Csides are usually Valuing assets and extending credit to them is the preoccupation of mortgage bankers and repo traders who arrange trillions of dollars in repurchase agreements for ultra-short-term government bonds every day. There’s a reason this activity is called financial plumbing: it’s important but not sexy. Just like normal plumbing, you only hear about it when something is wrong.
Now is one of those times. The Swiss National Bank offered Credit Suisse a $54 billion loan on March 16, backed by collateral from Credit Suisse, but the move proved insufficient to save the 167-year-old institution. On March 19, the US Federal Reserve announced that it would restart daily dollar swap lines with the UK, Canada, the Eurozone, Japan and Switzerland. The central banks of these economies can now borrow dollars from the Fed at a fixed rate for short periods, backed by their own currencies, and lend them to local financial firms.
In normal times, assets with little risk and unlikely to fluctuate wildly in value underpin a lot of market activity. Government bonds and property are typical examples of collateral. Commodities, corporate credit and equities are riskier, but are sometimes employed. Both types of collateral have been at the root of many financial crises.
The sense of security is why risk ultimately arises. The safer people think assets are, the more willing lenders are to extend credit to them. Sometimes the assets themselves are safe, but the loans they facilitate (and the use of the funds) are not.
This tension between safety and risk can trigger financial panics. At other times, the problem is simply a miscalculation. Activities of Silicon Valley Bank (SVB) is essentially making leveraged bets on assets its bankers consider reliable: long-term mortgages and Treasuries. The company’s management believes it can safely borrow money — money owed to bank depositors — against these solid assets. The ensuing rapid decline in asset prices eventually led to the bank’s failure.
During the 2007-09 global financial crisis, belief in the impenetrable safety of the U.S. mortgage market led to a surge in mortgage lending. The explosion doesn’t even require an actual default on mortgage-backed securities. A change in the probability of default alone increases the value of credit default swaps, and the liabilities of the companies that sell them, enough to put institutions that sell large amounts of swaps in a bind. In the early 1990s, a collapse in the price of land, the collateral of choice for domestic banks, led to a series of slow-burning financial crises that lasted more than a decade.
A crisis will not only reveal where collateral has been misjudged as safe. They are also a source of innovation that is disrupting the way collateral works. In response to the panic caused by the collapse of Overend, Gurney & Company, a London wholesale bank in 1866, the newspaper’s former editor, Walter Bagehot, promoted the idea of central banks operating as lenders of last resort for private financial institutions, opposing sound mortgages Taste. The Fed’s recently restarted daily swap lines were introduced during the financial crisis and reopened early in covid-19.
The ‘Term Funding Program for Banks’ launched after the Fed collapsed SVB, This is the first innovation in collateral policy during the current financial turmoil. The program’s generosity is both novel and astounding. The 30-year Treasury bond, issued in 2016, is worth about a quarter below its face value in the market, but if an institution holds it up as collateral, the Fed will value it at face value. In the first week of the program, banks borrowed nearly $12 billion and borrowed a record $153 billion from the central bank’s ordinary discount window, which banks can now borrow without the usual collateral haircuts.
The program could change the understanding of collateral that has been established over the past 150 years. Long-dated bonds enjoy a new and very valuable backing if investors want the facility to be part of a regular panic toolkit, like a swap line. That means financial institutions benefit when rates fall and bond values rise; when rates rise and bond values fall, the Fed comes to the rescue. In order to remove the risk of a sudden collapse and make the financial system safer, policymakers may do the opposite in the long run.
Learn more from our financial markets columnist Buttonwood:
Why Commodities Shine in an Era of Stagflation (March 9)
Anti-ESG industries are attracting investors (March 2)
Wall Street takes China with reservations despite bullish rhetoric (Feb. 23)
Plus: How the Buttonwood column got its name