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Revisiting Rehypothecation: JP Morgan Markets Its Latest Doomsday Machine (or Why Repo May Blow Up the Financial System Again)

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Yves here. One of our ongoing frustrations at NC is when the media and blogosphere get up in arms about what we think are secondary issues.

We’ve been loath to comment on a Thomson Reuters article that claimed that rehypothecation of assets in customer accounts was the reason MF Global customer funds went missing. The reason we’ve stayed away from this debate is that the article, despite its length, did not provide any substantiation for its claim. While it did contend that US customer accounts were set up so as to allow assets to be rehypothecated using far more permissive UK rules, and described how rehypothecation could be abused, it did not provide any proof that this was what took place at MF Global. Note that this does NOT mean we are saying that rehypothecation did not play a role, merely that the article was speculative.

The bombshell testimony of CME chief Terry Duffy yesterday, that a CME auditor heard an MF Global employee say that “Mr Corzine was aware of the loans being made from segregated [customer] accounts,” suggests that some of the money went missing via much more straightforward means, namely, taking it and hoping to be able to give it back if the firm survived.

But there is plenty of reason to be worried about rehypothecation. Richard Smith, in a post last January, described not only how rehypothecation played a major role in the last crisis, but also waved a big red flag regarding JP Morgan’s push to promote unrestricted rehypothecation.

And it may be completely unrelated to the issue of collateral, but consider this tidbit from the Financial Times yesterday:

Separately, in a court filing, James Giddens, the bankruptcy trustee of MF Global, said that “certain” actions of JPMorgan Chase, a lender to the collapsed company, “are likely to be the subject of investigation”.

Given that it was JP Morgan withholding cash and collateral that struck the fatal blow to Lehman, one wonders if we’ll find a similar aggressive move as a contributor to the scale of MF Global customer losses.

We thought the earlier Richard Smith post would again be of considerable interest to readers.

By Richard Smith

Readers of ECONned will be very familiar with the name of Gary Gorton, author of ‘Slapped in The Face by the Invisible Hand’, which explores the relation of the so-called shadow banking system to the financial crisis. His work is pretty fundamental to understanding some of the mechanisms which made the crisis so acute. Now he’s done an interview, which I would like to have a growl at; but first, he has some basic points about shadow banking, useful later in this rather long post. Gorton explains repo thus:

You take your $200 million to the bank, to Lehman Brothers, say. You deposit it, so to speak, overnight so you can have access to it the next morning if you want to. They pay you 3 percent. And you want it to be safe, so they give you a bond as collateral. But Lehman earns the interest on the bond, say, 6 percent.

..and then “haircuts” (an extra margin of security in case that bond isn’t so safe after all):

There may be a haircut. If you deposit $100 million and they give you bonds worth $100 million, there’s no haircut. If you deposit $90 million and they give you bonds worth $100 million, then there’s a 10 percent haircut.

…and then “rehypothecation”:

If you put a dollar in your checking account and the bank has to keep 10 percent of it on reserve, they lend out 90 cents. Somebody deposits that 90 cents, the bank can lend out 81 cents (because of the 10 percent reserve requirement) and so on. So you end up creating $10 of checking accounts for $1 of demand deposits, assuming there’s a demand for loans…And that can happen in repo as well because if you’re Lehman and I’m the depositor, and you give me a bond as collateral, I can use that bond somewhere else. So there is a similar money multiplier process.

…and finally the link to regulated banking:

And shadow banking very importantly is not a separate system from traditional banking. These are all one banking system.

So much for the preamble. The other point you need to know: we are talking about an unregulated banking system that at its height was just as big as the regulated banking system, yet coupled to it, and apparently more profitable, though, as we now know, much riskier. Now we get to the part of Gorton’s interview that I’m not so happy with:

In summary, I would describe shadow banking as the rise to a significant extent of a very old form of bank money called repo, which largely uses securitized product as collateral and meets the needs of institutional investors, states and municipalities, nonfinancial firms for a short-term, safe banking product.…It’s a valuable innovation.

The bit in bold is where I raised my eyebrows. The truth of the bolded claims depends on the yet-to-be-discovered solutions to repo’s core problem, formulated thus by Gorton:

Of course, the problem with repo and shadow banking is that they have the same vulnerability that other forms of bank money have. We can talk at great length about what that vulnerability is, but loosely speaking, it’s prone to panic. Looking back at history, think about how long it took to devise a solution to the first banking panic, related mostly to demand deposits. That was in 1857. It wasn’t until 1934 that deposit insurance was enacted. That’s 77 years where we’re trying to understand demand deposits and figure out what to do.

The situation that we’re in now, seriously, is one where we are back in about 1860: We’ve just had a big crisis, and we’re trying to figure out what to do. We can only hope that it doesn’t take 77 years to figure it out this time.

That doesn’t sound like a safe banking product to me. Next comes some irritating pussyfooting:

Nobody wants to be given collateral that they have to worry about. And the mechanics of how repo works is exactly consistent with this. Firms that trade repo work in the following way: The repo traders come in in the morning, they have some coffee, they go to their desks, they start making calls, and in a large firm they’ve rolled $40 to $50 billion of repo in an hour and a half. Now, you can only do that if the depositors believe that the collateral has the feature that nobody has any private information about it. We can all just believe that it’s all AAA.

Gorton is polite, and that can mislead. Impolitely: for “private information”, read “knowledge that the collateral is wildly overvalued”, or ”aware that the collateral is backed by assets with massive gearing to fraudulent loans”. The system’s gatekeepers (originators, ratings agencies and credit insurers) had an “agency problem”, (impolitely: issued cows, or rated cows, or insured cows, for money), so the fraud-backed collateral got past them.

Gorton is vague about how this “information insensitive” collateral is to be created. Presumably the options are to have reliable ratings agencies, or some other gatekeeper on the collateral, or a very deep-pocketed credit guarantor (that’s you, dear reader), or all three. But he doesn’t quite spell it out; perhaps that’s just the interview format. What we get instead is this:

We want all securitized product to be sold through this new category of banks: narrow-funding banks. The NFBs can only do one thing: just buy securitized products and issue liabilities. The goal is to bring that part of the banking system under the regulatory umbrella and to have these guys be collateral creators.

Well, I don’t immediately see why a narrow funding bank, thus described, is a more reliable generator of quality collateral than a narrow rating agency, or a narrow monoline insurer, or for that matter, Gorton’s old client, AIG. Why would an NFB be any better than any of those organizations in filtering out low quality collateral, given the demand for collateral? The NFB has exactly the same agency problem.

And are we really sure we know what ‘good collateral’ is? Gorton’s formulation of the problem isn’t quite accurate: it’s the stability of the haircuts that matters, not the reliability of the ratings. In truth, the ’08 crisis in repo was ended by explicit and implicit government backstops. By that time: haircuts on pristine US treasuries had gone from ¼% pre crisis to 3% mid crisis; on investment grade bonds, from 1.5% or so to 10% plus. As we will see later, when there is lots of rehypothecation, those moves would matter just as much as the annihilation of triple-A CDOs. More on this later: identifying a different problem with repo is the meat of this post.

