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JP Morgan Markets Its Latest Doomsday Machine (or Why Repo May Blow Up the Financial System Again) By Richard Smith
Readers of ECONned will be very familiar with the name of Gary Gorton, author of `Slapped in The Face by the Invisible Hand', which explores the relation of the so-called shadow banking system to the financial crisis. His work is pretty fundamental to understanding some of the mechanisms which made the crisis so acute. Now he's done an interview, which I would like to have a growl at; but first, he has some basic points about shadow banking, useful later in this rather long post. Gorton explains repo thus: You take your $200 million to the bank, to Lehman Brothers, say. You deposit it, so to speak, overnight so you can have access to it the next morning if you want to. They pay you 3 percent. And you want it to be safe, so they give you a bond as collateral. But Lehman earns the interest on the bond, say, 6 percent. ..and then "haircuts" (an extra margin of security in case that bond isn't so safe after all): There may be a haircut. If you deposit $100 million and they give you bonds worth $100 million, there's no haircut. If you deposit $90 million and they give you bonds worth $100 million, then there's a 10 percent haircut. ...and then "rehypothecation": If you put a dollar in your checking account and the bank has to keep 10 percent of it on reserve, they lend out 90 cents. Somebody deposits that 90 cents, the bank can lend out 81 cents (because of the 10 percent reserve requirement) and so on. So you end up creating $10 of checking accounts for $1 of demand deposits, assuming there's a demand for loans...And that can happen in repo as well because if you're Lehman and I'm the depositor, and you give me a bond as collateral, I can use that bond somewhere else. So there is a similar money multiplier process. ...and finally the link to regulated banking: And shadow banking very importantly is not a separate system from traditional banking. These are all one banking system.
You take your $200 million to the bank, to Lehman Brothers, say. You deposit it, so to speak, overnight so you can have access to it the next morning if you want to. They pay you 3 percent. And you want it to be safe, so they give you a bond as collateral. But Lehman earns the interest on the bond, say, 6 percent.
..and then "haircuts" (an extra margin of security in case that bond isn't so safe after all):
There may be a haircut. If you deposit $100 million and they give you bonds worth $100 million, there's no haircut. If you deposit $90 million and they give you bonds worth $100 million, then there's a 10 percent haircut.
...and then "rehypothecation":
If you put a dollar in your checking account and the bank has to keep 10 percent of it on reserve, they lend out 90 cents. Somebody deposits that 90 cents, the bank can lend out 81 cents (because of the 10 percent reserve requirement) and so on. So you end up creating $10 of checking accounts for $1 of demand deposits, assuming there's a demand for loans...And that can happen in repo as well because if you're Lehman and I'm the depositor, and you give me a bond as collateral, I can use that bond somewhere else. So there is a similar money multiplier process.
...and finally the link to regulated banking:
And shadow banking very importantly is not a separate system from traditional banking. These are all one banking system.
Much more detail and discussion follows, but eventually we come to this:
What you have here, in the equivalent language of repo, is a 10 per cent haircut, with unlimited rehypothecation (so that you can just keep reusing the collateral to raise more and more liquidity, haircutting away until the amount you can still pledge isn't worth bothering with), and a credit multiplier of 10. To get a general picture of how the credit multiplier, haircuts and rehypothecations tie together, we now need a tiny spot of mathematics. An aside: one of the peculiarities of mathematical economics, as opposed to mathematics, is the relative frequency of "theorems". In mathematics, theorems are as rare as unicorn droppings, things of near-holy awesomeness; in mathematical economics, by contrast, they occur horribly frequently, like depictions of unappealing sexual acts in the oeuvre of the Marquis de Sade. So I should probably try to get people to give this shoddily presented and deeply unoriginal formula, some kind of grand title: Smith's Unrestricted Rehypothecation Theorem, perhaps. What does it mean? It describes the relation between the credit multiplier under unrestricted rehypothecation, Cm¥, and h, the haircut, which is a value between 0% and 100%; k keeps count of the number of rehypothecations. Any charges levied for the rehypothecation are assumed to be negligible (I won't keep saying this, but bear it in mind - it means that the credit multiplier is never quite as big as I say it is, though pretty close, because the charge for a rehypothecation is not huge). As you see, with unrestricted rehypothecation, you just invert the haircut to get the credit multiplier. That is the big picture.
