Monday, September 29, 2008

The Unraveling of the Money Markets: The Flip Side of Efficiency

To the uncritical mind of finance professors who see the markets with the eye of a P.R. agent, the changes that have taken place in the past thirty years in the financial markets were a series of inspired events brought about by visionary bankers, insightful academics and bold traders. The result, naturally, was “sophisticated” and “efficient” markets which benefited all.

In reality, finance is a dialectical discipline. Its development follows the logic of internal evolution of finance capital which turns the phenomena to their opposites – commerce to speculation, hedging to arbitrage, equilibrium to volatility, just to name a few. The most benign phenomena then reveal a hidden side that is in contrast to their docility. Such is the case with the “efficient” markets.

By efficient markets, the academics mean a market where, thanks to arbitrage, the borrowing costs are low and capital is allocated in the optimum way. In practice, this means markets in which capital never stands idle. It is employed at all times, earning however small a return. In a time of crisis, this constant engagement turns into entanglement. To free the capital then, it is necessary to unwind; mere selling would not do. Search for “unwind financial markets” in Google for various instances of unwinding.

In money markets, two areas oil the efficiency engine. One is the tri-party repo market which I described in Credit Woes. The other is the even larger securities lending market – called “sec lending” by everyone in the industry – whose size is well above the tri-party’s $4 trillion daily transactions.

The sec lending market is driven by short selling, or shorting, which is selling something you do not have. Outside the financial markets, the practice amounts to fraud; if you sell a house, or a car, or a farm you do not have, you would probably go to jail. In the financial markets, the practice is legal and very common. With the ownership requirement eliminated, the buy-sell sequence could be reversed; instead of buying first and selling later, you could sell first and buy later. So if we think that, IBM, for example, might fall, we call our broker and short 1000 IBM shares. We hope to buy them back later when the price falls.

For every seller, there is a buyer. Someone must have bought the 1000 shares we just sold. But we did not posses the shares. How are we going to deliver the shares to the buyer? That brings us to sec lending.

Take a large investor – a mutual fund, for example – that owns tens of billions of dollars worth of securities. In the modern financial markets, there is no physical certificate. All securities, rather, are held in street name, for the fund, by a custodian bank.

In the efficient capital markets, with the constant struggle by funds to improve their performance by even 1/100th of a percent, these securities are a potential source of addition income to the funds which own them. So as part of an active arbitrage strategy, the custodian bank approaches the fund and makes the following pitch:

We are holding large securities positions for you that currently sit idle. Through our sec lending program, we could lend all or part of them to short sellers. You need not worry about risk. Among various precautions, we indemnify the lent securities, so that should you suffer any loss, we would make you whole.

As collateral for the lent securities – you will even have the option of telling us whom not to lend to – we would receive cash collateral from the borrower (short seller). We would invest the cash and share the proceeds in some equitable manner, say 80-20, where you get 80% and we get 20% .
After the securities owner (the fund) agrees, the custodian bank inform short sellers that it is open for business.

Assuming the same 1000 IBM shares is trading at $120 per share, the following then takes place:

1. The custodian bank “delivers” 1000 shares, worth $120,000, from the fund’s account to the short seller, or the borrower (of stock)

2. The borrower posts cash collateral to the bank equal to $122,400, which is 102% of the value of the borrowed stock.

(Upon termination of the short sale, the securities are returned to the fund. The bank returns short seller’s $122,400, plus accrued interest calculated at the Fed Funds rate.)

3. The bank invests $122,400. If the spread between what the bank earns for this investment and the Fed Funds rate is 10 basis points, the interest income would be $122.50, which is split in a pre-agreed manner between the bank and the fund.

This is the most critical step. Since the interest income is the difference between what the bank can earn and the Fed Funds rate, there is a strong incentive for the bank to invest aggressively. In the mean time, short sellers do not sit on their positions for long, so the investment has to be short term, which is the realm of money markets.

There are two ways to increase – to enhance, in the language of marketing brochures – the return on a money market fund: to go down the credit ladder, or to extend the term. The first option exposes the fund to the risk of loss due to a downgrade. The second, in addition to a credit downgrade, locks up money for a period ranging from one week to just under one year.

Imagine now that the borrower of shares is Lehman Brothers. The owner of the shares – a mutual fund, in our example – becomes concerned about the health of the firm and instructs the bank not to deal with Lehman. The lent shares must now be recalled and $122,400 with the accrued interest returned to Lehman. If the bank has locked the money in a money market fund that has an as-yet-in-the-future maturity, it has to liquidate the position. If the money market fund is aggressive and has invested in junk mortgage securities that have dropped in price, the hit to the principal is even more pronounced. The custodian bank must then make up the shortfall, an act that requires an immediate infusion of cash. It is in this way that short term markets come under pressure, which is why the Treasury immediately responded by guaranteeing the principal in money market funds; large custodian banks with trillions of dollars in custodial accounts, not to mention many “boutique” firms, are actively engaged in sec lending. The efficiency of markets brought about by the sec lending business is one of the primary sources of disorder in money markets that is reflected in unprecedented Fed Funds/Libor/OIS spreads.

That is also why the stock price of custodian banks took a beating on September 18, a process that continues to date. Check State Street, for example, whose violent price swings on that day showed that traders were aware of the role of the “custody banks” and the vulnerability that follows from their business model.

All in all, the individual stock price changes, like today’s 700 plus point drop in the Dow Jones, are mere consequences. That index could rebound tomorrow – or the day after. The unraveling of the money markets, on the other hand, is here to stay – well beyond tomorrow and the day after.