Also missing from Gorton’s picture: how much of the need for repo collateral is simply driven by the increase in OTC derivatives. According to another of Gorton’s papers, there was $2Trillion of derivatives collateral in 2007; $4Trillion in 2008. So is that why Gorton simply assumes that repo “has” to grow: to provide collateral for the OTC derivatives market? So why, then, does the OTC derivatives market have to grow? One would like to see the connection between ETFs and repo worked out by someone, somewhere, too.

Despite my whining, do have a read of the interview:  here it is again. There’s plenty more, and plenty of it is good – why Dodd-Frank is a big miss, how few data are available on the enormous shadow banking system. That’s what happens when you don’t supervise financial innovations: you don’t know what they do, you don’t know how they work, and you don’t know what went wrong. If you are in full geek mode, you can download the papers that underlie the interview here and here (I must get round to that). Metrick and Gorton write about haircuts here. That lot should keep you going…

Now I’m going to double back to something that Gorton skirts: the interaction of repo haircuts, rehypothecation and the credit multiplier. Recall his interview:

If you put a dollar in your checking account and the bank has to keep 10 percent of it on reserve, they lend out 90 cents. Somebody deposits that 90 cents, the bank can lend out 81 cents (because of the 10 percent reserve requirement) and so on. So you end up creating $10 of checking accounts for $1 of demand deposits, assuming there’s a demand for loans. Now, that money multiplier process is very important because it means that the amount of endogenously created private bank money in checking accounts is 10 times the size of the collateral, so to speak, of $1 of government money. So, in a traditional banking panic, if everybody wants their $10 back, there’s only $1. And that’s the problem.

What you have here, in the equivalent language of repo, is a 10 per cent haircut, with unlimited rehypothecation (so that you can just keep reusing the collateral to raise more and more liquidity, haircutting away until the amount you can still pledge isn’t worth bothering with), and a credit multiplier of 10. To get a general picture of how the credit multiplier, haircuts and rehypothecations tie together, we now need a tiny spot of mathematics.

An aside: one of the peculiarities of mathematical economics, as opposed to mathematics, is the relative frequency of “theorems”. In mathematics, theorems are as rare as unicorn droppings, things of near-holy awesomeness; in mathematical economics, by contrast, they occur horribly frequently, like depictions of unappealing sexual acts in the oeuvre of the Marquis de Sade.

So I should probably try to get people to give this shoddily presented and deeply unoriginal formula,

Repo Equation 1

some kind of grand title: Smith’s Unrestricted Rehypothecation Theorem, perhaps. What does it mean? It describes the relation between the credit multiplier under unrestricted rehypothecation, Cm¥, and h, the haircut, which is a value between 0% and 100%; k keeps count of the number of rehypothecations. Any charges levied for the rehypothecation are assumed to be negligible (I won’t keep saying this, but bear it in mind – it means that the credit multiplier is never quite as big as I say it is, though pretty close, because the charge for a rehypothecation is not huge). As you see, with unrestricted rehypothecation, you just invert the haircut to get the credit multiplier. That is the big picture.

So, as with Gorton’s deposit example above, if the repo haircut is 10%, the ultimate credit multiplier is 10. Which is to say: if you could rehypothecate for ever, liquidity amounting to 10 times the amount of underlying collateral would be created, if the haircut was 10%. Once again his polite example might be a bit misleading. Consider instead the effect of a haircut of just 1% – then the ultimate credit multiplier is 100. With zero haircuts and no rehypothecation charge, the credit multiplier would be infinite…

For anticlimactic comparison, Singh and Aitken estimate that the credit multiplier in force at the height of the bubble was about 4: there were $1Trillion of rehypothecable hedge fund assets, transmuted by the magic of rehypothecation into $4Trillion of pledgable collateral at banks. No cause for concern then? Well, that depends how much you enjoyed the ’08 liquidity crisis; and unfortunately, much higher levels of rehypothecation may be just around the corner, which is a worry.

To show why, we need another theorem, Smith’s Restricted Rehypothecation Theorem this time, I suppose. It’s just as banal as the other one:

Repo equation 2

This gives you the total credit multiplier Cmr, when you have a finite number of rehypothecations. The number of rehypothecations is given by r; h is the haircut again. As r tends to infinity, the first term on the right hand side of the equation tends to zero, giving you, in the limit, the Unrestricted Rehypothecation Theorem.

Now we can work out, for a range of haircuts, what number of rehypothecations it takes to give a credit multiplier. I’ll use the example of the IMF haircut table that Yves exhibits in ECONned (figure 9.4 there), assume an initial credit multiplier around 4 per Singh and Aitken, and use the rehypothecation formula to show the impact of the increased haircuts. The table is a bit rough and ready, but it gives an idea. The collateral has been rehypo’d on average just over three times, giving a credit multiplier of 4. Given the assumed proportion of each collateral type, the loss of liquidity amounts to $750 Billion for every $1Trillion of collateral (this is August ’08, is before the crisis got really acute).

Crisis haircuts 2

The estimate of the amount of each collateral type involved is pretty much a guess. If only we knew! But I hope it doesn’t matter much: the table does illustrate the point that haircuts increasing from a single digit number to 10 or more, on widely held collateral (in this example, investment grade bonds, or Prime MBS), can have just as big an effect on liquidity as total wipeouts on CDOs, or big haircuts on ABS (rightmost column, in bold).

With lots of rehypothecation, it gets worse. To get a better idea of how haircuts, rehypothecation and the credit multiplier work together, it’s time for a picture of Dragon Country.

Repo Graph

This is my two equations, graphed. Some more explanation:

  • Haircut: the 1.0 (bottom right hand corner) is of course 100% , in other words, there is no repo, and the credit multiplier is 1, so there is no effect on credit. I’ve assumed the charge for rehypothecation is negligible.
  • The thick black curving line shows the theoretical maximum credit multiplier when there is an infinite number of rehypothecations. On the basis that a 1000x credit multiplier is absurd enough, I stopped at 0.1% haircuts, though 0% haircuts have supposedly been used in repo.
  • The unimaginable top left hand corner won’t fit on the graph: a haircut of zero and an infinite credit multiplier.
  • The thin green line shows the credit multiplier for various haircuts when there are just 4 rehypothecations. You can see from the graph that this gives to a credit multiplier of around 4, for a range of haircuts from 0-20% or so.
  • The just about detectable blue curve, above the green one, shows the credit multiplier when there are 20 rehypothecations: already enough to move the credit multiplier to worrying levels when the haircut is less than 20%, and when there is only a 0.25% haircut, to an absurd 17x.
  • I’ve assumed that Q4 ‘08 is nasty enough for all of us, and that therefore an overall credit multiplier of 4 is as much as we want; so that’s where I’ve put the horizontal red line.
  • The red area is Dragon Country, where low haircuts and lots of rehypothecation result in huge credit multipliers, and very great (exponential-like) sensitivity to increases in haircuts.
  • I’ve used a logarithmic scale on the y-axis to cram the whole thing in. Dragon country would be impressively vast on a linear scale.
  • The graph shows you something else Gorton doesn’t really emphasize: the only reason to like a small haircut is to maximize the amount of liquidity you create via repeated rehypothecation.

Have I just put forward one of those daft theoretical constructs beloved of economists and technocrats? I think not, for a couple of reasons.

