underlined the importance of secured borrowing through repurchase agreements.

Shortage of Collateral

“There is an enormous shortage of collateral,” said Simon Gleeson, a financial-services lawyer at Clifford Chance LLP in London. “That’s because the European banks can no longer raise unsecured funds. There’s never been enough quality collateral so the only way to do it was to re-use the securities.”

European banks are opting to park money on deposit at the central bank rather than lend it to one another. They kept an average of 273 billion euros ($356 billion) at the Frankfurt-based institution during the past 20 days, within 6 billion euros of the most since July 2010, according to ECB data.

The importance of secured lending in the interbank market has grown largely unnoticed in recent years, said Matt King, global head of credit strategy at Citigroup Inc. in London. Its size may make it a source of risk, since borrowers may struggle to find enough acceptable securities should lenders demand more security, he said.

“Risk has become channeled here in an increasing way in recent years, and we just don’t focus on it,” King said. “Everyone is just doing what is efficient under the rules but it’s built up to become a source of systemic risk.” There is “scope for runs on banks due to collateral suddenly becoming very scarce, as in Europe at present,” he said.

Systemic Risk

Repo trading volumes in Europe are sliding, according to ICAP Plc, the largest interdealer broker and the owner of BrokerTec, the biggest platform for repo trading, where securities such as government bonds are loaned for a fee.

“We’ve seen quite a significant fallback in the past two to three months, and most of that’s driven by Germany,” said Don Smith, an ICAP economist, who puts the decline at as much as 20 percent. “The German repo market has been getting very, very tight,” forcing borrowers to use larger amounts of lower-quality collateral and pushing up borrowing costs, he said.

“There is a lack of position-taking going on which is consistent with elevated levels of risk aversion, the sense that people just want to buy and hold German government collateral,” Smith said.

Risk Aversion

Secured lending was viewed as having two big advantages, said Barbara Ridpath, the chief executive of the International Centre for Financial Regulation in London, who was head of Standard & Poor’s ratings activities in Europe until 2008.

“Bankers realized that if they took collateral, two good things happened,” she said. “One, they could stop looking at the credit of a counterparty. And two, they could get ahead of other creditors in a bankruptcy because they had security.”

Rehypothecation, where a bank takes an asset pledged to it and recycles it to another institution, makes it hard for creditors to keep track of ownership, as was shown in the 2008 collapse of New York-based Lehman Brothers Holdings Inc. in the biggest bankruptcy to date.

In a paper dated 10 days before the collapse, King at Citigroup pointed out how assets pledged to Lehman had declined 54 percent since November 2007, compared with declines of no more than 3 percent among its peers. Those still using Lehman as a counterparty when it crashed found the securities they had pledged as collateral had been recycled through London and they were now in line for payment with other creditors.

‘Credit Claim’

“Once you engage in a repo with me, you no longer have the assets, you have a credit claim against me,” said Gleeson at Clifford Chance. “A wise counterparty doesn’t do repo with someone in a deep hole.”

As secured transactions increase, unsecured creditors get pushed further back in the queue for payment in a default. This, combined with reforms in countries such as the U.K. to make insured depositors whole before unsecured bondholders, mean it’s more costly for banks to issue unsecured debt, said Simon Adamson, a bank analyst at CreditSights Inc. in London.

“I suspect regulators will become increasingly concerned about asset encumbrance and levels of collateralized borrowing,” he said. “Senior unsecured will remain an option for banks, at least if and when the sovereign debt crisis is fixed. However, it will be a smaller market, partly because of bail-in legislation, lower-rated, and more costly.”

Debt Crisis

Faced with a situation in which the lack of collateral is starving the financial system of the instruments it needs to do business, the ECB agreed to offer unlimited three-year funding against collateral in two tenders starting today.

Banks asked to borrow 489 billion euros, the most ever in a single operation and almost double the median estimate of 293 billion euros by economists in a Bloomberg News survey. The ECB said 523 banks asked for the funds.

The central bank also said Dec. 8 it would accept lower-rated bonds and bank loans as collateral in its own lending, and cut reserve requirements, potentially freeing up another 100 billion euros of collateral, according to JPMorgan Chase & Co. estimates.

“Everyone wants collateral, everyone wants dollars,” said Mehrling at Barnard College. “If the central bank accepts bad collateral, then bad collateral goes out of the system. But that releases good collateral that the central bank would otherwise be demanding.”