LO 54.4: Compare transactions used in the collateral market and explain risks that can arise through collateral market transactions.
Collateral markets have two important purposes. First, they enhance the ability of firms to borrow money. Cash is only one type of asset that is borrowed. Securities are also borrowed in collateral markets. Second, collateral markets make it possible to establish short positions in securities.
Firms with excess cash are more willing to lend at a low rate of interest if the loan is secured by collateral. Securities are used as collateral for secured loans. Collateralized loans can be short term or longer term. Overnight loans are often extended automatically. The full value of the securities is not lent in a collateralized loan. The difference is called a haircut. For example, a lender may be willing to lend $95 against $100 of collateral.
Collateral values fluctuate and most collateralized borrowing arrangements require that variation margin be paid to make up the difference (called remargining). Variation margin is the additional funds a broker requests so that the initial margin requirement keeps up with losses. The haircut ensures that the value of the collateral can fall by a certain percentage (i.e., 5% in the previous example) and still leave the loan fully collateralized. The variation margin protects the lender.
Collateralized loans are used to finance securities or other assets or trades. The securities pledged to one firm are often loaned or pledged again, hence the collateral circulates. This process is known as rehypothecation or repledging.
The role of collateral has expanded in contemporary finance, hand-in-hand with the development of securitization. Securitization creates securities that can be pledged as collateral for credit. Securitized assets generate cash flows, may appreciate in value, and can be used as collateral for other transactions.
Life insurance companies own large portfolios of high-quality assets. They may use these assets for collateralized loans to borrow at low rates and reinvest at higher rates. Hedge funds pledge securities to finance portfolios at rates cheaper than unsecured loans.
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
Markets for collateral take the following forms: Margin loans. Margin loans are used to finance security transactions. The margin loan is collateralized by the security and is often provided by the broker intermediating the trade. The broker maintains custody of the securities in a street name account (i.e., securities are registered in the name of the broker rather than the owner). This structure makes it easier to seize and sell securities to meet margin calls. An added advantage to the broker is that securities in street name accounts can be used for other purposes, such as lending to other customers for short sales. In practice, the broker uses the customers collateral to borrow money in the money market to provide margin loans to customers. The margin loan to the broker is collateralized by the repledged customer collateral. The Federal Reserves Regulation T sets the initial margin requirement for securities purchases at 50%. Cross-margin agreements are used to establish the net margin position of investors with portfolios of long and short positions. In general, cross margin involves transferring excess margin in one account to another account with insufficient margin, resulting in lower overall margin for the investor.
Repurchase agreements or repos. Repurchase agreements, also known as repos and RPs,
are another form of collateralized short-term loans. They involve the sale of a security at a forward price agreed upon today. The interest on the loan is implied from the difference between spot and forward prices of the securities. While traditionally collateral had little or no credit risk (collateral was usually Treasury bills), today acceptable collateral encompasses whole loans, high-yield bonds, and structured credit products. Repos allow banks and other firms to finance inventories of structured credit products and allow for high investment grade ratings for senior tranches of asset-backed securities (ABSs) and collateralized debt obligations (CDOs). Securities lending. Securities lending involves the loan of securities to another party in exchange for a fee, called a rebate. The lender of the securities continues to receive the dividends and interest cash flows from the securities. Lenders of securities are often hedge funds or other large institutional investors of equities. Securities are held in street name accounts to make them available for lending to traders who want to short stocks. Fixed income securities lending typically involves the loan of Treasury securities for cash. The cash is invested in a higher risk bonds and the investors objective is to earn the spread between the two.
Total return swaps. In a total return swap (TRS), one party pays a fixed fee in exchange for the total return (both income and capital gains) on a reference asset, typically a stock. The advantage is that the party paying the fee can earn the return from the underlying asset without owning the asset. The party providing the return (such as a hedge fund) is, in essence, short the asset.
Professor’s Note: Securities lending, like repurchase agreements, are often structured as sales o f securities, not loans o f securities, so the holder o f the collateral can rehypothecate the securities, or even sell them in a timely fashion i f the loan is not repaid.
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
L e v e r a g e R a t i o a n d L e v e r a g e E f f e c t