First, “infinite” rehypothecation just sets out a limiting case that exhibits some unfortunate but representative dynamics. It doesn’t have to be that bad to be bad. In particular, the graph highlights the critical relevance to banking stability of very small repo haircuts (and by extension, collateral ratings) and the concomitant large credit multipliers. If those ratings are volatile, haircuts are volatile, and your banking system is unstable. That combination of small haircuts and large credit multipliers may be exactly what we saw in the run-up to the crisis of Q4 ’08. It did seem to be the sudden doubts about the value of “AAA” rated CDOs that caused the initial spasm of funding difficulties before March ’08 and the Bear implosion.  But even unimpeachable collateral was tainted somehow. How did that happen? What’s to stop it happening again? Now add some counterparty doubts, courtesy of Lehman, with hedge funds deleveraging and then pulling their assets from Prime Brokers, which stops rehypothecation in its tracks, and by Q4 ’08 you are in a proper crisis. Even if the UK has better bankruptcy processes next time, they will get their first proper test live, in a crisis. There is no particular reason to expect a hedge fund to feel more confident about its UK Prime Broker next time we get a Q4 ’08.

Second, the doubts that have inhibited rehypothecation have been more about rights in bankruptcy than about the very idea of rehypothecation; but it’s rehypothecation that is the bogey. That’s not necessarily how the US lawmakers saw it back in 1934, when they capped rehypothecation in the US, as described by John Hempton, but the 1934 law helped a lot, anyway. Banks operated in London to get around the US restriction; then rehypothecation was a massive factor in the complexity of the Lehman bankruptcy, which dragged lots ($15-$45Bn, depending on how the bankruptcy plays out) of hedge funds’ rehypothecated assets into the mess; surviving hedge funds toned down their agreements to London rehypo, in a rush. But I suspect John is jumping the gun when he announces the end of the City of London; the availability of unrestricted rehypothecation is just too darned convenient, if you can get someone to do it. One notes that two years on, there is no UK reform of rehypo; yet there is consultation on reform of UK bankruptcy processes for investment banks, which might encourage hedge funds to agree again to unrestricted rehypothecation.

It also happens that JP Morgan, originators of those not unmixed blessings, Value-At-Risk and Credit Default Swaps, are thinking hard about how to get rehypothecation going in the grand style. They know a volume business with a cheap government backstop when they see one; they are on a marketing push, and presumably they have the systems and processes that go with it.

JPM is very keen to assure us and potential clients that the right business model (they think they have it) will be bankruptcy proof. So – unrestricted rehypo might breathe again, if enough London hedge funds can be reassured  by the UK treasury and by JP Morgan.

The JPM technologists are still at work, too. Rehypothecation is getting slicker, at least for banks whose custody and treasury systems aren’t a hopeless Augean mess of underinvestment, rubbish outsourcing deals, and unmaintainability. Again, see this JP Morgan offering, for an example of what they think they can do. Presumably they think that with an implicit Government backstop, it’s OK to rehypo to the max; they have a derivatives business to support, too.

That would be a Doomsday Machine: iterated rehypothecation, huge credit multiples multiples, low haircuts, and then – sudden increases in haircuts, due to some credit shock or other. Then add some derivatives margin calls arising from the same shock…

If JPM pull it off, there will be a big credit multiplier and a big area of Dragon Country for us all to visit. Replaying the ’08 repo crash with 20 rehypothecations rather than 4 gives a system that has $17 trillion of liquidity in it, pre-crash, for every $1 trillion of collateral. Apply the crisis haircuts and $8 trillion of liquidity vanishes. That is Doomsday. All it takes is some solvency doubts; the quality of the collateral makes no difference. Indeed, because of the small starting haircuts, the US Treasuries make a larger contribution to the liquidity loss, if the number of rehypothecations is larger.

Still, the rehypo graph above, and the availability of new rehypothecation systems, and JPM’s business model, charging some fraction of a bp for each rehypothecation, do suggest ways to make sure the Doomsday Machine doesn’t blow us all up, as long as regulators get a grip.

So how does one wall off Dragon Country? The ultimate objective must be a UK version of the 1934 Securities Law, which capped rehypothecation quite effectively in the US. Pending that, or as well as, some or all of the following:

  • The number of times a given piece of collateral can be rehypothecated is critical. Regulators might consider restricting it.
  • Haircuts also matter, especially when they are very small. Regulators might consider increasing the minimum haircut on rehypo’d assets. If haircuts of less than 10% were not permitted, then the credit multiplier could not exceed 10 for any repo collateral, no matter how much rehypothecation there was. If it was 20%, the credit multiplier could not exceed 5.
  • Regulators might consider eating some of, or a lot of, JPM’s lunch, by taxing each rehypothecation. The proceeds would build up a fund that provides the liquid assets needed in a crisis…something like an FDIC for repo liquidity.

But I wouldn’t hold your breath; the UK authorities’ response so far suggests that they, like JP Morgan, think unrestricted rehypothecation is a thoroughly good thing. I disagree.

UPDATE 7-Jan: Oops. I think this post overcomplicates things and has a big red herring (“rehypothecation steps”). From a leverage point of view, it’s the haircuts that matter. The ‘run on repo’ comes in two stages a) widening haircuts b) hedge funds pulling their assets from the PB. The effect of the run is magnified if the (London-style) Prime Brokerage agreement allows the PB to rehypothecate all the hedge fund’s assets.

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  1. SteveA

    Jill Summers, a CFTC commissioner, said today that CFTC ‘knows where the money went’ and ‘now it’s just [a matter of] finding out which ones of those transactions are legitimate and which ones of them are illegitimate.’

    I’ve not seen any reporting on the standard terms of MFG customer accounts, but I suspect that customers gave MFG the right to rehypothecate up to the 140% debit balance limit, and that the customers are nothing more than general creditors of the MFG estate, and that DC is terrified that the game of rehypothecation will come to a screeching halt. That scenario is worse for them than a regulatory failure to catch illegal behavior. The absolute worse case is that the investigation has turned up nothing illegal.

    1. Yves Smith Post author

      Correct, and I neglected to make that point, which is key: if the losses really were due to rehypothecation, and MF Global did paper it up more or less correctly, then Corzine & Co. did nothing wrong. You may recall that yours truly harrumphed at the CME saying to the FT a couple of days ago that MF Global broke exchange rules and that was why customers lost money. That seems awfully definitive.

      I think it is more likely that there was chicanery (one reader pointed out the CFO was ON VACATION when the firm was imploding. WTF? Standard procedure would be for her to fly in from whereverthehell she was. This does not smell right).

      Of course, with numbers this large, multiple bad things could have been done.

      1. ron

        “The New York Fed designated MF Global as a primary dealer to meet our highly specialized needs, and we followed our primary dealer policy to the letter without fear or favor,” said Baxter, in prepared testimony to a Congressional subcommittee.

      2. MichaelC

        Regarding chicanery: No one has asked,or answered the central question.

        Who was the Repo counterparty to MF Global’s repo to maturity trade that triggered the MFG meltdown?

  2. ReaderOfTeaLeaves

    Shaxson mentions rehypothication in his Treasure Islands chapter on the City of London (Corporation). He mentions it as a way to remove assets from bank balance sheets, and I interpreted that to mean ‘off the balance sheets and into the City of London centered, Shadow Banking system’.

    Bruce Krasting posted recently that he’d not heard the term till recently. I take that as more evidence this bit of financial wizardry is London(grad)based. Smith appears to confirm this..

    How key was rehypothecization to the voodoo that 400 London-based AIG employees wrought on the global financial system? Surely it was a key reason they were based in Londongrad.