An aside: one of the peculiarities of mathematical economics, as opposed to mathematics, is the relative frequency of "theorems". In mathematics, theorems are as rare as unicorn droppings, things of near-holy awesomeness; in mathematical economics, by contrast, they occur horribly frequently, like depictions of unappealing sexual acts in the oeuvre of the Marquis de Sade.
So I should probably try to get people to give this shoddily presented and deeply unoriginal formula,
some kind of grand title: Smith's Unrestricted Rehypothecation Theorem, perhaps. What does it mean? It describes the relation between the credit multiplier under unrestricted rehypothecation, Cm¥, and h, the haircut, which is a value between 0% and 100%; k keeps count of the number of rehypothecations. Any charges levied for the rehypothecation are assumed to be negligible (I won't keep saying this, but bear it in mind - it means that the credit multiplier is never quite as big as I say it is, though pretty close, because the charge for a rehypothecation is not huge). As you see, with unrestricted rehypothecation, you just invert the haircut to get the credit multiplier. That is the big picture.
I don't claim to fully understand this, but it does seem to show why there is so much pressure to demand lower and lower amounts of "haircut". From here: On to Dragon Country!
With lots of rehypothecation, it gets worse. To get a better idea of how haircuts, rehypothecation and the credit multiplier work together, it's time for a picture of Dragon Country. This is my two equations, graphed. Some more explanation: * Haircut: the 1.0 (bottom right hand corner) is of course 100% , in other words, there is no repo, and the credit multiplier is 1, so there is no effect on credit. I've assumed the charge for rehypothecation is negligible. * The thick black curving line shows the theoretical maximum credit multiplier when there is an infinite number of rehypothecations. On the basis that a 1000x credit multiplier is absurd enough, I stopped at 0.1% haircuts, though 0% haircuts have supposedly been used in repo. * The unimaginable top left hand corner won't fit on the graph: a haircut of zero and an infinite credit multiplier. * The thin green line shows the credit multiplier for various haircuts when there are just 4 rehypothecations. You can see from the graph that this gives to a credit multiplier of around 4, for a range of haircuts from 0-20% or so. * The just about detectable blue curve, above the green one, shows the credit multiplier when there are 20 rehypothecations: already enough to move the credit multiplier to worrying levels when the haircut is less than 20%, and when there is only a 0.25% haircut, to an absurd 17x. * I've assumed that Q4 `08 is nasty enough for all of us, and that therefore an overall credit multiplier of 4 is as much as we want; so that's where I've put the horizontal red line. * The red area is Dragon Country, where low haircuts and lots of rehypothecation result in huge credit multipliers, and very great (exponential-like) sensitivity to increases in haircuts. * I've used a logarithmic scale on the y-axis to cram the whole thing in. Dragon country would be impressively vast on a linear scale. * The graph shows you something else Gorton doesn't really emphasize: the only reason to like a small haircut is to maximize the amount of liquidity you create via repeated rehypothecation. Have I just put forward one of those daft theoretical constructs beloved of economists and technocrats? I think not, for a couple of reasons.
This is my two equations, graphed. Some more explanation:
* Haircut: the 1.0 (bottom right hand corner) is of course 100% , in other words, there is no repo, and the credit multiplier is 1, so there is no effect on credit. I've assumed the charge for rehypothecation is negligible. * The thick black curving line shows the theoretical maximum credit multiplier when there is an infinite number of rehypothecations. On the basis that a 1000x credit multiplier is absurd enough, I stopped at 0.1% haircuts, though 0% haircuts have supposedly been used in repo. * The unimaginable top left hand corner won't fit on the graph: a haircut of zero and an infinite credit multiplier. * The thin green line shows the credit multiplier for various haircuts when there are just 4 rehypothecations. You can see from the graph that this gives to a credit multiplier of around 4, for a range of haircuts from 0-20% or so. * The just about detectable blue curve, above the green one, shows the credit multiplier when there are 20 rehypothecations: already enough to move the credit multiplier to worrying levels when the haircut is less than 20%, and when there is only a 0.25% haircut, to an absurd 17x. * I've assumed that Q4 `08 is nasty enough for all of us, and that therefore an overall credit multiplier of 4 is as much as we want; so that's where I've put the horizontal red line. * The red area is Dragon Country, where low haircuts and lots of rehypothecation result in huge credit multipliers, and very great (exponential-like) sensitivity to increases in haircuts. * I've used a logarithmic scale on the y-axis to cram the whole thing in. Dragon country would be impressively vast on a linear scale. * The graph shows you something else Gorton doesn't really emphasize: the only reason to like a small haircut is to maximize the amount of liquidity you create via repeated rehypothecation.
