What Could Possibly Go Wrong ?

Big Banks Hide Risk Transforming Collateral for Traders 

"...Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the USD 10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the USD 648 trillion derivatives market..The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead."

My first thought was:   Anyone remember the 2008 financial meltdown?  Think hard.  It was a long time ago.  It had something to do with offering mortgages (specifically ARMs) to people who did not have the earning power to support the debt.  And there was something about packaging these ARMs into securities called CMOs.  Financial institutions had been securitizing mortgages for years but in the past the loans which got packaged together were pretty independent in their default probabilities.  However the default probability on an ARM is very dependent on the level that interest rates reset to.  So if you package a bunch of ARMs together you get a CMO which is extremely sensitive to the level of interest rates.  And if I recall correctly financial institutions and funds which were used to treating CMOs as low risk instruments started using these securitized ARMs as collateral for loans.  When it was suddenly revealed that this collateral might be far from risk free cash lenders demanded more collateral or pushed the CMOs back onto borrowers.  This forced borrowers to liquidate these securities which further depressed their prices which led to lenders demanding even more collateral which led to more liquidations etc...

So now these same banks are going to swap Treasuries or cash for low grade collateral (I assume not 1 for 1).  Wasn't that the problem that we just got into?  When we hit a bump and BB gets downgraded to B the  banks are going to require more low grade collateral in return for Treasuries (ie raise the haircut).  If borrowers cannot come up with additional collateral then banks will ask for their Treasuries back which is going to force borrowers to puke out these bonds which will further depress their prices etc...

My second thought was:   Centralized clearing has huge advantages in terms of risk mitigation.  However if some of our current economic problems are due to a shortage of high grade collateral (see link and abstract below) then the move to centralized clearing may also have some significant negative consequences as it further strains the supply of high quality collateral.

Ricard Cabellero - On the Macroeconomics of Asset Shortages

Abstract:   The world has a shortage of financial assets.  Asset supply is having a hard time keeping up with the global demand for store of value and collateral by households, corporations, governments, insurance companies, and financial intermediaries more broadly.  The equilibrium response of asset prices and valuations to these shortages has played a central role in global economic developments over the last twenty years.  The so-called "global imbalances", the recurrent emergence of speculative bubbles (which recently have transited from emerging market, to the dot-coms, to real estate, to gold...), the historically low real interest rates and associated "interest rate conundrum," and even the widespread low inflation environment and deflationary episodes in parts of the world, all fall into place once one adopts the asset shortage perspective.