    How much more evidence do we need that offshore, tax haven based ‘financial services’ –on the pretext of creating imaginary wealth — have governments by the throat?

    David Cameron has certainly been doing The City’s bidding. Hard to know what’s really motivating Clegg. Like too damn many politicians, they appear to be intimidated by this Doomsday Machine.

    We probably all need to have some better sense of how it actually functions.

    1. Bruce Krasting

      I did say recently that the term re-hypothecation was new to me.

      I like to think I understand a bit of all this, yet I was clueless as to the implications of Re-Hypo. I don’t think I’m alone. How many people out there actually understand what they have signed off on in their documents for brokerage accounts? I think only a small percentage actually understand the fine print regarding margin accounts and the use of both hypothecation and re-hypothecation.

      I believe that all brokerage account doc.s have legal language re these issues. Behind this is the Fed’s Reg. T covering margin accounts and the use of collateral.

      If we do find out that re-hypothecation (permitted under Reg. T) was the source of the commingling at MFG, then Reg. T is flawed and will have to be amended.

      Keep in mind that re-hypo is a significant funding leg for the shadow banking system. There is currently $10T outstanding in the shadow bank. And the world is already tight on liquidity….

  3. Fiver

    This is a very big deal. Though the original Reuters’ story re the precise mechanism for triggering the “disappearing” of the clients money may have been off, it was the major implications they raised given the Legalized Crime Zone that is the City of London, and the HUGE amounts of US and other foreign clients’ monies which were possibly unknowingly at risk in rough seas. Google around and you’ll find many claiming rehypothecation is already causing considerable damage to holders of paper gold, for example.

    I agree with the questions raised in this short piece on the “bombshell” Tuesday, which rightly questions whether CME’s story is necessarily entirely credible, and in particular, whether or not what was done was illegal:

    Quote from linked piece:

    “They are now saying that the information they received indicated Mr. Corzine knew about the loans, but not whether they knew these loans were illegal or improper. They cannot comment on that, they said.”

    As noted in this link, there may actually be a very big bias in favour of finding illegality. Let’s not forget the role of the Fed/NYFR in handing little MFG its exalted status while far bigger players with solid track records cooled their heels in the Not An Insider Room:

    1. reprobate

      Boy, with a comment like that, I can see why Yves is cheesed off.

      Richard puts up a great post with solid detail on rehypothecation in January. No traction. An over the top Reuters article tries to connect it to MF Global and everyone is agog.

      And you still fixate on Reuters and not the much earlier NC piece.

      1. Fiver

        And if I was not here in January, was I supposed to have absorbed it from the ether? I read the piece. I provided a comment. If to do so means being simply pissed on, I’ll note your presence on any given thread and be sure to post only things of which you approve – please provide a complete list of what that might entail, and I will aim to avoid you.

      2. Jim Haygood

        The Reuters-Thomson article cited the same paper that Richard Smith does, concerning the shadow banking multiplier:

        For anticlimactic comparison, Singh and Aitken estimate that the credit multiplier in force at the height of the bubble was about 4.

        Then it proceeded to update the potential rehypothecation exposures of some large U.S. and European players.

        While claiming that rehypo tipped over MFG is a speculation until the forensic results are in, the rest of the Thomson-Reuters article was well-researched and dovetails nicely with Richard Smith’s paper, supplementing his theoretical explanation of the rehypo multiplier with the potential rehypo pools of major players.

        ‘Over-the-top?’ Only if you’ve got an ax to grind against the Reuters-Thomson author.

        1. reprobate

          Looks a bit testy to me. Pot trying to call the kettle black?

          Over the top? I’ll bold the parts that fit the bill of “over the top,” starting with the headline.

          MF Global and the great Wall St re-hypothecation scandal

          A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients.

          MF Global’s bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous $6.2 billion Eurozone repo bet.

          If anyone thought that you couldn’t have your cake and eat it too in the world of finance, MF Global shows how you can have your cake, eat it, eat someone else’s cake and then let your clients pick up the bill. Hard cheese for many as their dough goes missing.

          The Thomson Reuters goes on like that, a combination of inflammatory language with steps down (“appears,” “may be”) and technical detail that he does not fully understand (as in, for instance, how/why the repo to maturity was off balance sheet). If the article had proved its charges, the author would be justified in using this type of language. But he didn’t! And worse, his strong-sounding presentation served to cover up the lack of proof. That is misleading journalism, like it or not.

          This matters because once people have ideas in their heads, when the information comes out it is hard to dislodge earlier impressions.

          And if rehypothecation was abused, why is no one pointing fingers at the professional dealers for signing agreements that allowed for it in the wake of Lehman? It was clear that the huge mess in London in the Lehman bankruptcy was due to permissive rules on rehypothecation. I can see retail clients being unsophisticated enough and not being able to afford good legal counsel to review their account documents, but any professional who was caught with his pants down on this one is partly to blame. This was a KNOWN PROBLEM post Lehman.

          If rehypothecation abuses really were the reason customer accounts lost money, I don’t see how you can be all that sympathetic as far as the professional money managers are concerned. They didn’t do their job in terms of being vigilant in protecting their end customer interests.

          1. Fiver

            Perhaps the answer to:

            “And if rehypothecation was abused, why is no one pointing fingers at the professional dealers for signing agreements that allowed for it in the wake of Lehman? It was clear that the huge mess in London in the Lehman bankruptcy was due to permissive rules on rehypothecation. I can see retail clients being unsophisticated enough and not being able to afford good legal counsel to review their account documents, but any professional who was caught with his pants down on this one is partly to blame. This was a KNOWN PROBLEM post Lehman.”

            is exactly the same as why there is still such a thing as a CDS trade AT ALL or any of the other garbage that is now fully embedded in the system and taken as something between “routine procedure” and a “vitally important mechanism for efficient use of capital” , or whatever, that needs (or not) a minor tweak here and there and it’s otherwise all hunky-dory.

            I note the issue of the Reuter’s article was specifically raised at the Committee hearings during the regulators’ panel. Whether it was raised intentionally in order for these bank-owned regulators to publicly demolish any “concerns” with the practice or whether to quite rightly put the spotlight on the IMPORTANT part of the piece, which is that huge sums of client money are riding on thousands of bank-enabled merry-go-round loans which if stopped for any reason at all deposits a pile of vomit in unwitting clients’ laps. You should ensure you have a shot at testifying to correct any false impressions while leaving your own as Yves’ representative, as you are so well-versed with the shortcomings of the Reuters’ piece and the stance here at NC.

  4. LucyLulu

    From November 28,

    Some industry lawyers liken JPMorgan’s role in the MF Global bankruptcy to the bank’s position in the messy collapse of Lehman Brothers, albeit on a smaller scale. As the nation’s largest bank, JPMorgan is intimately involved in many large bankruptcies. In 2008, as Lehman Brothers was struggling to survive, JPMorgan officials demanded several billion dollars in collateral to meet margin calls. Lehman acquiesced, severely draining its liquidity.

    In the case of MF Global, the process is further complicated since the roughly $200 million is believed to be in Britain, which has its own bankruptcy rules.

    Furthermore, was it a comment from a reader on your blog who had wired funds out of MFGlobal at the time of the bankruptcy, only to have it reversed the following day by JP Morgan? Sorry, I can’t remember where I read things, but FWIW, I swear I did read it.