Have I just put forward one of those daft theoretical constructs beloved of economists and technocrats? I think not, for a couple of reasons.
If the US electorate is dumb enough to allow you a ride on "the full faith and credit" why not make it a really good ride for yourself? "It is not necessary to have hope in order to persevere."
A repo is really just a fancy interbank loan that can be extended by entities that aren't part of the ordinary interbank market. The reason that a bank might want to borrow in the money markets rather than the discount window is that the widows and orphans in the money market don't have access to the central bank support rate, so they might charge a lower interest rate.
I can't quite see how this can come back to bite anybody on the ass who is remotely important for the continued functioning of the financial system. The solution to a speculative bubble in a non-critical part of the financial system is to let the suckers go tits-up, and apply Ye Olde-Fashioned Keynesian Stimulus to the real economy. But if you don't like money market players repoing with the banking system, just allow money market players to make deposits in a central bank reserve account like regular banks, and pay the overnight target rate as a support rate for central bank reserves. That should kill the repo business stone dead.
- Jake Friends come and go. Enemies accumulate.
I would suppose that the danger of such a "Dragon Country" scenario emerging could be determined by the "haircut" being required for repo operations.
It's not a problem with repo operations. It's a problem with banks accepting shit collateral against their loans. You don't solve that problem by prohibiting repo operations, you solve that problem by making the banks stop accepting shit collateral against loans.
The whole situation is rather like a rich family or a royal family having a criminal in their midst who is empowered to continue his crime spree because, if found out, it would damage the family. If things get too out of hand, he could suffer an "accident". Except in this situation, failing a thorough-going housecleaning, none of the guilty are likely to pay any price, at least not a serious price. But there is already a world full of victims. "It is not necessary to have hope in order to persevere."
The problem with low haircut high multiplier scenarios could well be that of creating 10 or 20 to one multipliers with "high powered money" and then using that money to blow asset bubbles in stocks and commodities.
The multiplier is irrelevant. It is an ex post accounting construct, not an ex ante operational constraint. As long as the financial regulator does not wish to ensure that banks do not finance speculative ventures, and as long as the central bank wants to retain control of the overnight funding cost (that is, the monetary policy rate), a lower multiplier simply means that more of the trash goes on the central bank balance sheet and a higher multiplier that it stays on member bank balance sheets.
If, as I suspect, the TBTFs are doing this starting with Fed money from one of the many "credit facilities", it will make it very difficult for the Fed to ever rein in the money supply by raising rates or reserve requirements without causing a monster crash.
Well, yeah, if you're using Maiden Lane facilities to cover up the fact that your big money market banks are insolvent, then it will end with Stuff Blowing Up. But a high money multiplier won't make stuff blow up any more spectacularly than it would with a low money multiplier. The money multiplier is a liquidity thing. You are having a solvency problem.
The insolvency of the general population - or rather a 'solvency' dependent purely upon inflated property prices - is a much greater problem than the related problem of the insolvency of the intermediary banks.
As Michael Hudson points out, 90% of the population are in debt to the other 10% who own substantially all the unencumbered productive assets.
And again, as he points out as an economic historian, there is nothing new about this: it's what always happens when compounding debt combines with private property in land, and is why debt relief such as Jubilees has been necessary, and is once again. "The future is already here -- it's just not very evenly distributed" William Gibson
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