It's hard to believe in a world where countries are printing bonds to borrow like crazy, but there's a shortage of the highest quality collateral that borrowers use to get cheap loans, and there are those who believe it's going to make it very difficult to restart struggling economies.
As strategists at Brockhouse Cooper point out, lenders are more careful these days, favouring secured loans, and they are demanding top-notch collateral, which usually means the highest-rated government bonds. The problem is, there aren't enough of those bonds to go around. That's not good news for borrowers, but it is good news for holders of highly rated bonds, because they will be increasingly sought after.
"Despite the vast quantities of debt issued by governments from developed countries in recent years, there is evidence that there is a shortage of collateral at the moment," the strategists at Brockhouse Cooper write.
They point to evidence such as negative repo rates in Europe, which means that banks are willing to lose money lending out cash to get bonds in return in a repo transaction. They can then use those bonds to obtain funding.
Where has all the collateral gone?
Certainly, some countries that were top-notch government bond issuers are no longer, thanks to a string of downgrades by credit agencies and botched fiscal management by the countries' governments. Bonds from such countries are no longer acceptable to many lenders as collateral.
In total, collateral received by 14 large securities dealers that the International Monetary Fund looked at as of the end of 2007 was $10-trillion (U.S.). By the end of 2010, that stood at $5.8-trillion. (The figures are available in this 2011 working paper from the IMF.) There is another factor at play, and that is the reduced ability to reuse that collateral. The International Monetary Fund tracks this and has found that collateral that had been reused on average 3 times before the financial crisis and the failure of Lehman Brothers Holdings Inc. is now reused on average 2.4 times.
Why?
One answer is the growing concern about what's known as rehypothecation. Say a hedge fund puts on a trade that may involve credit, it will pledge government bonds as collateral against the trade. The bank on the other side has traditionally been able to turn around and repledge that collateral. The bank might use the bonds as collateral when borrowing from another bank, to get the funds it needs to lend out. Most big securities dealing banks use this mechanism, known as rehypothecation, including Canadian firms like Royal Bank of Canada RY-T . Around the world, other big players that the IMF points to are Goldman Sachs, Morgan Stanley, HSBC and Nomura.
Hedge funds alone pledged an estimated $1.6-trillion of collateral to large dealers as of the end of 2007, according to the IMF, giving the banks a big pile to use in their own funding plans.
Repledging or rehypothecation of that collateral allows banks to fund loans more cheaply, because the banks can then offer security for their own borrowings. But in the wake of high profile failures of brokerages like Lehman Brothers Holdings Inc. and MF Global, borrowers are less willing to let their collateral be reused. They want to know that if the bank they are dealing with collapses, the collateral will be there, rather than having been passed on to some other lender down the repledging chain. That may lead borrowers to stop allowing banks to repledge collateral. That means that banks can't fund as easily or cheaply, cutting down on their ability to lend.
And thirdly, as Brockhouse Cooper points out, active central bank purchasing of bonds as part of quantitative easing programs have sucked a lot of bonds out of the markets and parked them on central bank balance sheets.
"U.S. Treasuries are among the few 'high-quality' assets left, and the Fed’s Treasury purchases make them scarcer still," Brockhouse Cooper's analysts wrote.
The bottom line as Brockhouse Cooper sees it is that "the shortage of acceptable, high-quality collateral means that credit will contract and that the transmission of monetary policy will remain difficult. This is bullish for bonds, but not so much for equities and risk assets."
