Everything that has happened since 2007, every Central Bank move, ever major political decision regarding the big banks, every trend, have all been focused solely on one issue.
That issue is collateral.
What is collateral?
Collateral is an underlying asset that is pledged when a party enters into a financial arrangement. It is essentially a promise that should things go awry, you have some “thing” that is of value, which the other party can get access to in order to compensate them for their losses.
You no doubt are familiar with this concept on a personal level: any time you take out a bank loan the bank wants something pledged as collateral should you fail to pay the money back. In the case of property, the property itself is usually the collateral posted on the mortgage. So if you fail to pay your mortage, the bank can seize the home and sell it to recoup the losses on the mortgage loan (at least in theory).
In this sense, collateral is a kind of “insurance” for any financial transaction; it is a way that the parties involved mitigate the risk of their deal not working out.
As many of you know, our entire global financial system is based on leverage or borrowed money. Collateral is what allows this to work. Without collateral, there is no trust between financial institutions. Without trust there is no borrowed money. And without borrowed money, money does not enter the financial system.
In this sense, collateral is the “reality” underlying the “imaginary” or “borrowed” component of leverage: the asset is real and can be used to back-stop a proposed deal/ trade that has yet to come to fruition.
For financial firms, at the top of the corporate food chain, sovereign bonds are the senior-most form of collateral.
Modern financial theory dictates that sovereign bonds are the most “risk free” assets in the financial system (equity, municipal bond, corporate bonds, and the like are all below sovereign bonds in terms of risk profile). The reason for this is because it is far more likely for a company to go belly up than a country.
Because of this, the entire Western financial system has sovereign bonds (US Treasuries, German Bunds, Japanese sovereign bonds, etc.) as the senior most asset pledged as collateral for hundreds of trillions of Dollars worth of trades.
Indeed, the global derivatives market is roughly $700 trillion in size. That’s over TEN TIMES the world’s GDP. And sovereign bonds… including even bonds from bankrupt countries such as Spain… are one of, if not the primary collateral underlying all of these trades.
How did the world get this way?
Back in 2004, the large banks (think Goldman, JP Morgan, etc.) lobbied the SEC to allow them to increase their leverage levels. In very simple terms, the banks wanted to use the same collateral to backstop much larger trades. So whereas before a bank might have $1 worth of collateral for every $10 worth of trades, under the new regulation, banks would be able to have $1 worth of collateral for every $20, $30, even $50 worth of trades.
Another component of the ruling was that the banks could abandon “mark to market” valuations for their securities. What this means is that the banks no longer had to value what they owned accurately, or based on what the “market” would pay for them.
Instead, the banks could value everything they owned, including their massive derivatives portfolios worth tens of trillions of Dollars using in-house models… or basically make believe.
This is getting a bit technical so let’s use a real world example. Imagine if you had $100,000 in savings in the bank. Then imagine that the bank let you use this $100,000 to buy millions and millions of dollars worth of real estate. Then imagine that the bank told you, “we aren’t going to have our analysts independently value your real estate, you can simply tell us what you think it’s worth.”
In this set up, you would potentially buy $10 million worth of real estate or more… using just $100,000. But what if your newly purchased real estate drops in value to $5 million? No worries, you could simply tell the bank, “my analysis indicates that the properties are worth $20 million.” The bank believes you so you continue to buy more properties.
This sounds completely ludicrous, but that is precisely the environment that banks operated in post-2004. As a result, today US banks alone are sitting on over $200 TRILLION worth of derivates trades. These are trades that the banks can value at whatever valuation they want.
Now, every large bank/ broker dealer knows that the other banks/dealers are overstating the value of their securities. As a result, these derivatives trades, like all financial instruments, require collateral to be pledged to insure that if the trades blow up, the other party has access to some asset to compensate it for the loss.
As a result, the ultimate backstop for the $700+ trillion derivatives market today is sovereign bonds.
When you realize this, the entire picture for the Central Banks’ actions over the last five years becomes clear: every move has been about accomplishing one of two things:
1) Giving the over-leveraged banks access to cash for immediate funding needs (QE 1, QE 2, QE3 and QE 4 in the US… and LTRO 1, LTRO 2 in the EU.)
2) Giving the banks a chance to swap out low grade collateral (Mortgage Backed Securities and other garbage debts) for cash that they could use to purchase higher grade collateral (QE 1’s MBS component, Operation Twist 2 which lets bank their long-term Treasuries and buy short-term Treasuries, QE 3, etc).
All of this is a grand delusion meant to draw attention away from the fact that the financial system is on very, very thin ice due to the fact that there is very little high quality collateral backstopping the $700+ trillion derivatives market.
Indeed, if you want further evidence that the financial elites are already preparing for a default from Spain and a collateral crunch, you should consider that the large clearing houses (ICE, CEM and LCH which oversee the trading of the $700+ trillion derivatives market) have ALL begun accepting Gold as collateral.
Gold as Collateral Acceptable for Margin Cover Purposes
From 28 August 2012 unallocated Gold (Loco London) will be accepted by LCH.Clearnet Limited (LCH.Clearnet) as collateral for margin cover purposes.
This addition to acceptable margin collateral will be subject to the following criteria;
Available for members clearing OTC precious metals forwards (LCH EnClear Precious Metals division) or precious metals contracts on the Hong Kong Mercantile Exchange. Acceptable to cover margin requirements for all markets cleared on both House and ‘Segregated’ omnibus Client accounts.
CME Clearing Europe to Accept Gold as Collateral on Demand
CME Clearing Europe will accept physical gold as collateral, extending the list of assets it’s prepared to receive as regulators globally push more derivatives trading through clearing houses.
CME Group Inc. (CME)’s European clearing house, based in London, appointed Deutsche Bank AG (DBK), HSBC Holdings Plc and JPMorgan Chase & Co. as gold depositaries. There will be a 15 percent charge on the market value of gold deposits and a limit of $200 million or 20 percent of the overall initial margin requirement per clearing member based on whichever is lower, Andrew Lamb, chief executive officer of CME Clearing Europe, said today.
“We started with a narrow range of government securities and are now extending that,” Lamb said in an interview today. “We recognize there will be a massive demand for collateral as a result of the clearing mandate. This is part of our attempt to maintain the risk management standard and to offer greater flexibility to clearing members and end clients.”
It is no coincidence that this began only when the possibility of a sovereign default from Greece or Spain began. The large clearinghouses see the writing on the wall (that defaults are coming accompanied by a mad scramble for collateral) and so are moving away from paper (sovereign bonds) into hard money to attempt to stay afloat.
The most telling item is that clearinghouses now view Gold as money. Indeed, you can see this fact in other stories indicating that various entites are concerned about having their gold stored “inhouse” if the stuff ever hits the fan.
Heck, even the Alan Greenspan, the man most responsible for the 2008 financial crisis, has admitted that “gold is money.” Of course, he couldn’t admit this until he’d left the Fed. But this is a man who knows all too well just how the financial system works.
Take note, Gold is officially money for the most powerful entities in the world. They are not only accepting Gold as collateral but are openly trying to insure that they have their own Gold in safe custody.
Courtesy: Graham Summers – Phoenix Capital Research
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