Hypothetical collateral – that was what one newsman writing an article on the topic called it. For most intents and purposes, that is what it is to you and to me. However, it is also a vital part of our financial system, just as much as the supply of money itself, or any quantitative easing. The fact that many have never heard of it does not mean that it does not exist.

What the journalist meant was “hypothecated collateral”. The mainstream press has largely ignored it, even though at its peak, prior to the GFC, it amounted to almost $10 trillion. And here, those in high finance may learn something from those in low finance because there is another context in which the world hypothecation is used: the pawnshop. To hypothecate means “to pawn”. Except in the world of high finance, it is a whole collection of pawnshops in different cities around the world, which do business with each other 24 hours a day, with the efficiency borne of electronic registries and computer networks and people working longer hours than they used to.

How does it work? Imagine that someone has a valuable painting assessed to be worth $2 million. They have a need for a loan but don’t want to sell the painting. Now let’s say, for convenience, that there are 20 such paintings around, all by the same artist, all worth about the same amount. So they bring the painting to the pawnshop – the bank – and the bank loans them $1 million. It’s just like Monopoly. But the bank doesn’t just hold the painting in its vault. To make more money, it pledges the part of the painting that is not collateralised ($1 million) to another bank, and gets money for itself. It might get $800,000 this way. Then the next bank can also re-pledge the excess of the collateral value over its loan ($1 million – $800,000 = $200,000). So in concept, collateral pledging is similar to the money multiplier – a fixed amount of collateral can be stretched out over a large number of people and transactions.

When it comes time to unwind that complex arrangement of loans and asset transfers it can get complicated but the global financial crisis proved that it can work without bringing down the whole financial system. Investment bank Lehman Brothers, by way of example, used hypothecation through its international subsidiary to lend out more than half of the $40 billion in assets it held on behalf of its hedge fund clients. When the bank failed, it required multiple loans to be unwound and a complex transfer of assets but the system survived. The global unwinding of hypothecation resulted in an estimated $3 trillion reduction in the amount of liquidity in the financial system, exacerbated by a permanent increase in the haircut borrowers were forced to take on the collateral they provided as banks became more risk averse.

Chart1: Hypothecation boosts liquidity

What other effects did it have? For one, it caused the price of eligible collateral – the collateral that was still viewed as good enough to lend against – to rise significantly. This caused the price of government bonds to rise – and, by implication, the yield on government bonds to fall.

Today, the only collateral ordinarily available for lending against are the bonds of 12 European countries – all rated AA or AAA – as well those of the United States, Canada, and Australia – nothing else. No asset backed securities mortgage backed securities, and definitely no CDOs, even if they were still rated AAA, are allowed Although, even if they were, the amount of such bonds that are still rated AAA has shrunk immensely. [1] The largest beneficiary of this has been the United States Treasury, which has seen yields shrink to microscopic levels.

Chart 2: World Issue of AAA fixed income

Second, it caused asset prices to temporarily collapse. Greater haircuts on collateral – and eliminating collateral-like mortgage-backed securities no longer considered eligible – were self-fulfilling, in that they caused these same asset prices to tumble.

Third, it made the Federal Reserve’s quantitative easing to replace this lost liquidity that much more urgent – the Fed replaced about $2 trillion over the last five years. Both the Fed’s QE and the US government’s bank bailouts were probably necessary to stop a full-scale liquidity implosion. As it was, QE – by buying up Treasuries – also had the effect of tending to increase prices, just as a government buying its own currency tends to cause that currency to appreciate. QE has made asset prices in other parts of the world, as well as commodities, appreciate.
Finally, it has also caused large US-domiciled banks with inventories of now ineligible collateral to be innovative with it. According to one account, some banks are paying employee bonuses not in cash or company shares, but as fractional interests in mortgage backed securities held by the bank when the music stopped in 2008.

Regulation T in the US, which regulates the extension of credit by securities dealers and brokers, now largely prohibits US-domiciled banks from taking collateral that has been pledged to it and using it for its own liquidity. But they can still do it through their global operations, particularly in Europe, where it is still permitted. Europe is a leader in another way as well, since through its sanctioning of banks using a very broad range of assets as collateral for loans, it is providing liquidity where the private bank market would not permit it. However, if this ended – if European regulators no longer allowed collateral to be re-pledged, or if they restricted what could be pledged – then we could see another severe contraction in liquidity there. Large banks – and especially their lawyers – are usually clever at finding ways to do things the private market wants to do, even if regulators are against it. It is more likely that another banking system crisis would cause this liquidity to contract again, and in this case the same pattern as occurred in 2008 is likely to recur.

This article was originally published in the van Eyk View iPad app. To download the app, go to
http://itunes.apple.com/au/app/the-van-eyk-view/id476210180?ls=1&mt=8

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[1] At their peak in 2006, structured credit debt accounted for a majority of AAA ratings. That does not even include US agency mortgages, which were downgraded in line with the US credit rating downgrade in August 2011. Almost 35% of original AAA ratings were downgraded by credit agencies (in many cases making them ineligible for funds to continue holding), and probably an additional 10% was sold based on rotation away from structured credit by managers.

