I have been hearing how all the banks were highly levered (up to 30 to 1). What constituted such a high leverage factor? The point I don’t grasp is that all these banks are borrowing as indicated by their high leverage, who are the lenders providing the financing?
Leverage isn’t real and these numbers don’t mean anything except that the risk was high. Suppose for example that I own bonds worth $10M. I repo the bonds to you and you give $9.9M. I buy back bonds from you with the 9.9M. Then I repo these bonds to you again and you give me 9.8M. Then I buy the bonds back from you… At the end of the day, I’m taking on lots of bond risk and have levered up 30x (to a $300M investment), but the only money required to do it was your initial $9.9M
Nice example.
http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130 That’s a very interesting article on this very subject you bring up. It’s about an Ex-SEC official that cites an exception for the (previously) 5 big IB’s to a regulation limiting leverage to 12:1 as a primary reason for this mess. Check it out.
JoeyDVivre Wrote: ------------------------------------------------------- > Leverage isn’t real and these numbers don’t mean > anything except that the risk was high. Suppose > for example that I own bonds worth $10M. I repo > the bonds to you and you give $9.9M. I buy back > bonds from you with the 9.9M. Then I repo these > bonds to you again and you give me 9.8M. Then I > buy the bonds back from you… > > At the end of the day, I’m taking on lots of bond > risk and have levered up 30x (to a $300M > investment), but the only money required to do it > was your initial $9.9M Thanks Joey but I’m not comprehending this. (I was never sharp with the repo market.) How does the transaction you are describing make money? How could you buy back 10MM of bonds with 9.9MM.
“How could you buy back 10MM of bonds with 9.9MM?” I buy back 9.9MM in bonds. So I own all $300M in bonds because we have a contract for you to return them to me at a set price (note also that there is only $10M worth of bonds here too, which is why this nonsense of counting up the amount of mortgages in the world to determine something about the losses is pretty dumb). If you unwind all this, we have just done a total return swap on the bond vs repo rate with a notional size of $300M.
Fractional Reserve Banking
Austin12 Wrote: ------------------------------------------------------- > JoeyDVivre Wrote: > -------------------------------------------------- > ----- > > Leverage isn’t real and these numbers don’t > mean > > anything except that the risk was high. > Suppose > > for example that I own bonds worth $10M. I > repo > > the bonds to you and you give $9.9M. I buy > back > > bonds from you with the 9.9M. Then I repo > these > > bonds to you again and you give me 9.8M. Then > I > > buy the bonds back from you… > > > > At the end of the day, I’m taking on lots of > bond > > risk and have levered up 30x (to a $300M > > investment), but the only money required to do > it > > was your initial $9.9M > > Thanks Joey but I’m not comprehending this. (I > was never sharp with the repo market.) How does > the transaction you are describing make money? > How could you buy back 10MM of bonds with 9.9MM. I’m not so great with repos either. Someone said to forget about all of the repossession aspects and just think of it as a short term collateralized loan. I have $10M in bonds and I hand them over to someone who takes a tiny portion as interest and gives me $9.9M in cash. With that cash, I go out on the market and buy $9.9M in new bonds (from other people)… I then hand those bonds over to my repo partner as collateral, and they give me $9.8M in cash… repeat… repeat… repeat… until you are out of money. You end up owning 10M + 9.9M + 9.8M + 9.7M … (approximately, this is geometrically declining, not arithmetically) You end up owing 9.9M + 9.8M + 9.7M … As long as your bond values have increased you get great returns. Something freezes up and then… WHAM!
so this is analogous to the money multiplier effect? So with some now having to go to 1:1 we have effectively shrunk that portion of the $ supply 30 fold? And now all the banks have to go out and find the cash to unwind thus liquidity crisis?
That’s how I understand it, and this sudden contraction in the money supply is why it’s possible that we will have deflation (though I still think inflation is more likely).
But the real world has an added layer of abstraction. Suppose that a bank went into default having repo’ed out bonds to 20 different places having a $300M bond position. Each of those places is holding a bond that at least at the outset over-collateralized the loan. The pace just sells the bond and gets back their money. If the bond has fallen in value to the point where the over-collateralization doesn’t cover it (likely as a company in default would unwind the trade otherwise) then they have a claim against the company for the difference. This is routine bankruptcy stuff and each of the banks probably just eats the same percentage of the difference. In the real world, this repo procedure is certainly a cumbersome way of doing things so a company takes its credit line to someone else and says “Let’s do a $300M notional swap on [some bond index] vs [some short-term interest rate]”. Furthermore, he has done dozens of those with everybody. Now if the company declares bankruptcy the situation is way different. The swaps aren’t offsetable against each other and each counterparty is an unsecured creditor (if they are ahead in the swap) rather than a secured creditor as above. If a counterparty is behind in the swap then the entire amount they owe is an asset of the bankrupt company. That means that if AIG (e.g.) did a $300 M 30-year Treasury vs LIBOR swap with me and a nearly offsetting Fed Funds vs 30-year Treasury with me also and AIG goes bankrupt, I am really screwed and my risk on these trades just went up hugely. It’s dynamics like these that are the contagion that the Fed and Treasury are worried about. Attacking the leverage is not the right solution to the problem.