Tuesday, June 25, 2013

NO COLLATERAL? NO WORRIES, THE FED WILL FIX IT

The people at Zero Hedge write solid stuff on the economy and finance. Unfortunately the people at Zero Hedge can also come across as overly brainiac market guys as their writing, at times, is filled with market-speak jargon many find difficult to navigate. "Desperately Seeking $11.2 Trillion in Collateral, Or How 'Modern Money' Really Works" is one of those articles.

Fortunately, I can translate market-speak. Because what they have to say in the article is important, I'm doing that here.

In "Desperately Seeking $11.2 Trillion ..." Zero Hedge is telling us one thing: In spite of betting trillions of dollars on financial instruments (again) market players are refusing to put good assets behind their bets (again), which means that the Federal Reserve is going to have to print more money when the market collapses (again).

Ta-da.


So you know, with graphs "Desperately Seeking $11.2 Trillion ..." will print out to about 13 pages. If you have the time you should try and read it since the nuance and the graphs are what drive home the point(s) made in the article. Since the details are what make their argument come alive, below is a jargon-free 1 page translation of Zero Hedge's article ...

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OK, let's start here.

After the 2008 market collapse it became clear too many market players were gambling on toxic products that didn't have the proper assets or financial backing to pay out when the market turned sour. The end result was not pretty, as we all know.

In real simple terms what happened in 2008 was the functional equivalent of your insurance broker taking in your monthly premiums, but then not having the money to pay out when an uninsured driver crashed into your car. Multiply this scenario by hundreds of billions of dollars and tens of thousands of crashes where the participants didn't have real insurance (or assets) to back their activities and you have a (partial) idea why our 2008 market meltdown happened.


Global financial authorities didn't like what they saw after 2008 and convened a meeting (Basel III) where they pretty much said that financial players need to come up with more collateral to back their market bets. Put another way, Basel III said market players hould have greater reserve and asset requirements if we want our financial markets to be stable.

Sounds fair so far, right? If you're going to gamble and invest in markets you should at least have the ability to back your market activities in case of an emergency.

Unfortunately, as Zero Hedge points out, recent attempts to make sure that the bets that have been made are backed with good assets fell flat on its face. Simply put, there weren't enough fools or institutions with good collateral willing to back the trillions of dollars in bets that the financial wizards on Wall Street have waged.

The problem that Basel III is trying to fix is a simple one. A good portion of the market bets made on Wall Street these days are made using the borrowed assets of other market players. It's kind of like hocking your grandparents China at the pawn shop so you can go gamble in Vegas. You have every intention of paying the money back, but you still need to win in Vegas. In market lingo these activities are referred to as rehypothecated market plays (click here for a description of how it works).


What's been created over the past 30 years is a multi-trillion dollar shadow banking system built around unregulated loans, borrowed assets, and a casino mentality.

Basel III is simply asking that market players start backing their market plays with "good collateral" instead of borrowed money and borrowed assets. To reemphasize (because it needs reemphasizing), Basel III is simply asking that if you're going to gamble you should at least have the money to back your bets.

Pretty simple, right? Unfortunately two problems have developed.

First, the $1-2.5 trillion in good collateral that Basel III asked for could not be found. No one wants to put up their stuff to back the market bets that they are involved with. This should tell us something (especially since it's happened before).

Second - and this is where it gets good - serious market players have made it clear that what's really needed to back the market plays out there is NOT simply $1-2.5 trillion in collateral but rather between $5.7 trillion and $11.2 trillion in good assets. There will be no way to pay off the counter parties if (when) the market collapses again without this amount of hard collateral.

So this is what we have. Speculators, institutional investors, and rock solid brick and mortar firms want to play in the casino. But they don't want to put anything of substance up to back their bets. And why should they? The people at the Federal Reserve - and their economic illiterate sycophants in the U.S. Congress - have made it clear that they are more than willing to fill in the financial holes with bailout cash.


This is precisely the point that the good people at Zero Hedge make. The Federal Reserve is going to have to bail out the system (again) when the next market collapse happens because there's no good collateral to back the bets made. Borrowed and leveraged assets aren't enough.

And you can bet that the good folks at the Fed will be yapping about "saving the system" in spite of the fact that the system they're saving doesn't deserve saving.

What a mess.

- Mark

UPDATE: Have regulators started to move on the reserve (capital rule) requirements? This seems to be a start; i.e. until the next legislative favor/gift from Congress guts the requirement.

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