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.

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.

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.

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."