Praise the Lord and Pass the Collateral

I read an interesting blog the other day, with a line that made me stop and think for a moment. The blog is here, and the line in question was this one:

the willingness of government and regulators to allow banks to borrow among themselves on secured terms (with collateral being passed round like a nursery game, so that locating it when the music stops adds additional hazards for us all)

which reminded me of something that everybody thought but no one really talked about that much back when banking was fun and nobody ever lost any money (by which I mean post-internet bubble, pre-Northern Rock).

The thing was, we did take and hand out collateral like it was candy. We wouldn’t expose ourselves to a fortune in someone else’s default on a repo or interest rate swap without making sure we had something out of it, just in case. And if someone else had the unprecedented nerve to suggest we might not be good for our exposure on something similar, then we’d bung them a few hundred million in something-or-others and that would keep them quiet until everyone settled and we got our something-or-others back again.

But sometimes, you’d get the feeling you were just wasting your time.
I mean, for Christ’s sake, did anyone really think someone like Lehman Brothers was going to go bust? Did anyone really believe there was a chance in hell RBS wouldn’t be good for every penny it owed?
And I wonder if sometimes, someone just put down their pen or switched off their computer and thought sod this, I know the deal’s supposed to be triple A but really, what’s the chance anything’s going to go wrong?

Now I need to make it clear that I never saw or even suspected anyone of doing that, but I don’t doubt that all these institutions invested far too much trust in each other and in precisely what they did with each other’s collateral once it was handed over. A lot of the time this stuff was supposed to be segregated, after all, not just enter some general treasury pool. But was it? And if it wasn’t, would we even have known? Isn’t it more likely that Bank Y used Bank X’s collateral to fund their own collateral requirements with Bank Z, and the chances are that from time to time Bank Z would have used the same stuff on their deal with Bank X, so everyone ended up holding the stuff they’d started with and no one was really any more protected than they would have been if no one had bothered in the first place.

Which is probably one of the reasons the Lehman insolvency was as messy and drawn-out as it was, and yet another one of the reasons the possible insolvency of a major UK bank was such a terrifying prospect. Bad enough seeing one of your biggest and most reputable institutions go to the wall. Even worse if it made a mockery of the whole notion of “security” at the same time.

Of course things must be different now. Everyone knows that no one is above suspicion, that anyone can go from investment grade to dead in a matter of days. So one would hope that the collateral’s all sitting just where it’s suppose to be sitting.

Just sitting there.

Buried in the garden.

Generating no return at all.

Oh dear.

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If you liked this, there’s poems and sketches here, extracts from my novel here, and a selection of the best posts here. Oh, and please comment, like, share, whatever takes your fancy.

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