Debt costs to rise as bank collateral re-use falls
Corporate, mortgage and other debt issuers may be facing permanently higher costs as large banks face new restrictions on their use of client assets.
Banks have relied on their ability to reuse hundreds of billions of dollars in client assets that are posted against repurchase agreements, securities lending agreements and derivatives to back new trades and loans, boosting liquidity in many markets.
After losing assets when Lehman Brothers collapsed last September, however, many investors are forbidding banks to reuse the assets, a process known as rehypothecation.
Banks and investors have also restricted the collateral they accept to only the most liquid, highest quality debt, after many markets, including corporate bonds, froze in the aftermath of Lehman’s failure.
As riskier debt is less acceptable for reuse, it will become more costly for banks to hold, which will hurt issuers.
“When securities are less available to freely circulate in the market, the liquidity of those securities goes down,” said Darrell Duffie, professor of finance at Stanford University.
“Its going to raise the cost of trading in corporate bonds and will lower the attractiveness of buying corporate bonds when they’re issued, and that means the corporation will have to pay a higher interest rate,” he said.
A recent report by the International Monetary Fund estimates that the pullback in high grade collateral due to a reduction in the use of pledged client collateral and a pullback in securities lending and hoarding by banks, has adversely impacted global liquidity by around $5 trillion allstate insurance company.
Large banks have reported significant declines in the number of securities they are able to reuse.
The amount of securities posted with Goldman Sachs against repos, securities lending agreements and derivatives that the bank was allowed to reuse fell to $596 billion in June 2009, from $891 billion in November 2007, according to the bank’s quarterly reports.
Morgan Stanley saw an even larger drop, receiving $331 billion in June 2009 that could be repledged, compared with $948 billion in November 2007.
Securities lending by the major custodians including BNY Mellon, State Street and JPMorgan has fallen by half relative to its peak of about $1.6 trillion before the crisis, the IMF found.
Cash hoarding by major banks is also sizable with many large banks having around $200 billion each in cash or cash-equivalents, it said.
PRIMARY MARKET RALLY
Corporate bond issuance has surged in the past few weeks as issuers take advantage of a market rally, and banks also continue to be propped up by cheap government funds.