The swift implosion of MF Global highlights a common practice used by aggressive speculators, one that experts say makes the broader financial system vulnerable to another crisis. It's called rehypothecation, and it allows a firm to essentially pledge the same limited collateral to arrange fresh loans.
MF Global is believed to have used client funds as collateral to borrow money to make bets on the risky sovereign debt of Portugal, Spain and Italy, leading to a daisy chain of securitization, Thomson Reuters Business Law Currents reported. It's akin to using a single home as collateral for several loans and then investing that money to earn dividends before payments are due on the loans.
In recent weeks amid the turmoil of the debt crisis, European banks appear to be taking measures to restrict their exposure via these collateralized loans made through rehypothecation and have shortened the daisy chains of loaned securities. Clamping down on lending, they have instead deposited assets at the European Central Bank where the assets cannot be recommitted, Bloomberg reported on Thursday. They kept an average of $356 billion at the central bank over the last 20 days, nearing the record high from July 2010.
But the overall value of collateral made available through rehypothecation is $5.8 trillion at the 14 largest securities dealers, according to November figures from the International Monetary Fund.
MF Global's London-based subsidiary had sold or repledged $16.1 billion in customer collateral as of March 31, 2011, according to accounts filed by the firm. Its use of rehypothecation is now being closely examined by bankruptcy trustee James Giddens, according to his spokesman.
Before declaring bankruptcy, MF Global held about $6.3 billion in sovereign debt from struggling European countries, which is equal to almost five times the firm's net worth of $1.23 billion at the end of September, according to its own filings. With $41 billion in assets, the company was skating close to the edge: If any of those assets, including overvalued sovereign debt, slipped in value by more than 3 percent, the company's equity would be erased.
Several former MF Global brokers in the United Kingdom did not return calls and emails for comment.
The greatest financial disasters in recent history -- the collapse of Lehman Brothers in 2008 and the Long Term Capital Management (LTCM) fiasco in 1998 -- both involved rehypothecation, although they differed in many ways from the MF Global situation. As the housing crisis mounted in the summer of 2008, hedge funds and other investors had difficulty getting their money back from Lehman because the bank had rehypothecated the funds, using its customers' collateral as security for its own debts. And when hedge fund LTCM found itself exposed during the Russian debt crisis in 1998, fund investors had a hard time retaining their money due to LTCM's reliance on rehypothecation.
"It makes no sense to use the same collateral for more than one investment unless it's virtually certain that the single collateral is large enough to make whole all of the counter-parties for multiple smaller investments," writes Kelly Jones, a financial adviser with his own investment services firm, in an email to The Huffington Post. But "that's generally not what's done at all -- leverage is maxed, opening the possibility of major collapses when business confidence and the economy pulls back, as happened in 2008 and with MF Global."
Although most investors know little about rehypothecation, it has been going on for decades, explains James Allen, the head of capital markets policy at the CFA Institute. The MF Global collapse "brings to light that this is still an issue," he says. "It is a means of increasing leverage, and anytime you increase leverage, you increase system risk."
The practice may represent a systemic risk depending on how it's employed, says Stanford Business School professor Darrell Duffie. "A significant amount of hedge fund assets are placed at prime brokers, and they are able to post those to other market participants. Normally, that works pretty well -- until hedge funds pull out." Duffie emphasizes that rehypothecation is commonly "done within limits that preserve the liquidity of the broker and protect client funds."
Asked if rehypothecation represents a systemic risk, one Wall Street lawyer quips, "Does the sun rise in the east?" The veteran attorney, who declined to be named at the risk of offending his clients, says that the practice is quite common, citing examples of brokers who used customer money as collateral to make bad bets on Greek sovereign debt. "I know so many people on Wall Street who are like, 'How do we lever it back so we don't get caught?'" he says
Over the last decade, the practice has become riskier due to looser regulations. In 1934, U.S. lawmakers limited rehypothecated funds to investments in U.S. Treasury, state and municipal instruments, but those rules were relaxed from 2000 to 2005, allowing brokers to use client funds to make riskier bets on foreign bonds and sovereign debt.
