Variation margin: deep history Pt 2

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This is part 2 of an essay. Here is variation margin: deep history part 1. There will be a third.

Refresher

Prompted by the simple question “why do Americans prefer collateral pledges and Brits prefer title transfer collateral?” we were talking last time about the difference, in the JC’s argot, between “collateral” on one hand and “security” on the other.

In this sense, “collateral” is something you give bodily over to your creditor. “Security” is an enforceable legal promise you make over assets you keep hold of yourself.

These are quite different modes of performance assurance. They have different effects when it comes to doing the two things any lender cares about: managing the debtor’s credit risk and managing the creditor’s cost of funding the debt.

Another quick definition pit-stop: I sometimes refer to “borrowers” and “lenders” here, but more properly I should say “creditor” and “debtor”, because the same principles apply whether you have extended a formal “loan” or you are simply owed money under some other credit arrangement. A swap, for example, is not a formal loan, but any mark-to-market exposure under a swap, economically, is the same as a loan: specifically, like an overdraft, with a fluctuating balance accruing interest at a floating rate.

Now, since, when discussing loans, most lawyers rarely think past credit risk, we spoke a bit about the seldom discussed but vital, business of funding optimisation. We will do a bit more of that in this episode.

Along the way we will encounter Shylock, Spinal Tap, the Osmonds, the widow Herring, a nice fish restaurant overlooking a beautiful lake in the Ostallgäu and a resourceful young private in the house band of the 101st Airborne by the name of James.

Dans une coquille de noix

In part two of this essay I will trace the development of financial collateral from pure credit mitigation — from no collateral to customary liens to pawnbroking arrangements — to modern margin arrangements which introduce an important new feature: funding cost management. How can a creditors use collateral posted them to offset or optimise their costs of funding their exposure?

For most of history, security interests and even possessory collateral served only the purpose of credit protection. Funding management couldn’t come into it because the assets involved were unique, illiquid, or both. The creditor was obliged, therefore to just sit on them.

But just sitting on productive assets and not using them is a cost and a missed opportunity in any business. Finance is no different. We will see how as fungible, liquid financial instruments emerged in the 19th century, institutional creditors began to monetise their collateral portfolios, converting them, temporarily, into cash. The modern derivatives market developed out of that capability.

Though we started looking purely at collateral arrangements established to offset the risks and costs of extending credit, we will pause to notice how these arrangements resemble, very closely, other kinds of financial transaction in the market place. There is a sort of fractal similarity here. This idea of funding optimisation is embedded in every aspect of the financial markets.

But let’s not get ahead of ourselves. Let’s start at the beginning. There’s a good play about this.

Play the movie. Ja. Play.

Collateral as a credit tool

A pound of flesh?

Shylock: But ships are but boards, sailors but men; there be land rats and water rats, water thieves and land thieves—I mean pirates—and then there is the peril of waters, winds, and rocks. The man is, notwithstanding, sufficient. Three thousand ducats. I think I may take his bond.

The Merchant of Venice, I, iii

Shylock, you may remember, could not take collateral, or security, but had only Antonio’s word as his bond: Antonio was, in the vernacular, “expectation-rich, but asset-poor”: all his worldly possessions were out and about, on the water, in pursuit of riches but at the mercy of the land rats and water thieves of the seven seas.

Shylock was right to have been worried. It all went horribly wrong for Antonio as buccaneers on the high seas laid low his assurances. It hardly worked out any better for Shylock — xenophobia and the finer points of Venetian contract law — did for his, but at least drama fans got a pleasant evening out if it. But all this — well, drama — for the want of tangible performance assurance.

The famous “pound of flesh” is a kind of security, but it is not “collateral”. We could, therefore, regard The Merchant of Venice as a morality play about the danger of uncollateralised lending.

But collateralised lending goes way back before Shakespeare’s time, of course.

Collateral 101: credit risk

From the dawn of history — as Nigel Tufnel might say, hundreds of years before that — private lending arrangements have involved credit risk. That is their fundamental wager: I lend you money; you spend it. I hope you are wise enough, and honest enough, to give it back.

