Were you the kind of kid that liked to take a toy apart to see how it works? I hope so, because that’s what we’re doing this week.
Over the last two weeks I have introduced you to institutional cash pools and given an overview of one of the 3 main types, the cash balances of global corporations.
As a greater share of global income goes to profit rather than wages, these corporations are retaining ever larger cash balances. To maintain the circulation of money these balances need to be intermediated back to the real economy, to households for consumption and to firms for investment in fixed capital. The latter is particularly important to create a productive economy that provides enough for everyone. So what does happen to these balances?
I explained last week that these balances are far too large to be left in bank deposits, where only a tiny fraction will be covered by deposit insurance. So instead they are invested in safe, short-term assets. The mandate of the portfolio managers of these pools is, in the words of Pozsar (2015), “do not lose”. The corporations concerned are not looking for an impressive return, they simply want their pools to hold their value against inflation and market interest rates, and to be readily available should they need them.
The ideal assets would be government bonds (either short-term bonds, or long-term bonds that are close to maturity) and Treasury bills. But the demand for such assets from cash pools far outstrips supply. So what do they do?
Well just as these cash pools are awash with more money than they know what to do with, elsewhere in the economy there are funds that are seriously short of cash, and their underperformance has grave implications for the future prosperity of many of us in old age – I’m talking pension funds and insurance funds that face huge deficits.
This week I’m going to look at how financial markets have intermediated between these two camps of financial titans. Next week we’ll start getting into the juicy heart of what this all means for our longing to have an economy that provides enough for everyone, but you simply cannot understand the big picture if you don’t have a basic grasp of the technical workings that underpin it. So this could get a bit long and detailed, but stick with me, I’ll hold your hand, and we’ll get through it together.
So as mentioned, there are investment funds, particularly insurance companies and pension funds (ICPFs) whose portfolios are underperforming. Typically, they have a portfolio of long-term fixed income securities that are not, in the current economy, going to deliver the returns that these asset managers promised to their clients. They now need assets that will deliver exceptional returns – known in the business as “alphas”. But these are hard to come by, so instead they are using leverage – “leveraged betas”.
Leverage is a very simple concept. Suppose you find out that a horse is a dead cert to win a race at great odds of 10-1, but you only have £5 to bet, so you can only make £50 profit from this fantastic opportunity. You borrow £100 off a friend, offering to pay him back £150 (an attractive £50 profit for him, but equivalent to a paltry 1-2 bet on the horse) so you can now bet £105. Your winnings are £1,050, you pay back the £100 and the promised extra £50, leaving you with an amazing £900 profit on a £5, 10-1 bet. That’s the power of leverage.
Now that example might seem a bit dodgy, because you know as well as I do that no horse is ever a “dead cert”. But in “normal” times financial markets are much more predictable than horse racing, and using leverage to increase returns is very common. The difference in financial markets is that lending always needs collateral. Typically, an investor buys an asset and then uses it as collateral to borrow money to buy more of that asset.
So coming back to our underperforming ICPFs, in very simple terms the portfolio managers searching for greater yields are using their existing portfolios as collateral to borrow off the institutional cash pools and then using this leverage to enhance the performance of their portfolios.
The instrument they are using to do this borrowing is known as “repo” – a sale and repurchase agreement.
Legally, the cash pools are not lending the money. They actually buy the asset off the “borrower”, with an agreement to sell it back after a short period of time at a slightly lower price. This price difference, known as “the haircut”, provides the cash “lender” with a profit on the deal and is effectively the same as interest.
These “loans” are structured in this way partly so that they avoid any regulation around lending (because legally they are not loans), but far more significantly because if the borrower goes bust the lender is already the legal owner of the asset that was repoed. Think about your mortgage – if you fail to make your payments your bank has to take you to court to take repossession of the house. With repo, if the borrower cannot repay, legally the lender already owns the underlying asset. They don’t need to go through any time-consuming and costly legal process.
And there’s more – if repo was structured as a traditional secured loan, then if the borrower goes bankrupt the lender doesn’t automatically receive the collateral for the loan, they have to take their turn in the queue with all the other creditors. But with repo, if the borrower goes bankrupt then legally the lender already owns the collateral. They don’t need to worry about the bankruptcy proceedings, they just sell the asset and recoup their funds.
You can see why this structure would be so attractive to cash pools. While legally repos are not loans, everyone talks about them as if they are. As far as the cash pool is concerned, these are short-term loans, so they get their cash back quickly (with the necessary interest), and they are very safe because if the borrower defaults they automatically own the asset that they can sell on. Repo is a very common financial instrument, and was around long before the rise of institutional cash pools. I’m covering it here just to give you a complete overview of how cash pools relate to the financial system as a whole.
There is a final piece of this structure to understand. Cash pools are not dealing directly with the ICPFs. In between them stand the investment banks as dealers, holding inventories of assets (repoed across from the ICPFs) and of cash (as part of repo deals with the cash pools). These dealers bring essential stability to the market. The ICPFs raising cash through repo are typically buying assets that they will hold for longer than the term of the repo – they are “borrowing short to lend long”. So when the repurchase agreement expires they can’t repay the repo because the cash is tied up in the other assets. Instead, they just roll the repo over. If the cash pool that is at the other end of the deal decides it now wants its cash, the dealer bank standing in between covers this from its own capital until it finds another cash pool looking for a safe asset to repo. And overall, these banks are large enough to absorb all these little mismatches in the market, and keep it flowing smoothly.
In the financial crisis, the value of the assets being used as collateral in repo fell. Suddenly, lenders such as cash pools and investment banks weren’t happy to simply roll over repo at the same rate, they wanted more posted as collateral – or they even just wanted their cash back safely. But the borrowers didn’t have the cash, and the market froze. This is described very briefly here. This has often been described as a “run on repo” – the modern form of a run on the bank.
It’s very rare to see a bank run in the modern economy, but they were common in the 19th century, leading to economic turmoil. As a result, the role of the Central Bank as “lender of last resort” emerged, and has become accepted as just part of the wallpaper. But this public guarantee of the financial system (along with deposit insurance) has been essential to maintain stability in modern capitalism (it’s not just down to deregulated private sector free markets after all).
Just as “lender of last resort” is necessary to stop a run on the banks, to stop the “run on repo” during the last financial crisis the Federal Reserve had to step in as “dealer of last resort”, and lend against the collateral that the private sector would no longer accept. This role is discussed extensively in the papers of Zoltan Pozsar and Perry Mehrling, and I suspect (but cannot confirm) that Mehrling coined this term. Mehrling’s book The New Lombard Street is a brilliant introduction to this subject.
So that’s on overview of how financial markets were functioning before, during and straight after the crisis. I hope you coped! The picture has been changing since about 2015 in particular, and understanding these changes is the focus of my current reading. But even if that reading was complete, I wouldn’t be able to write about it on the blog – financial markets and central banks are still in a stage of transition, so no one can be entirely sure where we are right now.
But now that you have a picture of what has been going on in in financial markets this century, we’re ready to start exploring the implications for the economy next week.