Last Updated: 21 May 2023
According to Richard Comotto, tutor on this week’s International Capital Market Association course on the repo market and collateral management, you should “only do repo (secured finance transactions) with those counterparties to whom you would lend on an unsecured basis”.
Why? Lending and taking a pledge of collateral in return is clearly less risky than lending without security. But it’s easy to become too casual when lending is collateralised, said Comotto.
The experience of US mortgage lenders over the last few years gives some indications why.
Banks lending against the value of US real estate were collateralised, but lenders had made a series of miscalculations: they lent to the wrong counterparties (via NINJA or “liar loans”); the collateral risks were vastly underestimated (it was assumed that housing prices couldn’t fall); haircuts on loans were too small (loan-to-value ratios reached or exceeded 100 percent); loans were not documented properly, incurring unforeseen operational risks; and legal risks materialised when judges ruled widely that lenders couldn’t foreclose when mortgage holders stopped paying their debts.
In theory, said the ICMA’s Comotto, secured lending in the financial markets is good because you have so-called “double indemnity”. If your counterparty fails, you can sell the collateral. If the value of the collateral you hold falls, you can call on your counterparty to top it up. But if there’s a linkage between the behaviour of your counterparty and the value of collateral, then you’re less protected. At worst, you’re effectively lending unsecured.
An example would be conducting a securities loan with a Spanish or Italian bank and then taking a selection of other Italian or Spanish bank shares as collateral. If your counterparty defaults, how much is the collateral going to be worth? Avoid such “pig on pork” deals, or “wrong-way risk”, Comotto said. Keeping the correlation between counterparty and collateral as low as possible is crucial.
There are also legal and operational risks involved in secured lending, said Comotto. Having a pledge of collateral is riskier than taking title to (ownership of) the collateral. But even if there is a transfer of title, if it hasn’t been recorded properly you could still end up as an unsecured lender in the case of a default. And there’s also a risk of running into an unsympathetic judge who doesn’t allow you to net out obligations in the case of a bankruptcy, particularly in some jurisdictions. While the European collateral directive has greatly improved the consistency of close-out netting provisions across the region in the last decade, it hasn’t really been tested in a crisis.
You could also run into conflict of laws problems if you are operating cross-border, said Comotto. Imagine a fund domiciled in one jurisdiction, contracting with a derivatives counterparty in another country and holding collateral in a third. Which country’s legal system holds sway in the case of a bank failure? In theory, it’s the country where the bank is domiciled, but will judges play ball in those countries where the fund is domiciled and where the collateral is held?
Finally, said Comotto, if your secondary defence in a secured lending transaction is the collateral, your primary safeguard is the creditworthiness of your counterparty. It’s better, for that reason, he explained, to take poorer-quality collateral from a safer counterparty than to take top-notch collateral from a poor-quality counterparty.
For this reason, he concluded, you should only choose as a secured finance counterparty those firms to whom you would lend on an unsecured basis.
But if that’s our criterion for selecting counterparties, we’re talking about a very rapidly shrinking pool of acceptable names.
There’s a buyers’ strike in the market for senior bank term debt, for a start. Investors don’t want to lend on an unsecured basis to many banks at any price in the current market, except perhaps at very short maturities. The current all-time highs in the Markit iTraxx Europe financials indices provide ample evidence of their reluctance.
Credit default swap spreads, which serve as a measure of counterparty risk in bilateral transactions, have doubled or trebled this year for the vast majority of banks involved in writing derivatives in the ETF market. This isn’t just a European issue. In fact, some of the banks with the largest percentage rises in CDS spreads this year are US and Asian names: Morgan Stanley, Bank of America, Goldman Sachs, Nomura. For the majority of the banks writing derivatives with European ETFs, it now costs over 3 percent a year to insure against default on senior unsecured debt, a meaningful sum.
For those bank borrowers approved earlier this year by iShares as counterparties in securities lending operations, things are no better. Five of those twelve names—Bank of America, Santander, Goldman Sachs, Morgan Stanley and Unicredit—have senior debt CDS spreads of over 4 percent a year.
Not all European ETFs use derivatives and securities lending, and not all ETFs involved in lending lend out significant proportions of their holdings. Some of the funds involved in lending offer additional safeguards like indemnities. And these questions are not specific to ETFs; they apply to all funds engaging in similar activities.
But—taking Comotto’s point—if you wouldn’t be willing to lend unsecured to the banks involved in repo-like activities with the majority of the ETFs in Europe, should you be buying the ETFs that trade with those counterparties at all?