This publication has been prepared by van Eyk Research Pty Ltd ABN 99 010 664 632, corporate authorised representative of van Eyk Financial Group Pty Ltd ABN 28 149 679 078, AFSL 402146 (authorised representative number 408625) with information obtained from various sources deemed to be reliable. The publication is not guaranteed to be completely accurate and should not be relied upon as such. Past performance is not necessarily indicative of future results. This publication is but one tool to help you make investment decisions on behalf of your clients. It is not investment advice and has been prepared without taking into account any investor’s objectives, financial situation or needs. Therefore, you and your client should consider whether the financial services product(s) discussed are appropriate investments for your client. You and your client should always obtain other information available from your financial adviser before making any decision or recommendation in relation to any financial services product(s).

Copyright © 2012 van Eyk Research Pty Ltd ABN 99 010 664 632, corporate authorised representative of van Eyk Financial Group Pty Ltd ABN 28 149 679 078, AFSL 402146 (authorised representative number 408625) (van Eyk). This publication is subject to copyright of van Eyk. Except for the temporary copy held in a computer’s cache and a single permanent copy for your personal reference or other than as permitted under the Copyright Act 1968 (Cth.), no part of this publication may, in any form or by any means (electronic, mechanical, micro-copying, photocopying, recording or otherwise), be reproduced, stored or transmitted without the prior written permission of van Eyk.

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“Like the universe, there are at least three black holes in the world’s financial system whose nature and impact is not fully understood and have the potential to severely affect financial markets,” he told delegates. 

O’Brien nominated three black holes: computer-based high speed trading, inter-bank asset pledges and unfathomable valuations on developed market and emerging market banks. 

High speed trading already forms a substantial share of all turnover on the Australian Securities Exchange. The ASX’s annual report for the 2010-11 financial year reported there were 144 million trades that year, far higher than the number of human traders in the Australian market would suggest. “It’s the equivalent of everyone in the financial services industry each making 250 trades a day,” O’Brien said. 

“Investors need to be careful that they don’t suffer any adverse effects as prices move under the impact of such large and fast trading.” 

A second black hole is the potential for adverse effects from the use of hypothecated collateral, or the transfer of assets backing financial transactions, especially those by large banks acting as prime brokers. 

Such practises have been curtailed in the United States, but remain available to banks in Europe, where the financial system is under severe strain in the aftermath of the global financial crisis. 

O’Brien told the conference the IMF recently estimated that the value of trades worldwide using such assets had fallen from $US30 trillion to $US25 trillion from 2007 to 2008 – “a huge drop in the value of the system that simply disappeared”. 

Bank valuations in recent years are also concerning. The market valuation of emerging market banks remains consistently higher than those of developed nations. This is despite their relatively small size and the fact that emerging market equities have traditionally traded at a valuation risk premium. 

“In Australia, Bendigo Bank for example has more assets than those of the four biggest banks in Indonesia combined. Yet those banks trade at higher price to earnings valuations,” he said.

How the valuations adjust should remain of interest to investors because it is an apparent anomaly that has persisted for years.”

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Mr O’Brien noted the ASX 200 was trading on 11 times forward earnings, the MSCI World index on 12 times forward earnings, and the MSCI Emerging Markets on 9.5 times forward earnings. “These are not outstandingly good valuations but they’re not bad,” he said. “Compare equities to something like Australian residential property, where the P/E might be 30 times.”

However, the uncertainty over the European debt crisis and general economic uncertainty would continue to act as an impediment to an upswing in equity markets in 2012.

Similarly, investors were likely underplaying the potential for political and economic turmoil to damage markets and other threats like a potential breakout in inflation. “We still believe that political risk as it affects market returns is underrated as we did in 2011,” Mr O’Brien said. “Iran, the Arab world, Latin America, even stable countries like Thailand could all have problems this year.” Mr O’Brien said. “That informs our short term view on emerging markets, which is that they are a strong long-term growth story but not enough attention is paid to the political components of those stories.”

But after several years of poor returns and the loss of faith by many investors in shares, the contrarian investor would see this as a signal that the asset class was turning the corner, Mr O’Brien said.

“The difference between the benchmark US Treasury bond yield of less than 2% and the equity earnings yield of 8% is as stark as ever,” Mr O’Brien said.  “We can certainly say that piling into low-yielding assets, like bonds, at ever-higher prices isn’t a long term solution.”

He added that volatile markets this year would test the nerves of value investors but that the strategy had proven itself over the long term.

Mr O’Brien expands on his views in an article and video in the new February issue of the van Eyk View, van Eyk’s monthly investment newsletter for financial advisers and industry professionals, which is now available on the iPad.

The post Equities good value but markets will probably underestimate the risks again appeared first on AdviserVoice.

In this month’s issue:

• CEO Mark Thomas looks at the new rules for portfolio diversification in the post-GFC era.
• Head of Asset Consulting Jonathan Ramsay shows how focusing too much on past performance statistics can lose investors money.
• Head of Research John O’Brien tunes into the troubling rhythms building for Australia’s banking sector.
• Head of Ratings Matt Olsen ponders whether defensive stocks are as expensive as fund managers are saying.

All this content and more is available now in the iTunes App Store as a free download.

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