    JP Morgan is surely involved, and if not outright illegal, has done something shady and unethical. After all, they have a reputation to maintain.

    1. Foppe

      Furthermore, was it a comment from a reader on your blog who had wired funds out of MFGlobal at the time of the bankruptcy, only to have it reversed the following day by JP Morgan? Sorry, I can’t remember where I read things, but FWIW, I swear I did read it.

      Was from a post by krasting.

      1. Bruce Krasting

        I wrote about this in this blog:

        After I wrote it, I received copies of the Canadian account forms for MFG. Follows is a copy of the relevant section for Canadian clients. Note that re-hypothecation was not permitted in Canada. Not all Canadian clients have gotten their money back, but this notice from CME suggests that many have.


        20. COLLATERAL AND LENDING AGREEMENT. All assets, property and positions that MFGFX or its affiliates carry for you (either individually, jointly with others, or as a guarantor of the account of someone else) or which may at any time be in its possession or control or carried on its books for any purpose, including safekeeping, are held by MFGFX as security and subject to a general lien and right
        of set-off for your liabilities to MFGFX whether or not MFGFX has made advances in connection with such assets, property or positions. MFGFX may, at any time, without notice to you, apply and/or transfer the assets, property or positions it holds for you between any of your accounts. MFGFX has the right to pledge, re-pledge, hypothecate, invest or loan, either separately or with the property of other clients, to itself as dealer or to others, any of the assets, property or positions it holds for you as margin or security. MFGFX shall not be required to deliver to you the identical property delivered to or purchased by MFGFX for any of your accounts.

    2. Yves Smith Post author

      You can’t believe everything you read on the internet :-)

      From an attorney via e-mail:

      On NC links today you ran a blog post on MF Global by Bruce Krasting. I think this blog post is inacurate in its description of payment systems law. Please see the attached article to see what I mean.

      A bank that has accepted a transfer into your account can’t turn around and transfer it out without liability just because someone has agreed to indemnify it. The customer Krasting describes would have full recourse against the bank accepting the transfer into his account.

      I have not been following the MF Global story closely, but I thought I would learn something from the Krasting article and found it to be kind of silly.

      1. Parvaneh Ferhadi

        Bruce Krasting has another post up callen “The Fed, MFT and Regulation T” in which he refers to Regulation T and quotes it as:

        • Except as otherwise agreed in writing by the OTC derivatives dealer and the counterparty, the dealer may repledge or otherwise use the collateral in its business;

        • In the event of the OTC derivatives dealer’s failure, the counterparty will likely be considered an unsecured creditor of the dealer as to that collateral;

        • The Securities Investor Protection Act of 1970 (15 U.S.C. 78aaa et seq.) does not protect the counterparty.

        Probably “Bob” faces an uphill struggle to get his money back if he is consideder to be an unsecured creditor.

      2. Jim Haygood

        ‘From an attorney via e-mail: The customer Krasting describes would have full recourse against the bank accepting the transfer into his account.’

        True enough. But evidently, it’s a not serious constraint on banks’ behavior.

        A personal example: JPM informed me that they had received a levy notice from another state, pertaining to an alleged sales tax debt that I considered invalid (I had no place of business in the other state, and was not obliged to collect its sale tax).

        My brother — an assistant attorney general with expertise in out-of-state collections — advised me to write JPM, stating that the levy notice was invalid unless the other state ‘domesticated’ it in my state of residence. I did so. Guess what — JPM grabbed the money out of my account anyway, not even bothering to respond to my letter.

        Since the cost of litigation would have exceeded the rather nominal amount in question, I did not sue JPM. But the point remains: regardless of legal niceties, banks can and do engage in egregious, high-handed behavior that mocks the law. In a pinch, their interest comes first, while the customer’s is dead last.

        I assure you that there is nothing ‘silly’ about this reprehensible phenomenon. If an attorney workin’ for me made such a flippant remark, I’d fire his ass — obviously not a scrappy litigator!

        1. Yves Smith Post author


          That is not the same as reversing a bank wire. The Fed and the banks care re the integrity of the payments system. Their trading machinery would be hopelessly compromised if that was at all in question. These are really not at all comparable. The law is really clear on that.

      3. ohmyheck

        Silly or scary? This from a commenter of Krastings, who looked up a customer MFG contract:

        “I think the issue is you have to look at the agreement you signed when the account was opened (or updated).

        If you signed your name to something that reads like the following I think there is some risk.

        The following is the language used for two different MFG accounts. They are different, but the same. These are what to look for in your own brokerage docs:

        8-Within the limits of applicable law and regulations, you hereby authorize us to lend either to ourselves or to others any securities or other property held by us in your margin account together with all attendant rights of ownership and to use all such property as collateral for our general loans. Any such property, together with all attendant rights of ownership, may be [pledged, repledged, hypothecated or rehypothecated either separately or in common with other such property for any amounts due to us thereon or for a greater sum and we shall have no obligation to retain a like amount of similar property in our possession and control.

        Consent To Loan Or Pledge
        You hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate,loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.”
        In short–”Take all my money and do whatever you want with it, I promise not to whine when you lose it all.”

        1. Yves Smith Post author

          You are all missing the point. The bank wire is COMPLETELY SEPARATE from any other preceding step. It has nada to do with lending, collateral, anything. When the money is gone, it’s gone. If the bank tries reversing the wire, THE BANK that sent the money is liable.

          This is all about payment system integrity. This goes to deposits, checks, everything. This is tantamount to trying to reverse a check after it has cleared. That NEVER happens either. If you are gonna stop payment, you have to stop it before it has cleared.

          1. Bruce Krasting

            Yves makes two assertions, A) If there were a clawed backed wire the bank involved would have liability to the account holder and B) nothing like this ever happens so it doesn’t matter any way.

            She’s right on A. An indemnity letter (accepting the consequences) is required to reverse a wire.

            I maintain she’s wrong on B. I cut my teeth in the CHIPS system. That’s the Clearing House Interbank Payment System. This was a long time ago and hundreds of thousands of wires were sent through the system every day. Today there are many millions.

            Each bank has a department called “Investigations and Adjustments”. They handle the routine mistakes that happen in the payment process. Human error leads to wires being sent to the wrong banks or accounts. Wire payments that have been made incorrectly were reversed.

            Questions for the bankers in the audience. Are wires still being made through the interbank system that has an occasional error? Are there circumstances where wires can be clawed back today? Is a letter of indemnity still required?

            Old, old color. A Swiss fellow buys some valuable artifacts and pays for them with a wire through a NYC based Swiss Bank. The wire goes out to another US Bank. After delivery of the artifacts it was determined they were fake.

            I got the call from the bosses in Zurich. I wrote the letter of indemnity that got the wire reversed. There was hell to pay. A judge got involved. When the facts came out, the wire reversal stood.

            Of course stuff like this never happens according to Yves.

        2. Bruce Krasting

          Actually those are my words in response to a question of what to look for.

          Compare these sections to the one above I provided from a Canadian account holder. Re-hypothecation was permitted in the US but not Canada. Why?

      4. ron

        “A bank that has accepted a transfer into your account can’t turn around and transfer it out without liability just because someone has agreed to indemnify it”

        Thats great if the bank has assets that cover these liabilities and the recovery is quick but lets not forget the cost associate trying to recover your assets not to mention the time line that could easily morph into years of waiting.

