One of our regular contributors chatted with a reporter at a major financial media outlet who was frustrated that management was not willing to let him dig into open mysteries from the global financial crisis. Fortunately, the Financial Times takes a broader view, and Gillian Tett today focused on a recent IMF report that describes how rehypothecation blew up the shadow banking system to an even bigger size than experts realized.
While Tett provides a decent recap of the paper by Manmohan Singh and James Aitken, “The (sizable) Role of Rehypothecation in the Shadow Banking System,” I suggest you read it, since it’s relatively short and very informative, and a couple of key issues get short-changed in Tett’s summary.
Despite its daunting name, rehypothecating is not that hard to grasp. Imagine you operate a pawn shop. People bring things that are valuable and leave them with you as collateral for loans. In rehypothection, you as the pawn broker have gotten permission from the people who have provided their assets to you to take them to another pawn broker and get a loan from them.
You can already see this sounds dodgy. How many times might your gold watch be passed from pawnbroker to pawnbroker? And if the pawnbrokers were each willing to lend a high percentage of its market price, the loans made against this one watch could easily exceed its value.
The irony is that the US recognized the potential for abuse with rehypothecation long ago and provided for strict limits during the Depression. The Securities Exchange Act of 1934 limited the level of rehypothecation to 140% of customer loan balances. The rest of the assets must remain in a segregated account. By contrast, as Singh and Aiten remind us, there are no restrictions on rehypothecation in the UK and no customer protection laws (the US also has SIPC to provide some restitution in the event of a broker-dealer failure). The lack of restriction in the UK allowed hedge funds and dealer prop trading desks to achieve higher levels of leverage, but left many funds badly exposed when Lehman’s London operation, which had rehypothecated customer assets, collapsed. Needless to say, that mess has made participants a good bit more careful, with the result that the paper estimates that the total amount of assets that were permitted to be pledged fell from $4.5 trillion at the end of 2007 to $2.1 trillion at the end of 2009.
Note that rehypothecation is a source of funding to dealers (remember, if your pawnbroker can get a loan against your watch, he can use it to fund his business). The authors thus revised their previous estimates of the size of the US shadow banking system higher:
Note that $10 trillion peak figure. That’s roughly the size of the official banking system.
Any wonder why we had a crisis? We had a parallel financial system, which was not only largely unsupervised, but more important, had virtually no equity behind it. It was bound to implode when a meaningful shock hit. Get a load of this:
Discussions with collateral teams at large banks suggest that about $1 trillion of the market value of securities of the global hedge fund industry was rehypothecated, as of end-2007. Of the total pledgeable collateral of $10 trillion received by the large ten global banks that appears in their financials (via securities lending, repo and prime brokerage), about 40 percent came from hedge funds prior to the crisis; the rest of the collateral was largely posted by banks to each other to take advantage of their respective funding specialization.
40% ($10 trillion)
Churning factor of collateral =appears in their financials (via securities lending, repo and prime brokerage), about
40 percent came from hedge funds prior to the crisis; the rest of the collateral was largely
posted by banks to each other to take advantage of their respective funding specialization.
Churning factor of collateral =40% ($10 trillion)/ $ 1 trillion= 4
Papers like this illustrate why we need to keep shining a light on the crisis, since it serves the interest of the industry to move on and keep leverage mechanisms like this intact. The authorities in the UK, despite widespread recognition of how rehypothecation made the Lehman bankruptcy a huge problem for exposed customers, have taken no action. If the paper stirs up enough discussion, perhaps they will feel compelled to act.