The amount a debtor pays for the privilege of obtaining credit represents two things: the “time value” of the money borrowed — the opportunity cost of extending credit to this debtor and not using the money for something else — and a “credit spread”: a “premium” representing the creditor’s assessment of the risk the debtor won’t pay it back.

Whether a debtor repays depends firstly, on its honesty and secondly its solvency: its general business acumen over the period of the loan. This is a matter of a creditor’s personal faith: credit is, literally, latin for “he believes”.

Credit risk is not hard to get your head around, and lawyers spend an awful lot of time worrying about it.

Traditionally, there are three ways to manage it: by taking “security”, by taking “collateral” or by obtaining “sureties”. A quick reminder: I treat these three concepts as mutually exclusive in a way that does not really reflect common usage. Lawyers are oddly casual in their terminology here.

Security

Creditors can take security — the debtor grants the creditor abstract legal rights over some of its assets, but continues to hold and use those assets. For example, a mortgage. The debtor lives in the house, but if she does not keep up her payments, the creditor can turf her out and sell it to recover its debt.

Collateral

Creditors can take collateral — the debtor physically delivers assets to the lender for safekeeping, as a bond against repayment. For example, a pawnbroking arrangement. The pawnbroker holds your asset until you repay your loan, and can sell it if you don’t.

Sureties

Creditors can take sureties — a trusted third party underwrites the debtor’s obligation to the creditor. A guarantee or a letter of credit. I mention sureties for completeness: I am not going to dwell on them as they aren’t really practical funding mitigants.

I don’t want to get ahead of ourselves, but in the 19th century creditors began to look for ways to reduce the absolute cost of money they were lending, and wondered whether their credit mitigation arrangements might help.

Physical collateral: liens and pledges

Taking physical collateral against a debt obligation is as old as civilisation. Its simplest, most customary form is the lien.

Liens

Liens are “customary” in the sense that they did not grow out of some brilliant legal innovation but were an existing cultural practice that the law simply recognised. A lien is the original “self-help remedy”: oh, you want your watch back? Pay your bill.

Possession is nine-tenths of the law. Liens are all about possession. They arise automatically and without formality: when you take your car in for a service, the mechanic can hold onto it until you have paid your bill. Say, after an agreeable meal at the delightful Fischerhütte in Hopfensee, you are caught short. The proprietor points to your watch as a condition to letting you out the door.

This is mostly an honesty play, rather than a solvency one: what matters isn’t the watch’s realisable value so much as its value to you, and the hassle of having to replace it. Herr Fischer has very little interest in selling your watch: he is in the business of serving up Zanderfilet mit frischen Kräuter-Rahmschwammer rather than hocking off collateral to settle his debts: he just wants his punters to enjoy their perch and pay their bill. It is very good by the way.

Primarily, liens are a practical lever to make sure debtors do the right thing. They are an assurance mainly, of honesty. They not a great mechanism for recovering debts if they don’t. Hence — as with a mechanic’s lien over your car — the collateral value is often out of all proportion to the debt. The practical value of a lien is its awkwardness. Even a bankruptcy administrator will find it financially expedient to settle the lienholder’s bill — or walkaway altogether — than challenge the effectiveness of a lien.

We can see here the power of sentimental value. It brings the borrower back to the table regardless of any rational assessment of value the collateral. But you can take it a bit far:

The original human shield

A quick amusing sidebar, for which I am indebted to regular correspondent Mr. Johnston, who is a bottomless source of such ribaldry: the old case of Herring v Boyle (1834) 1 CM&R 378. It concerns a schoolmaster, Boyle, attempting to extract school fees from a widow, Mrs. Herring, for the education of her 10-year-old son. On Christmas Eve Mrs. Herring arrived at Mr Boyle’s school to collect her lad for the holidays. At the time she was up-to-date with her fees, but a new instalment was due the following day. Fearing he might not see the pair again, Boyle took an imaginative, if idiosyncratic, approach to the situation. In effect, he asserted a lien over the lad. You may have your son, said he, once you have settled your fees. Mrs. Herring was, at that moment, indisposed.