        1. Yves Smith Post author

          Please tell me of a case where this has happened. Per above, this is about integrity of the payments system.

  5. CM

    Where is the evidence that Prime broker assets make up the bulk of rehypothecation? This is just one subset of the repo market.

    1. Yves Smith Post author

      Exactly. That bothered me big time about the IMF article and why I am no sure it deserves the praise/attention it has gotten. It is a useful start but is far from definitive.

      I’d presume the reyhpothecation is mainly related to repo, not PB assets, although they can get fed into repo. And most people are now thinking due to the Reuters article that rehyothecation relates only to customer collateral, when it is the repledging of pledged assets.

      Should have said that more clearly in the intro.

  6. Rcoutme

    Okay, maybe I’m missing something? If not, I believe what you are suggesting is:
    1) Customers had accounts with MFG (for the purpose of ‘futurish’ trading)
    2) MFG gave them a bond-like assurance of being able to use the funds
    3) MFG then ‘assumed’ that the customers would not use all of that money (maybe only 1/4th or 1/5th of it)
    4) When a similar thing happened to Lehman, JPM required them to throw almost all of their cash on hand into JPM (thus leaving them with a serious liquidity problem) similar to Jimmy Stewart’s S&L in It’s A Wonderful Life with the bank–when he and his wife were going to go on their honeymoon.
    5) when this happens, since some of the assets that allowed the ‘extra’ cash to be lent were now in the hands of JPM, it led directly to a problem when Lehman (and now possibly MFG) needed to show that they had even more ‘cash on hand’ type assets
    6) Thus: since the accounts of the clients at MFG were, in effect, still money that MFG could use as assets, they had loaned on the ‘supposition’ that those accounts would, in effect, always exist? Thus, when the clients went looking for the money, all they had were pieces of a bond they never bought, which they (might) have been given a small amount of interest? And all of this might actually be legal? But since there is no FDIC for such accounts, they basically were putting their money in a Ponzi scheme that was (at least for these things) designed not to fail?

    Am I getting this right?

    1. ZeroInMyOnes

      After 9/11, undoubtedly most of the forensic accountants in the FBI were reassigned to Homeland Security.

      And then our big banks saw their opportunity…

  7. Slim

    Folks, don’t miss the forest for the trees. I will not even pretend to understand the complexities at the heart of re-hypothecation, I am just a computer guy. BUT – As far as I can tell there is a mechanism that allows these investment banks to use customer accounts (be it Gold futures, or cash) as collateral and then turns the customer into an unsecured creditor for their own money. That is insane.

    Even if it is just a “few” accounts. It’s a bit like a salmonella in the peanut butter scenario. Out of millions of jars, probably not that many have the salmonella… but as soon as you hear about it, are you going to run out an buy peanut butter? How about your bank account?

    The scary thing about MF Global, and possibly why it is taking so long to get any information – is that what they did may be perfectly legal. I do not know about you – but if I had any money, contracts, etc. with these banks, and I heard news that there was a legal way to for them to gamble with it, and turn me into an unsecured creditor (with no FDIC backing), my money would not be there long.

    The shadow banking system, off the books derivatives, dark pools etc. exist for one reason alone… to hide risk. Period. The bigger that system, the more derivatives, etc. the greater the risk. This year, I have read that over $100 trillion of were written in the first 9 months.

    I enjoyed this article.

  8. Fíréan

    “rehypothecated using far more permissive UK rules” – am i right in assuming that the safe guarding of those permissive City of London rules, or lack of rules, was what Cameron tried to negotiate, saving London from future EU regulations, in a trade off for his support when sitting at the table of the most recent Euro financial crisis summit ?

  9. Jim Haygood

    ‘Repo … meets the needs of institutional investors, states and municipalities, nonfinancial firms for a short-term, safe banking product. It’s a valuable innovation.’ — Gary Gorton

    ‘The bit in bold is where I raised my eyebrows.’ — Richard Smith

    Let me expand on what I think Gary Gorton was saying. Until the crisis, FDIC deposit insurance was limited to $100,000. Temporarily it’s been hiked to $250,000. Even for moderately wealthy individuals, this ceiling is easy to exceed. For businesses and governments needing to park cash balances in the millions (or even billions, in the case of Microsoft or Exxon-Mobil), FDIC insurance is irrelevant. These institutions are basically unsecured creditors of their banks.

    So what do they do? When small country banks fail, deposits over the FDIC limit can and do get haircut. But when monsters like B of A, Citi and JPM get into difficulty, the government bails them out. This is an important driver of the TBTF effect: practically speaking, a multi-million dollar deposit is safer in an undercapitalized money center behemoth with dangerous derivative exposures, than in a community bank whose plain-vanilla local loan portfolio has taken a hit.

    Rather than risk a loss when banks are shaky, large institutions can simply place their cash in secured repos. This is what Gorton means by ‘meeting their needs.’

    An alternate way of meeting those needs would be to drastically increase the FDIC deposit insurance ceiling. De facto, the TBTF doctrine already does this. But because TBTF rescues are discretionary (as Lehman’s failure showed), uncertainty remains.

    Another alternative would be to establish a standalone bank — call it ‘Repo Bank’ — offering privately-insured (or at least AAA-rated) large deposits. In contrast to other banks, Repo Bank would offer total transparency, posting the detailed list its mark-to-market assets daily, along with its accumulated liabilities to depositors.

    Skeptics will assert that if Repo Bank was a viable business model, someone would already have done it. I’ll confine myself to saying that if you don’t have a transparent, regulated Repo Bank operating in the sunshine of transparency to meet the needs of large depositors, then instead you will have an unregulated Shadow Bank operating on the dark end of the street.

    At the dark end of the street
    That’s where we always meet
    Hiding in shadows where we don’t belong
    Living in darkness to hide our wrong
    You and me, at the dark end of the street
    Just you and me

    - Chips Moman & Dan Penn

    1. Ransome

      Gorton calls for “narrow funding banks” that create AAA securitized collateral bundles. It is not clear how to ensure the loans are safe, no one predicted underwater housing.

      To me, it sounds like we are trying to replicate a gold backed system using a lot of debt and collateral as private money, the value of which appears to be subject to confidence in the unknown.

      If money was interest free, there would be less of an incentive to chase returns, even overnight returns.

      Gorton was not sure how bubbles are created. Behind every bubble you will find a “broker” selling on commission, frequently to a less knowledgeable person.

      Does anyone know how these pledged securities are moved around in the system?

      1. Alan H

        For companies with very large cash funds, repo is a means to make somewhat more than T Bill rates while gaining Treasuries as security, a winner for them which also meets the desires of an entity (say Lehman) to lever up while raising cash off the balance sheet. The problem with MF is that many of their customers (as for other brokers) signed agreements allowing MF to transfer funds to its international subsidiary (London). When the funds hit London the rules change. US rehypo rules are quite sound (or were) as to the kind of assets which may be acquired with the margin clients cash (i.e. treasuries). This limit has been somewhat loosen to include state and municipal bonds, depending on the regulator. Rehyps have terms. I wouldn’t be surprised if London MF subsidiary obligations to provide more collateral into the repo is what caused Corzine to make the 175 m ‘loans,’ were what cause JPM to say that ‘overdrafts’ had to be settled before any more MF bonds could be liquidated.

