Collateral is usually a boring affair. Valuing assets and making loans against them is the primary occupation of the mortgage banker and repo dealer who arranges trillions of dollars a day in very short-dated government bond repos. This activity is called financial installation for a reason: it’s important, but unsexy. And like ordinary plumbers, you only hear about it when something has gone wrong.
Now is one of those times. On March 16, the Swiss National Bank provided Credit Suisse with $54 billion backed by the bank’s collateral, a move that proved insufficient to bail out the 167-year-old institution. On March 19, the US Federal Reserve announced that it would reactivate daily dollar swap lines with the UK, Canada, the Eurozone, Japan and Switzerland. The central banks of these economies can now borrow dollars backed by their own currencies from the Fed at a fixed exchange rate for short periods and lend them to local financial firms.
In normal times, assets that are exposed to little risk and are not expected to fluctuate widely in value underpin much market activity. Government bonds and real estate are typical examples of collateral. Commodities, corporate credit, and stocks are more risky, but are also sometimes used. Both types of collateral are at the root of many financial crises.
The perception of safety is why risk eventually arises. The safer assets are considered, the more convenient it is for a lender to extend credit against them. Sometimes the assets themselves are safe, but the lending they enable (and the use of the money) is not.
This tension between security and risk can trigger financial panic. At other times, the problem is a simple misjudgment. The activities of Silicon Valley Bank (svb) were essentially a leveraged bet on assets their bankers thought were solid: long-dated mortgages and government bonds. The firm’s management believed it could safely borrow money – namely what was owed to depositors at the bank – against these reliable assets. The subsequent rapid fall in the value of the assets was ultimately the cause of the bank’s demise.
During the global financial crisis of 2007-2009, belief in the unassailable safety of the US mortgage market led to an explosion in secured lending. The explosion didn’t even require actual defaults on mortgage-backed securities. The mere shift in the probability of default increased the value of credit default swaps and the liabilities of the companies that sold the products, enough to bring down institutions that had sold massive amounts of the swaps. In Japan in the early 1990s, a collapse in land prices, the preferred security of domestic banks, led to a slow-burning series of financial crises that lasted more than a decade.
Crises not only show where securities were wrongly assessed as safe. They are also the source of innovations that are reshaping the way collateral works. In response to the panic of 1866 triggered by the collapse of Overend, Gurney & Company, a wholesale bank in London, Walter Bagehot, a former editor of that newspaper, promoted the idea that central banks should act as lenders of last resort for private finances institutions act against solid collateral. Recently reactivated by the Fed, daily swap lines were introduced in the financial crisis and reopened in the early stages of Covid-19.
The Fed’s Bank Term Funding Program, introduced after the collapse of svb, is the first innovation in collateral policy during the current financial turmoil. The generosity of the program is new and shocking. A 30-year Treasury bond issued in 2016 is worth about a quarter less than face value in today’s market, but is valued at face value by the Fed if an institution pledges it as collateral. In the first week of the program, banks borrowed almost $12 billion and a record $153 billion from the central bank’s usual discount window, at which banks can now borrow without the usual discount on their collateral.
The program could change the understanding of collateral that has been built up over the past 150 years. If investors expect the facility to become part of the regular anti-panic toolkit, as swap lines have, then long-dated bonds would enjoy a new and very valuable backbone. This would mean that financial institutions benefit when interest rates fall and their bonds appreciate in value; and when interest rates rise and bonds depreciate, the Fed comes to the rescue. In an attempt to remove the risk of sudden collapses and make the financial system safer, policymakers may have done the exact opposite over the long term.
Read more from Buttonwood, our financial markets columnist:
Why commodities shine in times of stagflation (9th March)
The anti-ESG industry takes investors on a journey (2nd March)
Despite the bullish talk, Wall Street has reservations about China (February 23)
Also: Like the Buttonwood column got his name
