Lesson 21 of 25 · 7 min

Contagion through shared collateral

Your exposure to strangers is not in your portfolio but in how much of theirs looks like yours on one book.

Two accounts with no relationship, no common owner and no knowledge of each other can be tightly linked. The link is a security they both hold and a lender that values both of them from the same closing price.

Popular collateral is popular for a reason, and the reason makes the problem worse. The names that appear in the largest number of pledged accounts are the large, liquid, generously credited ones, precisely because those are the names a schedule advances most against. So the pool of pledged collateral is far more concentrated than any individual account in it, and the concentration is invisible from inside any single account.

Illustratively: 1,540 pledged accounts, of which 61 percent — 939 accounts — hold the same three names, with an average of $214,000 of exposure to them. A 19 percent fall in those three removes $214,000 times 0.19 times a 55 percent advance rate, which is $22,363 of lending value per account and $20,998,857 across the book, from a move in three securities.

A second channel runs through the lender rather than the market. Track 8 lesson 12 notes that institutions monitor total exposure to each issuer across the whole lending book, and that an issuer approaching an internal ceiling triggers a review of every account holding it. That trigger is generated by other people's holdings and it reaches your account, which makes it the one review an account can neither cause nor avoid.

Put the two together. If 14 percent of those 939 accounts had less headroom than $22,363, that is 131 accounts in shortfall on the same morning, and their cures are sales of the same three names. A well-diversified account can be standing in a crowd without any way of seeing the crowd, because the crowd is a property of the lender's book and not of the portfolio.

Key terms

Overlapping portfolios: Unrelated accounts holding the same securities. The channel through which one account's forced selling reaches another's collateral value.
Collateral pool: Everything pledged across a lender's whole book. Much more concentrated than any single account in it, because schedules favour the same names.
Common holding: A security appearing in a large share of pledged accounts. Its price move produces simultaneous, correlated shortfalls that no single borrower caused.

Worked example

One move in three names, across a whole book

Illustrative figures. 1,540 pledged accounts, of which 61 percent hold the same three securities, averaging $214,000 of exposure at a 55 percent advance rate. Those three fall 19 percent.

Accounts affected: 939
Lending value lost per account: $22,363
Lending value lost across the book: $20,998,857
Accounts with less headroom than that: 131
What those 131 accounts then sell: The same three names

Three securities moved and a hundred and thirty-one unrelated accounts had to act on the same morning, in the same names, against the same order books.

Check yourself

A lender has 2,150 pledged accounts, 48 percent of which hold the same two securities with an average exposure of $168,000 at a 60 percent advance rate. Those securities fall 23 percent. How much lending value does the book lose?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.