  10. Abigail Caplovitz Field

    Thanks Yves. Your post provides much needed context for the Reuters piece and nicely highlights the intolerable systemic risk unlimited (via London) re-hypothecation poses. It’s a post to run and re-run periodically until the issue gets the traction it deserves.

    1. ohmyheck

      “via London”—I read this recently:

      “As I understand, the City of London has NO LIMIT on the amount of funds which may be re-hypothecated. Which is one reason that all the major banks have a presence there. They merely tunnel their customer accounts through the City of London and voila, they are not bound by the US 1.4 limit. Typically they use 4x…”

      For us laypeoeple, that means “broker-dealer was only entitled to leverage 140% of the amount being borrowed in any margin account.” That’s the 1.4. But in London, it can be 400%, not 140%. Why not run that borrowed money through London? You have the good possibility of of leveraging an extra 260%. Way more fun…(PS—when I say “layman”, I mean I personally barely understand any of this, but I’m still trying)

  11. ron

    Collateral value is not fixed in stone and as the underpinning for these leveraging actions will probably fail to cover if and when the broker/bank fails. These leveraging operations are critical to out sized profits/bonus/inflated salaries common in the financial sector.

  12. A Good Bankster

    Everyone who opens a brokerage account has to sign a form which contains language such as the following: “Brokerage X may rehypothecate any Securities or Other Property held, carried, maintained, or in the possession and control of brokerage X.”

    In other words, as an I-banker, I can rehypothecate your assets whenever I feel like it.

    But not to worry, re-hypothecation is just a big fancy word. Unlike the crude I-bankers depicted in Michael Lewis’ Liar’s Poker (I ripped the client’s f**kin’ face off, etc) the new breed of I-bankers are more prone to sesquipedalian loquaciousness. (i.e., they like using big words.) But other than that, they’re perfectly harmless. You have no reason to worry about losing a single dime of your money. And certainly not all of it.

    If it makes you feel better, and as an added precaution: if your account *should* somehow get accidentally re-hypothecated to a numbered offshore account in Andorra, and you find out about it, I promise to re-hypothecate someone else’s account, tout de suite après!, and use that to replace all of your missing funds.

    You can trust me, I’m a banker.

    1. Jim Haygood

      Speaking of ‘sesquipedalian loquaciousness’ (can’t even spell it, but I love its stately multisyllabic cadences), the I-bankers’ new euphemism is ‘shortening collateral chains.’

      Sounds anodyne, but as Kyle Bass points out, there’s a slow-motion run underway in Europe’s conventional banking system, which is mirrored in the Shadow Banking system as its multiplier contracts:

      Never mind ‘failing to print’ — even now, the ECB is making the advances to cover this bank run. But when (not if) several peripheral players default, the ECB is going to be insolvent on a mark-to-market basis.

      Even insolvency doesn’t put central banksters out of business — their fiat liabilities are unredeemable — but the optics are unflattering, and can be associated with currency convulsions. After all, even though you can’t redeem euros, you can sure as hell exchange them for other currencies.

      1. Fiver


        You likely saw this, but I toss it out for your (and others’) possible interest. A discussion featuring Bass back in early November. What he says about the sequence of this crisis, i.e., first Europe, then Japan, then in 3-5 years in the US absent some sort of sea change in policy presents a pretty grim picture. It fits in with my view that the US may actually see a 2-3 year pop as money pours in from abroad and both ECB and Fed print AFTER a couple defaults. I have no use for his politics, but he makes a good argument for what WILL happen vs what one might wish to see happen:

  13. Susan the other

    Richard Smith posted that last January? Wow. And since then MFG has been taking big risks with the sovereign debt of Italy, correct? And when interest rates spiked MFGlobal couldn’t meet some kinda margin call and used customer money and lost it all? JPM didn’t help because it demanded its money back and gave MFG no time to recover its balance. And just before all that hit the fan somebody tipped off one of the Koch brothers (can’t remember the source here) and he took all his money out of MFG. Then MFG went down. After which, we now read in Huffpo, George Soros made a killing on the same Italian bonds, now much, much cheaper. Question: Was MFG betting that the ECB would print up some bonds and buy Italy’s debt?

    Did Jon Corzine think he had time to take clients money and save MFG. Or did he know there was no time left? I bet he knew there was no time left when he went ahead and used his clients’ money on the dismal future of Italian debt.

    1. ron

      “Did Jon Corzine think he had time to take clients money and save MFG.”

      There will always be another Corzine if the current leveraging up of collateral assets by the banking sector continues. Little if any MSM attention has been given to exactly how the financial sector is able to deliver outsized bonus and salary but as the onion gets peeled away during deleveraging its becoming clear that our modern banking/investment system is a large scale leveraging operation creating significant inflated dollars that easily find there way into the insiders pockets.

  14. QuentinCompson

    Given that it was JP Morgan withholding cash and collateral that struck the fatal blow to Lehman, one wonders if we’ll find a similar aggressive move as a contributor to the scale of MF Global customer losses.

    Harry Crews on hawg-killin’ time:

    It never took but one blow, delivered expertly and with consummate skill, and the hog was dead. He then moved with his hammer to the next hog and straddled it. None of the hogs ever seemed to mind that their companions were dropping dead all around them but continued in a single-minded passion to eat. They didn’t even mind when another of my cousins (this could be a boy of only eight or nine because it took neither strength nor skill) came right behind the hammer and drew a long razor-honed butcher knife across the throat of the fallen hog. Blood spurted with the still-beating heart, and a live hog would sometimes turn to one that was lying beside it at the trough and stick its snout into the spurting blood and drink a bit just seconds before it had its own head crushed.

    Just sayin’.

  15. ron

    From Lee Alder: Lee reprints a David Stockman E-mail regarding rehyothecated collateral”

    “The real story of the present is the shadow banking system, the unstable and massive repo market, and the apparent daisy chain of hyper-rehypothecated collateral. It looks like the sound bite version amounts to the fact that the European banking system is on the leading edge of collapse for the whole system. These institutions are by all evidence now badly deficient of the three hallmarks of real banks–deposits, capital and collateral.

    BNP-Paribas is the classic example: $2.5 trillion of asset footings vs. $80 billion of tangible common equity (TCE) or 31X leverage; it has only $730 billion of deposits or just 29% of its asset footings compared to about 50% at big U.S. banks like JPM; is teetering on $500 billion of mostly unsecured long-term debt that will have to be rolled at higher and higher rates; and all the rest of its funding is from the wholesale money market , which is fast drying up, and from repo where it is obviously running out of collateral.

    Looked at another way, the three big French banks have combined footings of about $6 trillion compared to France’s GDP of $2.2 trillion. So the Big Three french banks are 3X their dirigisme-ridden GDP. Good luck with that! No wonder Sarkozy is retreating on France’s AAA and was trying so hard to get Euro bonds. He already knows he is going to be the French Nixon, and be forced to nationalize the French banks in order to save his re-election.”

  16. Anonymous Comment

    Thanks again, Yves, for the excellent sleuthing and explaining.

    Just one little quibble: We should be careful not to conflate [or give the impression of equating] ‘repo’ with rehypothecation. They are two separate activities although seemingly related.

