Modern Market Alchemy Explained: Converting Junk Debt Into Supersafe Treasuries Out Of Thin Air

From Zero Hedge:

When it comes to the actual functioning of capital markets, there is always much confusion within the made for TV punditry for one simple reason: the number of people who truly understand collateral transformation courtesy of the shadow banking system, which until recently was a massive $23 trillion off the books repository of everything the banks did not want you to know about, can be counted on one hand. That certainly would explain the existence of such media trolls as "conscientious" NYT columnists, and various three letter "modern" theories explaining how money would work in a world if only all practical reality was removed.

And while we have previously explained extensively how it is that what actually happens behind the scenes is so very different from what most believe is market reality, especially with our three+ years series on shadow banking, confusion is still rampant. Which is why we hope an extract from Fed Governor Jeremy Stein's speech titled "Overheating in Credit Markets: Origins, Measurement, and Policy Responses", will finally make it sufficiently clear that when it comes to shadow banking collateral transformations, modern day alchemy does in fact work, and one can transmogrify junk bonds into Treasurys with the wave of a magic (yield) wand.

From Fed's Stein: "The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade."

Thanks to the magic of FAS 140 banks can literally transform worthless garbage into supersafe Treasurys, then use that newly transformed collateral via further repo as cash to fund simple stock purchases, and at the end of the day nobody knows where the exposure came from, who the counterparty is, and what the ultimate liability is!

And that is why in the current market, the Fed has no choice but to keep the music going, because while an unwind of traditional liabilities will result in a maximum collapse of some $13 trillion in conventional financial liabilities, it is the $15-20 trillion in shadow banking exposure which nobody knows about except for the banks themselves (we hope), and which allows banks and hedge funds to literally create purchasing power out of thin air, that once the house of out of control deleveraging cards starts falling, it is truly game over.

http://www.zerohedge.com/news/2013-02-07/moden-market-alchemy-explained-converting-junk-debt-supersafe-treasurys-out-thin-air