Denied his Christmas hols, Herring Minor sued. The headnote from Crompton, Meeson & Roscoe’s law report is entertaining:

The plaintiff, who sued by his next friend, was an infant about ten years old. He was placed by his mother, who was a widow, at a school kept by the defendant at Stockwell. The terms of the defendant’s school were twenty guineas a year, payable quarterly. The first quarter; which became due on the 29th of September, 1833, was duly paid. On the 24th of December in the same year, the plaintiff’s mother went to the school and asked the defendant to permit the infant to go home with her for a few days. The defendant refused, and would not permit the mother to see her son, and told the mother that he would not allow him to go home, unless the quarter ending on the 25th of December was paid.

We must at any rate take our hats off to Mr. Boyle’s Dickensian Christmas spirit. Especially since the debt had not even fallen due. Sadly Herring minor argued the case as a trespass to the person and not an unenforceable lien so Mr. Boyle was denied the opportunity develop new jurisprudence of customary possessory security interests over natural persons.

It would have been fun to see what happened had Mr. Boyle tried to repo young Herring into the chimney-sweeping market.

Come to think of it, that is more or less the plot of Oliver Twist.

Pawnbroking and the third stone from the sun

Anyway. Let us move from unrealisable liens to realisable ones. These we see in the context of pawnbroking. Pawnbroking has something of a rock ’n’ roll flavour to it, as Major Charles Washington of the 101st Airborne division recounts in this great story about about one of his paratroopers, one Private Hendrix:

As you know, Jimi was a left-hand player. That being the case, he would have to string his guitar with the strings upside down, the heavy strings in reverse of what they normally should be.

This was okay in itself, with the one exception: Jimi, somehow, would always manage to pawn this guitar before a gig. And of course, the band would have to go re-pawn it, repossess it.

Nothing else could be used. Of course, he had to have this specific guitar. And I think he played this particular angle against the band.

As an aside this is quite clever financial structuring by Private Hendrix. In essence he is extracting cash upfront monetising his own performance by having his bandmates redeem his loan. Whether they set that off against his gig fees is not reported.

In the context of pawnbroking, the liens is more formal. Here you hand over your Stratocaster strung upside down for a m—g genius explicitly as collateral for a short-term loan.

Pawnbrokers double as second-hand stores so, unlike restaurants (and school masters) they have a ready-made mechanism for quickly realising the value of collateral assets. And they will use it. As long as it complies with the consumer credit regulations — which tend to focus on the terms of the loan rather than the terms of security enforcement if it is not repaid — the pawnbroker has little incentive to obtain a price much higher than the debtor’s accrued liability.

Here are all the elements of a modern collateral arrangement, but one: A money debt advanced against bodily delivery of a valuable asset — a Stratocaster strung upside down for a m—g genius — for safekeeping. Legal title does not (at first change) hands: if all goes well the broker must return the asset to its owner (Private Hendrix) upon settlement of the debt (in this case, by Major Washington on Private Hendrix’s behalf). Private Hendrix remains legal owner of the asset throughout.

The one missing element is that the pawnbroker may not deal with the collateral asset in the meantime. It must look after it throughout the term of the loan. It might sound obvious, but the broker cannot, until the loan defaults, sell the borrower’s asset. Imagine if Private Hendrix returned, an hour before the gig, to find his Stratocaster strung upside down for a m—g genius had been sold? Actually it is not that hard to restring a Stratocaster, but it sounds like Major Washington didn’t realise this).

Why would a pawnbroker want to sell a pawned Stratocaster before the loan fell due? Well, think about funding. The pawnbroker is advancing money to Private Hendrix. It must get that money from somewhere. It must borrow it, and pay interest of its own. If only it could somehow sell Private Hendrix’s Stratocaster strung upside down for a m—g genius — temporarily, during the term of the loan, and quickly buy it back again when Major Washington came to collect it, the pawnbroker could offset its own borrowing costs. In stead of an inert asset — it may be a Stratocaster strung upside down for a m—g genius but to a lender it is still a dead weight — it would have more money to make more loans to other borrowers.

