Paul Mylchreest: Gold Collateral: Could the Post-Lehman Reflation be Reaching its Limits?

silver break freeThe greatly under-reported repo market sits at the centre of the banking system and the securities markets.  It is a primary source of leverage and, therefore, risk. Time after time, the risks remain hidden until events cascade beyond the point of no return.  Stability in the repo market depends on confidence in repo-counterparties (which can evaporate at near light speed, e.g. Lehman, Bear Stearns, MF Global and LongTerm Capital Management), confidence in the valuation of collateral used in repo loans (remember sub-prime etc) and a sufficient pool of acceptable securities (e.g. Treasuries, MBS, etc) which can be pledged as collateral.
In stressed market conditions, liquidity crunches, declining collateral values and re-hypothecation (i.e. re-useof the same securities as collateral by more than one party) can undermine this market. This results in capital being wiped out, a run on collateral and the telltale sign of spikes in “fails-to-deliver”, when a scramble to post eligible securities ensues.
A surging gold price, backwardations and shortages of physical bullion are proverbial “canaries in the mine” regarding an overstretched system.

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