Understanding today’s credit event
Guest Post by Macro Story.
“Those that fail to learn from history, are doomed to repeat it.” – Winston S Churchill
Hard to believe that the following post can be written just three years after the 2008 financial collapse. What is even harder to believe is how the majority either fail to or simply refuse to acknowledge the events unfolding and the comparisons to that historic moment in the global economy.
In 2008 we were forced to learn about various financial terms like subprime MBS, CDS and capital calls . Today we have commingling, sovereign debt yields and my favorite rehypothecation. So what does it all mean?
Think of the global economy as the construction of a house. On the surface is a beautiful home adorned with towering windows, magnificent roof lines and vibrant lighting. Hidden beneath the surface is the foundation working diligently to maintain the structure.
Builders go through painstaking efforts to maintain the integrity of the foundation. Assuring there are no air pockets or voids in the concrete that will crumble with time. The foundation is the basis in which a home is built and is analogous to the formation of credit in which an economy is built. Credit formation is truly the structure that supports the global economy.
The complex financial instruments we hear about today have been around for years. When credit was formed they were part of the building process. They represent cracks and voids which weaken the structure. They weaken over time and can fail simply under the stress of their own weight or from a shock event.
We are all waiting for that one “credit event.” That one failure that brings the system down but I say it has already happened. It was not the failure of MF Global. It was the failure of confidence.
The Failure Of Confidence
Placing a trade never involves wondering if the counterparty on the other side will honor the trade. Yes we have counterparties. When I sell stock the exchange works with the brokers to insure the trade is processed. They insure the investor on the other side has the capital to facilitate the sale of my asset. I trust the system works. I trust my money is safe. I trust when I sell something that upon settlement the cash will be available in my account.
But that all changed just a few weeks ago with the failure of MF Global. $1.2 billion in client money simply vanished. Trades were broken or frozen. Money requested prior the bankruptcy turned into returned checks or reversed wire transfers. The CME failed to step in and backstop these transactions. Simply said confidence was broken. The one key aspect of the global financial system, trust has “failed to deliver.”
All traders now have to wonder if their money is safe. Does their cash exist or is it being used to fund their broker’s trades. Has the broker pledged their client’s asset and will it too simply vanish.
That is the tremor that has begun the process of failure within the foundation. The rest is a simple cascade of events.
What Are The Implications
Let’s fast forward to a highly likely scenario in the coming weeks. Let’s assume equity markets correct 5% while the reality of sovereign default risk grows. Assume another broker like MF Global begins publicly having to defend their own practices as their stock price plummets.
A run on the “brokers” will result. Clients in fear they will be part of the next MF Global and lose their life savings or capital in which they need to trade opt to simply leave the futures and options market. They call their broker and ask for their $100,000 account to be liquidated and a check sent to them. The broker receives many of these calls.
Problem is this broker used $10 million in client funds weeks earlier to meet their own margin call. This is known as the commingling of funds.
The broker who bought Italian debt weeks ago when yields were 5% is now receiving calls from the creditor which has financed this deal via repo to maturity. With yields now over 6% the creditor is demanding more collateral in the form of capital. Capital the broker simply does not have. This is known as a capital call.
But that broker will not simply rollover and die. They will not march themselves into bankruptcy court. No they will take their UK based affiliate and raise more capital. Perhaps they have a lien on an asset in which they have loaned money. They will take that asset which is already pledged and use it again as collateral to raise capital for themselves. This is known as rehypothecation.
There is an ongoing deleveraging in the credit markets which is driving broker capital calls. The commingling of client money is deteriorating confidence. The rehypothecation of collateral where perhaps four creditors are claiming the same underlying asset will accelerate the contraction of credit. Simply said the foundation is failing.
Next time you close out a trade do you know you will get paid? For the first time you now must worry if the counterparty is trustworthy. When you sell that SPY put for a nice profit you will instantly get your order filled. Your broker statement will instantly show the sale and the cash in your account. It will also show that cash as unsettled. Now the waiting begins. As your broker waits to collect your funds for you will they be there? Has the broker commingled their clients funds. Does the broker have capital calls they cannot meet?
For the first time in possibly ever being on the right side of a trade may still mean you lose. If you think this is a far fetched scenario tell that to the MF Global customers, the farmers and traders, people like us who lost $1.2 billion in capital. As Jon Corzine said “I simply do not know where the money is.”