Government securities are a headache for investors
Government securities were once regarded as gilt-edged investments, guaranteeing a steady income and safety of capital. Income levels have declined with lower rates. No more!
Heavily indebted governments have seen their credit standing decline, making return of principal less certain. Even where the state can print money to meet its liabilities, the purchasing power of investors in government bonds may be eroded. Trade and currency wars mean that international investors face additional risks.
National Front leader Marine Le Pen has indicated that if she gains France’s presidency euro denominated government bonds will be re-denominated in new French Francs.
The risks are compounded by the fact that the entire global financial system is now underpinned by the use of government bonds as collateral to secure financial transactions. The practice continues to be a central
tenet of banking regulation, despite its role in compounding the 2008 crisis.
Collateral is used to secure borrowing, structured as repurchased agreements as well as mortgages over or pledges of real estate or other assets. In derivative transactions, collateral is lodged periodically to secure current mark-to-market exposure.
But there are several issues with collateral. As Yogi Berra astutely observed, “in theory there is no difference between theory and practice. In practice there is”. Rather than make the financial system safer, collateral use does not reduce but creates different risks.
First, the emphasis shifts from the borrower or counterparty’s creditworthiness to the collateral. Focus on financial strength and ability to perform is reduced. Parties normally ineligible to borrow or transact in the first place are able to enter into transactions. The rapid growth in debt levels, volume of derivative contracts and hedge funds or structured investment vehicles relies on collateral.
Second, the choice of collateral, originally limited to cash and government securities, creates risks. Even government securities now are not risk free.
To accommodate growth, the range of securities accepted as collateral has increased. In these cases, the value attributed to each security is adjusted by “haircuts”, introducing the risk of volatile unexpected changes in the value of the collateral itself.
The correlation between the risk covered and the value of the collateral becomes crucial. Wrong way correlation, where the underlying risk increases at the same time the value of the collateral decreases, reduces its utility as security.
Third, it assumes liquid markets for the collateral, which must be realised in case of default. Fourth, it creates asset liability mismatches where the loan is for a shorter maturity than the security pledged or where collateral must be adjusted frequently over the life of the transaction. Unexpected changes in the amount of collateral needed create liquidity risks.
Fifth, collateral use entails significant model risk. The underlying exposure (in the case of derivatives) as well as the value of the collateral must be determined. As evident during crises, there are difficulties in valuing less liquid securities, as well as risk of potential manipulation of and disputes about valuations. Models must establish the level of initial collateral posted, to cover the fall in value between the last margin call and the close out date. Initial margin amounts are based on historical volatility that may be inadequate in periods of stress. Where collateral is calculated on a portfolio basis, offset methodologies (based on correlation) may be flawed.
Sixth, collateral introduces significant operational and legal risk. It places large demands on operational procedures to ensure mark-to-market calculations are accurate, collateral is paid and received, collateral is monitored and control over the cash or securities are held. The legal validity of these arrangements in all jurisdictions is not assured because of a complex mix of domestic and international laws. Enforcement may be practically difficult because of the frequent unwillingness of courts to enforce foreign judgements.
Seventh, the use of collateral entails moral hazards. While lowering collateral levels increases leverage but decreases risk mitigation, pressure to increase business volumes may lead to inadequate collateralisation.
Finally, collateral has systemic risks which deeply alter the functioning of financial markets, especially the quantum of credit available, liquidity risk and behaviour.
Use of collateral is an important source of endogenous liquidity. The practice of re-hypothecation – where collateral received is re-pledged to support other transactions – allows exponential expansion in leverage. But if re-hypothecation is restricted, then the cash and securities committed as collateral cannot be used, precipitating a rapid contraction in liquidity.
Reliance on collateral encourages the creation of high quality securities that lenders are willing to lend against. This led to the creation of complex structured securities, reliant on complex ratings models. According to the Bank for International Settlements, between 1990 and 2006, AAA rated securities increased from around 20 per cent to over 55 per cent of all securities on issue, with asset-backed securities accounting for about two-thirds of the increase.
Collateral exacerbates financial distress risk where a solvent party cannot meet unexpected margin calls. Limited disclosure of collateral provisions and potential liquidity claims also makes it difficult to assess the financial position of counterparties.
Where collateral use is widespread, it exacerbates the problem of herding behaviour. In periods of stress, market participants all seek more collateral or need to sell pledged securities increasing market instability, potentially fatally.
Collateral use is becoming more entrenched. Banks rely on secured funding, including repos with central banks. Regulations encourage the use of collateral through favourable capital treatment. The Central Counter Party (CCP), the key element of derivative market reform, is predicated on collateralisation.
Economist Hyman Minsky identified three phases of finance. Hedge financing is where income flows can meet principal and interest on debt used to finance. Speculative financing is where income flows cover only interest repayments but not principal, requiring debt to be continually refinanced. Ponzi finance is where income flows cover neither principal nor interest repayments with the borrower relying on increasing asset values to service debt.
In the progression from hedge financing to Ponzi finance, asset prices become completely delinked from fundamental values until the structure collapses as no one is willing to borrow or lend the required amounts to finance asset purchases. The decline in quality of once gilt edged government securities and their inappropriate use of collateral is central to this process.
Satyajit Das is a former banker. His latest book is ‘A Banquet of Consequences’ (published in North America as ‘The Age of Stagnation’ to avoid confusion as a cookbook). He is also the author of ‘Extreme Money’ and ‘Traders, Guns & Money’