And in late 2010, the Commodity Futures Trading Commission proposed changing one of its regulations, known as Rule 1.25, to restrict firms like MF Global from investing their customers' funds in risky sovereign debt. But Jon Corzine, then CEO of MF Global, and his team vigorously fought the change, meeting several times with CFTC Chairman Gary Gensler to express their opposition, claiming that the proposed revision would restrict the firm's profits. The CFTC temporarily postponed the change.
But existing U.S. limits on leverage -- a firm's ratio of debt to liquid assets -- still frustrated MF Global in its desire to take big bets on sovereign debt. So the firm exploited a back door channel also used by Lehman Brothers by relying on its subsidiary in the UK.
In the U.S., a prime broker may rehypothecate assets to the value of 140 percent of the client's liability, but in the UK there is no limit on the amount that can be rehypothecated. As a result, London has become the hotbed of such activity, with 20 percent of the world's hedge fund managers registered in London at the end of 2010, according to the IMF. To get around the U.S. rules, American brokers move their clients' assets to a British subsidiary, which is what Lehman Brothers did in 2007 and 2008.
After the London-based Financial Products division of AIG nearly destroyed the insurance behemoth in 2008 by selling $2.7 trillion of insurance on overvalued securities, U.K. lawmakers vowed to change things. "We must not allow London to become a bolthole for companies looking for a place to conduct questionable activities," said Conservative Party treasury spokesman Philip Hammond.
Duffie, the Stanford professor, says he has proposed additional liquidity requirements to limit the ability of prime brokers to fund themselves on client assets and new rules to require the operational, rather than just legal, segregation of customer accounts.
Rehypothecation has been practiced for decades, but the systemic risks grow as the leverage increases. At the height of the financial crisis, the credit multiplier was 4, according to the IMF, and $1 trillion in hedge fund assets had been transformed into $4 trillion of pledgeable collateral at banks. The problem comes when everyone wants the money back.
Many of Wall Street's most prominent players "have been piling into re-hypothecation activity with startling abandon," reported Thomson Reuters Business Law Currents, essentially creating "what may be the world's largest ever credit bubble." Among them are Goldman Sachs ($28.17 billion rehypothecated in 2011), Wells Fargo ($19.6 billion), JPMorgan ($546.2 billion) and Morgan Stanley ($410 billion).
More alarming is the lack of transparency about such rehypothecations, which are off-balance-sheet transactions. Because they don't appear on a firm's ledger of revenues and expenses, a significant amount of liability may be hidden. Thus, it is not clear how much in rehypothecations is tangled up with risky sovereign debt. U.S. banks hold $181 billion in the sovereign debt of Greece, Ireland, Italy, Portugal and Spain, according to the Bank of International Settlements, but that total does not include off-balance-sheet transactions.
In the wake of the MF Global fiasco, Wall Street firms are scrambling to reduce their exposure to Euro debt and to show that their use of rehypothecation has been prudent. When ratings firm Egan-Jones warned that Jefferies investment bank could be at risk due to its European exposure, CEO Richard Handler cut the firm's exposure to the debt of Greece, Ireland, Italy, Portugal and Spain in half and claimed that its leverage had been decreased from 12.9 to 9.9, Forbes reported.
Soon after the MF Global bankruptcy made headlines, Ray Unger, chairman of Forward Investment Advisors in Madison, Wis., warned investors about the dangers of rehypothecation, advising them to ask their brokers if their portfolio can be accessed as collateral for their brokers' investments.
Unger blames the current regulatory regime for not effectively enforcing the rules. "They missed Bernie Madoff, Allen Stanford and now Jon Corzine. They're allowing people to run roughshod over the regulations," he says, complaining that the Dodd-Frank financial overhaul provides an illusion of safety without doing much. As for the CFTC's new MF Global rule, which largely prevents brokerage firms from using client funds to buy foreign sovereign debt, he calls it "locking the barn door after the horse has been stolen."
One of MF Global's highest-profile and most outspoken clients, Gerald Celente, director of the Trends Research Institute, claims that his gold futures account was frozen and hit with a margin call (when a broker demands that an investor deposit additional money to bring his account up to a minimum level) despite being fully funded. The longtime investor says that he is so upset about the experience that he will never trade again.
"No one's money is safe," says Celente. "A month ago, no one had ever heard of rehypothecation. Now everyone knows: It's a scheme by the banks to squeeze as much money out of you as they can."
A timeline of MF Global's collapse:
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