Why collateral transformation is the new UXB

Since the US Dodd-Frank Act of 2010, punters and investors making derivative bets have needed to show genuine collateral – to ensure that any debt dominoes can be stopped at a certain point. The Dodd Act can’t address the remaining toxic bets from before then, of course; but on the whole, it is an entirely sensible  piece of legislation.

As always, however, the definition of what genuine collateral (ie, something secured against the bet) really is becomes important. Employing the Russian definition would be less than useless, as much of the toxic lending undertaken beyond the Urals was for things that don’t exist, let alone collateral that’s dodgy. If the rules about what represents real security are lax, then the 2010 Act becomes something of a Maginot Line. This will become more important still next year when (assuming Obama is re-elected) new Dodd-Frank rules designed to prevent another meltdown will force traders themselves to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets.

The bottom line, in short, is that making derivatives sales has been tougher, and is about to get tougher still; while the effects on cashflow for a provider of having to back everthing have been negative.

So you’ll be less than surprised to learn that a number of banks and Wall Street firms are busily engaged in showing folks where each end of the Maginot Line is in order to boost sales. It’s very profitable for the providers…..but obviously very dangerous for the stability of the already unstable global financial construct – that construct being a 28-high pyramid of motor bikes, atop which sits a large oil tanker.

The new wheeze has one of those names just waiting to become next year’s headline: collateral transformation. The name even has a ring of Alchemy about it: like transmuting lead into gold. Otherwise called ‘impossible’. Not so, says Jennifer Zuccarelli, a spokeswoman for New York-based JPMorgan. You’d never have guessed Morgan would be into this gambit, would you? “Collateral transformation is a client service that does not hide risk,” she avers, “It is a form of short-term secured lending, which has always been an important part of capital markets, subject to tight capital and liquidity rules, and fully transparent to regulators.”

She’s right, it doesn’t hide risk – it makes it bloody obvious. “We just keep piling on lots of operational risk as we convert one form of collateral into another,” said Richie Prager, global head of trading at New York-based BlackRock, the world’s largest asset manager.

This is what he means: at least seven banks plan to let customers swap lower-rated securities that don’t meet the Dodd-Frank standards…in return for a loan of Treasuries or similar holdings that do qualify. Essentially, the firms will be taking on toxic assets, and losing good stuff, to make the sale. I bet you can’t guess who’ll have to swallow the toxicity some day further down the line.

The new sector resembles the existing $5.5 trillion repurchase market, known as repo, where banks and investors can temporarily pledge their bonds to other lenders or mutual funds in exchange for cash loans. The sudden withdrawal of some participants from that market in 2008, partly because of concerns about the quality of collateral, contributed to the near-collapse of Bear Stearns Cos. and led the Fed to create a $148 billion emergency-lending program to backstop other Wall Street firms that depended on the financing.

But here we are, four years on, doing it again. With the same list of suspects involved.

No doubt the Mayor of London Boris Johnson would approve of this as a splendid example of free-market ingenuity getting round all the bureaucratic red tape. As for the rest of us, we can only sit in awe of the psychopathy involved here – and wait for the inevitable day of reckoning.