Savings & Investment, Smart Spending

Abracadabra — Money From Nothing With Unfractional Repo Banking

OK, almost nothing would be more accurate, I suppose. If anyone was under the illusion that repo (repurchase agreements) abuse was curbed by regulation, a new report may snap you out of it. Of course, if you really thought that government actions such as the Dodd-Frank bill (now law, sort of–they still haven’t settled on all of the minutiae) solved those leverage problems then you may be in too deep of a trance for recovery. Still, even the most cynical of investors had to be jolted by the plain language used in the latest musings of the Financial Stability Board. Well, to be fair, the hard core cynics were probably mildly amused, especially those actually using the system:

Naturally, any product that can allow participants infinite leverage is something that all “sophisticated” market participants not only know about, but abuse on a regular basis. The fact that this “unfractional repo banking” is at the heart of the unregulated $71.2 trillion shadow banking system, the less the general public knows about it the better.

“Unfractional Repo Banking”…hmmm. They certainly have a way with words don’t they? Anyway, while this may be common knowledge to many investors, it is a subject that many people are unaware except in the most opaque fashion. Even as this market gets supposed extra scrutiny from government agencies around the world, it goes on and on. The reasons for this are fairly obvious as regulators are reluctant to do any harm to the too-big-to-fail banks. In addition, it is fashionable to be biased toward a sort of pro liquidity, pro debt outlook on the economy. As Zero Hedge (at link) helpfully points out, The Financial Stability Board has some really helpful words that help clarify what the heck is really going on:

As a simple illustration of the way in which repo transactions can combine to produce adverse effects on the system that can be larger than the sum of their parts, suppose that investor A borrows cash for a short period of time from investor B and posts securities as collateral. Investor A could use some of that cash to purchase additional securities, post those as further collateral with investor B to receive more cash, and so on multiple times.

Yes, yes, yes…but so what else is new you may say. That’s true for many investors but there is a vast population that may not realize exactly how bad this is. As the above example illustrates, the more the chain expands, the more the multiple increases and abracadabra–money from virtually nothing. In fact, the systems leverage can be nearly never-ending:

Which means that after just a few turns of rehypothecation, leverage approaches infinity. Needless to say, with infinite leverage, even the tiniest decline in asset values would result in a full wipe out of one collateral chain member, which then spreads like contagion, and destroys everyone else who has reused that particular collateral.

Say, isn’t this exactly the kind of thing that led to the 2008 troubles? Why, yes it is! Then why are they not putting some curbs on this stuff? Well, besides the reasons just mentioned above, the simple fact is that they don’t want to. They may blame leverage for the downturn, but they don’t really believe it. That is just pabulum for the consumption of the rubes. They are fully aware that the mess that was (and is again) being created was mostly their doing, they just don’t want to be found at fault. Anything that avoids that outcome is fine by them. Oh, and don’t think they won’t blame the banks again either. And with nearly unlimited leverage something bad will happen again. It’s just the nature of the beast. And the weak links in the repo chain will cause further weak links and on and on. We’ll have to see if this time the strongest links can withstand the onslaught. Admittedly it would be difficult to be optimistic, too-big-to-fail or no too-big-to-fail.