Author : John E. Charalambakis
Date : October 19, 2014
The Age of Michelangelo, Raphael, Leonardo da Vinci, and High Renaissance was followed by the age of Mannerism, known by its artificial qualities. Two of the main characteristics of Mannerism are compositional tension and instability. Do those attributes ring a bell about the markets since the dawn of the financial crisis? There seems to be little doubt that the markets have been superficially sustained by high power money/reserves that the central banks are circulating. We need realism to be infused into the marketplace now that signs of turbulence shake up the belief that central banks can sustain an inverted credit pyramid that has so many collateral holes. In the midst of this turmoil, not a lot of attention was paid to the collateral pool venture between DTCC and Euroclear, announced two weeks ago.
We cannot exclude the possibility that the recent market turmoil had a deeper cause of liquidity and margin calls. I know that this might sound like a heretic view in the midst of quantitative easing (QE) exercises, but let’s not forget that the QEs only created reserves (not money supply) and actually contracted the pool of available collateral for re-hypothecation and recycling, since the Fed absorbed the Treasuries on its balance sheet. It is a fact that during market shakeups liquidity dries up since counter-party risk increases significantly. As liquidity drains, credit contracts and securities are sold to meet margin calls.
With new regulations soon taking effect regarding derivatives (these regulations demand that some derivative trading is backed up by high quality collateral), as well as the new regulatory scheme regarding the number of times an acceptable collateral can be re-hypothecated/recycled, margin calls are expected to increase fivefold, which could create havoc in the markets. The joint venture between the US-based DTCC and the EU-based Euroclear, will hold trillions of dollars of collateral. Hence this joint venture is expected to ease collateral pressures. The Bank of International Settlements (BIS, a.k.a. the central bank of central banks) estimates that the additional collateral needs reach $4 trillion. However, more realistic calculations that take into account the collateral needed for the derivatives trading estimate the need to over $10 trillion.
Let’s recall that declining asset prices and deleveraging reduce the velocity of collateral. The latter needs to rise if more collateral is to be generated. Therefore, the goal is to have portfolio effects. As the joint venture takes effect, the supply of financial collateral rises and as the latter is re-hypothecated the collateral chain expands and hence asset prices rise too. Welcome to the heroic vision where leverage rises, asset prices increase, and instability becomes even greater. After all Mannerists were not good imitators of the great Renaissance artists.
Let me briefly return to my heretic interpretation of the recent market turmoil (i.e. declining liquidity). Bond trading is vital in maintaining liquid bond and stock markets. When deliveries of Treasuries fail (and do so at an alarming rate) liquidity is drained and thus equity markets are destined to decline. As an example let’s think of an ETF index searching for the securities needed to back up its trades. Failure to find the securities needed, will force an investors’ exit and thus a decline in the price of the ETF. Imagine then what might happen if gold deliveries fail in the paper gold market. Those paper gold assets will evaporate and gold prices will skyrocket.
What are the potential prognostications we can make as the new joint venture is rolled out?
Like with the reverse repos, initially credit and liquidity will rise and thus I expect markets to perform relatively well. Thus for the foreseeable future, I anticipate decent returns in the markets. However, and as Led Zeppelin would have said, our shadows are taller than our souls. We have been trying to create assets by re-hypothecating liabilities. When all are one and one is all, we will end up with a rock that is unable to roll.
How then shall we go about the marketable asset business? Investors may be wise to take a long term realist’s view of the manufactured instability that got into the market’s DNA due to overleveraging and debt accumulation. They will be better off if they overlook Mannerism and focus on Caravaggio’s realism. When he painted the basket of fruit all he wanted to portray was some fruits, so real that they seem ready to pop out of the frame. When his painting of the Madonna dei Pellegrini appeared in the church of Sant’Agostino (where it can still be seen), a scandal was provoked. Why use such an ordinary woman to portray the Madonna? Who are those poor men without boots and with filthy feet? Caravaggio was a master of realism in an age of idealism and that’s why he endured his early passing at the age of thirty nine.
We may be better off then, if we forget the symbolism and the drama of sophisticated paper assets. It’s time to start thinking and hedging using real assets which always carry intrinsic value, especially if they are undervalued.