Tuesday, January 10, 2012

Collateral Damage

Money, the folding paper type, is really only as good as the value of the 'stuff' it represents.

If you loan money to someone, you expect to have a 'thing' of similar value backing that monetary loan in case (hypothetically) the borrower defaults on the loan ie. if the borrower doesn't pay, you get the 'thing' in return.

You may have heard of the latest buzz word made famous by the MF Global bankruptcy. Rehypothecation. Well, in the example above the first 'hypothecation' is the collateral pledged for the loan. However, if the original lender wanted to borrow money off another party, then he could theoretically use the 'thing' of the first loan as collateral for his loan. This would be rehypothecation. So the same collateral is re-pledged to another party. Apparently this can go on for many agreements. The same asset used many times.

If the first borrower defaults, the hole shebang crashes.

But it's the value of the 'thing' or, using more financially aware language, the asset that is the problem. Assets such as mortgages in the early 2000s were packaged up and sliced and diced and sold to fund managers on a world-wide scale. These packages were bought and sold many times, all for profit. But then some poor soul, who owned a mortgage in America, decided not to pay anymore. And down came the dominos, ending in large disasters like Lehman Brothers. You see, the asset side of their balance sheet suddenly became worthless.

But it didn't end there. Even now, most of the European banks have bad collateral on their books. This is why the Europeans are in a bit of a fix. The money, or the values, they thought they had are gone. This causes mistrust between each bank as each one doesn't have the confidence that the other has any collateral for it to lend against. When this occurs, short term financing grinds to halt. That's why central banks recently did huge EURO/USD swaps. They managed to oil the system for a few more months.

They managed to delay the fateful day

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