The single most important issue for understanding why the finacnial system is not healthy and why we’re set to have an even bigger crash than in 2008 has to do with one word…
Collateral.
Collateral is an underlying asset that is pledged when a party enters into a financial arrangement. It is essentially a promise that should things go awry, you have some “thing” that is of value, which the other party can get access to in order to compensate them for their losses.
You no doubt are familiar with this concept on a personal level: any time you take out a bank loan the bank wants something pledged as collateral should you fail to pay the money back. In the case of property, the property itself is usually the collateral posted on the mortgage. So if you fail to pay your mortage, the bank can seize the home and sell it to recoup the losses on the mortgage loan (at least in theory).
In this sense, collateral is a kind of “insurance” for any financial transaction; it is a way that the parties involved mitigate the risk of their deal not working out.
As many of you know, our entire global financial system is based on leverage or borrowed money. Collateral is what allows this to work. Without collateral, there is no trust between financial institutions. Without trust there is no borrowed money. And without borrowed money, money does not enter the financial system.
In this sense, collateral is the “reality” underlying the “imaginary” or “borrowed” component of leverage: the asset is real and can be used to back-stop a proposed deal/ trade that has yet to come to fruition.
On a consumer level, our bank deposits (cash), homes, and other assets are the collateral pledged when we borrow money from a bank to finance something. This applies to everyone in the US all the way up to the multi-billionaire bracket.
On a corporate level, companies pledge various assets as collateral for their corporate loans. For manufacturing firms, this might be the actual steel inventory they own. For property companies, it’s portions of their real estate portfolios.
And for finacial firms, at the top of the corporate food chain, it’s sovereign bonds.
Modern financial theory dictates that sovereign bonds are the most “risk free” assets in the financial system (equity, municipal bond, corporate bonds, and the like are all below sovereign bonds in terms of risk profile). The reason for this is because it is far more likely for a company to go belly up than a country.
Because of this, the entire Western financial system has sovereign bonds (US Treasuries, German Bunds, Japanese sovereign bonds, etc.) as the senior most asset pledged as collateral for hundreds of trillions of Dollars worth of trades.
Indeed, the global derivatives market is roughly $700 trillion in size. That’s over TEN TIMES the world’s GDP. And sovereign bonds… including even bonds from bankrupt countries such as Spain… are one of, if not the primary collateral underlying all of these trades.
How did the world get this way?
Back in 2004, the large banks (think Goldman, JP Morgan, etc.) lobbied the SEC to allow them to increase their leverage levels. In very simple terms, the banks wanted to use the same collateral to backstop much larger trades. So whereas before a bank might have $1 worth of collateral for every $10 worth of trades, under the new regulation, banks would be able to have $1 worth of collateral for every $20, $30, even $50 worth of trades.
Another component of the ruling was that the banks could abandon “mark to market” valuations for their securities. What this means is that the banks no longer had to value what they owned accurately, or based on what the “market” would pay for them.
Instead, the banks could value everything they owned, including their massive derivatives portfolios worth tens of trillions of Dollars using in-house models… or basically make believe.
This sounds completely ludicrous, but that is precisely the environment that banks operated in post-2004. As a result, today US banks alone are sitting on over $200 TRILLION worth of derivates trades. These are trades that the banks can value at whatever valuation they want.
Now, every large bank/ broker dealer knows that the other banks/dealers are overstating the value of their securities. As a result, these derivatives trades, like all financial instruments, require collateral to be pledged to insure that if the trades blow up, the other party has access to some asset to compensate it for the loss.
As a result, the ultimate backstop for the $700+ trillion derivatives market today is sovereign bonds.
However, there is one BIG problem with the Fed, Bank of Japan, and Bank of England’s QE programs… they’ve SHRUNKEN the global pool of high grade collateral.
By actively buying Treasuries, Japanese bonds, etc. central banks have soaked up over $10 trillion worth of high grade collateral from the system.
As Zero Hedge has done a great job of exploring, the results of this are already showing up in the bond market with fund managers admitting that there is little if any liquidity in the corporate bond market.
The same problem applies to the sovereign bond market with bond managers putting money into fixed income derivatives because they can’t get their hands on sovereign bonds themselves.
It is not coincidence that the first ever Interantioanl Conference on Sovereign Bond Markets took place this year… nor is it coincidence that “liquidity” was the first topic of focus.
This has the makings of a Crash that will be far worse than 2008. If you’ll recall, 2008 was primarily an investment banking crisis. However, when the next crisis hits, it will be a global bond crisis. And given that bond liquidity is already a trickle when bonds area rallying one can only imagine the selling panic that would ensue once the market turns.
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