Aside from the fact that that just is not the deal, a few things make this hard: a pawn loan is typically short, the pledged assets are typically hard to buy and sell quickly, and each asset is unique: this Stratocaster, however it is strung, is not identical to that one: Major Washington wants Private Hendrix’s original Stratocaster back.

The pawnbroker leaves quite a bit of money on the table, therefore. Its funding position is not “optimised”.

For the longest time, this was simply the deal. If you want to finance assets you need an independent source of funding. The assets have to just sit there, inert.

But as they self-organised and formalised over the 19th century, the financial markets would change all that. With a heavy heart we are now going to leave Private Hendrix behind and turn to the financial markets.

The emergence of the monetisable asset

Enter the financial markets

Over the course of the 19th century, financial markets in the western hemisphere evolved from informal wagers in smoky coffee houses to organised venues where traders in silly blazers would gather to buy and sell financial instruments, shouting odd things, pulling odd faces and giving each other odd hand signals. Legal systems developed increasingly sophisticated means of granting security like debentures, pledges, charges, floating charges, equitable assignments and trusts.

At the same time the emerging classes of financial instruments, bonds and shares especially, presented new opportunities. They were different from the sorts of assets a pawnbroker might take in.

It is a bit unfortunate that the market settled on a misleading label for these instruments: “securities”. This is confusing, because on the whole, they are not “secured”: they offer no better “security” than any contractually binding promise to pay. One class — shares — do not even do that. Since we are talking here about “security” in the strict sense, I will avoid using the same word to describe “unsecured financial instruments”.

“Instruments”, I know, sounds old-fashioned, but it has the advantage of being clear.

The value of a financial instrument lies in its nature as an abstract legal construct. Financial instruments are, in essence, carefully articulated, transferable promises. Because the whole point is to syndicate a big borrowing amongst a large number of small investors, and to let them trade between themselves, an issuer’s financial instruments tended to be subdivided into series of small, identical instruments.

Financial instruments don’t depreciate the way conventional assets do. Indeed, they appreciate. Being abstract legal rights, you can’t prang them. They won’t rust, break, malfunction, or go off. Individual instruments in a series remain materially identical to each other throughout their term. There are no-individual vicissitudes that mean this instrument is in “immaculate condition” and that one is merely “acceptable”. They are identical: in legal lingo, instruments of a given series are inherently “fungible”.

And there was a liquid market where these instruments could be bought and sold every day.

So collateralised lenders might have been forgiven for thinking:

Hang about. I have a big portfolio of assets various people have given me as collateral for all my loans. Now, on any day, loans and borrowers may come and go, like tears in rain, but the ongoing value of my collateral portfolio remains pretty stable. And this collateral is comprised of financial instruments. These are useful assets, yet here I am just sitting on them. That costs me money, in custody and clearing house charges. And while I sit on them, these assets are not working for anyone.

This feels like — opportunity.

Optimising funding

Somewhere out there, lenders pondered, there must be a way of working this to an advantage. If only we could somehow use the collateral assets we have been pledged. If only we could raise money against them. If we could do that, we could dramatically reduce our lending costs. We could shrink our balance-sheet. We could create space for more loans.

If a lender could sell the collateral asset on receipt — covert it immediately into cash — and then buy a fungible equivalent asset back at maturity, the lender wouldn’t need to borrow the money from its treasury departments at all: as long as it was quick and juggled expertly, its collateralised lending book would “self fund”: the lender would raise the money it needed to lend by “monetising” the collateral provided by its borrowers.

Self-funding loans from pledged collateral: now wouldn’t that be a fine thing?

So there we have it: fungible instruments and liquid markets finally solved the pawnbroker’s ancient problem. Lenders could now monetise collateral portfolios, achieving the self-funding loan. Over time, derivatives markets evolved the structures to capitalise on the unique properties of financial instruments as collateral assets.

But this financing logic doesn’t just apply to explicit loans and collateral arrangements. It applies to the swap transactions themselves.

And here we are going to leave it, until next time.

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