  17. Sunny129

    I read on the net(? cannot recall the site at this moment) that Those clients of MFG in CANADA got their MONEY BACK apparently Canadian regulation doesn’t allow re-hypothecation. May be some one could comment on this.

  18. Hugh

    Rehypothecation is just another scam to allow gearing. Gearing is the problem. It is all very reminiscent of 1929. On the upside of bubbles, gearing is a sign of financial brilliance, but as the bubble ages the costs of the gearing rise and eventually precipitate a collapse. I suppose we should rework Mellon’s old saying, that what we are seeing now is the privatizing of genius morphing into the socializing of stupidity/criminality.

  19. Thorstein

    On page 50 of “Slapped by the Invisible Hand,” Gary Gorton writes:

    “Estimates of the size of the repo market are that it is roughly $8 trillion to $10 trillion. If repo haircuts increase to an average 20% (a guess), then between $1.6 and $2 trillion must be raised by the banking system. Without investors willing to finance this by investing in these firms, the only alternative is to sell assets.”

  20. Jon

    I am not sure I agree on the analogy to fractional banking and re-hypothecation. If I have $100 of bonds and lend them vs $95 of cash, the guy who borrows them can also raise $95 of cash, and so forth (assuming the bond value doesn’t change). Bits of the bond don’t disappear as the collateral churns in the market. In theory, the turnover is infinite. But it isn’t. Some bonds move around a lot until they’ve found their most efficient use. Other bonds don’t turnover more than once (for example, paper financed in tri-party repo just sits there). Sure, lower haircuts promote leverage, but I doubt collateral turnover is the driver. Without re-hypothecation (or re-pledge as it is called in repo, re-hypoth is mostly a securities lending term but there differences are minor) the banks who lent cash vs. securities wouldn’t have a way to fund those loans except by unsecured borrowing. Isn’t the financial world a sounder place when there is collateral backing transactions?

  21. Union Member

    I’m gonna have to go over this a couple of times more for a better understanding, but I still won’t sleep well tonight. (A Glossary would help.)

    To read stuff like this, here and elsewhere, makes a working stiff wonder: What about the Unemployment Multiplier Effect? If there is such a thing?
    When Bernanke, Geithner and others view Hypothecation from their Commanding Heights do they ever consider who really takes the punch in the face for this arrogant deceit. (This commenter knows two children who have really struggled in school since their parents lost 4 jobs, their house, filed bankruptcy, and then separated, all in the last 3 years.) Analysis like this makes all the gibberish in Washington about “job creation” pretty f***ing insulting.

    Speaking of elsewhere: It should be compulsory that Brian Williams, Katie Couric et al should have to explain this to their nightly audience.

  22. kevinearick

    secondary issues…

    Empire Contracts

    Empire building has been going on for a very long time; during normalized static operations, the denizens accepting its authority assume it is all powerful, which is the point of its education system. Bad assumption.

    The universe is quantum by nature. The empire is not; empires are incremental proprietors, operating a positive feedback loop between geographic control, through government misdirection, and the resulting scarce resources, created by the nonperforming output relative to planetary design. The empire seeks scale; the planet seeks diversity.

    From the perspective of the empire, human life is transitory, without individual value. From the perspective of the planet and universe, the empire is transitory. Quantum adaptation is the resulting distillation process.

    Because the universe is a balanced timer, it can and does anticipate collapse of sub-fulcrum gears into smaller, more flexible gears, which provide the same function at much more economical cost to the universe, in a negative feedback loop, which keeps time. The minute hand moves the hour hand and the process repeats.

    The beginner chemist is impatient relative to the titration process. All the action happens in the last drop and the objective is to make that drop as small as possible to increase precision (relativity circuit).

    The empire is an impatient procrastinator, as are its followers, which is why it busies itself with busy-work, expanding its positive anxiety feedback loop, and narrowing the exit straits, right up until its momentum carries it over the energy of catalysis cliff. The universe is not.

    If you think about it, your ladder, the sun, and all other processes work the same way. You beat your brains out trying to learn, and, once the picture becomes clear, you realize you worked a thousand times harder than necessary to replicate, which is why very few want to make pie (economic growth), and the vast majority prefer to compete for slots at the resulting trough.

    The objective is not to encourage anyone to enter into a real marriage. There is nothing on this planet more difficult. It’s a calling. The objective is to provide both a basic understanding of physics and the resulting socioeconomic outcomes, with little to no math, which the empire always outlaws in its death spiral.

    Universities increase complexity through specialization so that losses may be deemed profits in the obfuscation. To make that happen, math must be replaced by event horizon groupthink, in K-12, and, ultimately, from the womb, which brings us to breeding.

    The cattle are not going to feel secure unless tomorrow promises to look like yesterday, and they will be bored if successful, unless the profit, the amount of nonperforming assets hoarded in their closets, increases. If they should accidently happen upon happiness, a system unknown, they would immediately become anxious about how they destroyed yesterday’s happiness as the means to avoiding the same outcome in the future, ensuring that they are never happy, because the empire rewards increasing anxiety oscillation with nonperforming assets, as the imprinted need. That’s the proprietary civil marriage contract in a nutshell.

    Stimulus does have a multiplier effect, a negative one, which has passed the tipping point, creating credit/equity VIX. At some point, no amount of heroin will get the zombie up off the gurney again. The external symptoms are an aggregate function of the internal thinking process, and the American Enterprise System Constitution is brain-dead. The only difference between it and its predecessors is a few event horizons, which is why it is devolving into socialism and tyranny. It doesn’t pay to take the children of empire builders for the purpose of ransom.

    Empires are not evil; they are stupid. Hard-wired fiscal discipline… and the insanity of the false reserve assumption continues. Space travel is a function of timing; power is the derivative.

    1. F. Beard

      Good weed, eh?

      I was wondering if a computer could be programmed to create your comments. I decided, no. You are not a machine. Still, I did wonder.

      1. ohmyheck

        (Smile) I was leaning more towards a good acid trip. Not sure if I mean he must be on some good stuff in order to write this, or I need to be on some to comprehend it.

        Life—you can’t say it isn’t entertaining…

        1. lambert strether

          I have, er, heard that those small, flexible gears are a sign of impurities in the mix; to wit, formaldehyde. I was with him until that point. Also, too, empires are stupid and evil.

  23. Siggy

    A repo is a loan that is often collateralized by the hypothication of specific assets. The assets are never conveyed to the lender, a hypothecation form is what the lender gets. The lender does not have formal title to the hypothecated asset until such time as the loan that the hypothecated asset backs is defaulted.

    When the lender hypothecates an asset that has been hypothecated to him, he is offering collateral which is contingent in nature.

    It may occur that a lender may hold in a segregated account assets that have been hypothecated to it. The lender may hypothecate those assets to obtain a loan; however, the third party lender may now be assuming substantial risk because he has granted what is effectively and unsecured loan.

    $1.2 billion is a rather large amount of money to be missing. And I find the testimony of the three blind mice to be not credible.

  24. Rich Hartmann (Miss America)

    Hello Yves.

    I used to write for the RGE, and I believe we have conversed on a few occasions back then??? (I’m pretty confident that London Banker, whom I’m pretty sure you converse with, can vouch for me.)
    Anyhow, with regards to this article, there are some things I’d like to point out. (as a 15year banking operations person)

    This based on the Richard Smith stuff (so if you are using him as your reference…. ugh)

    When the client brings $200 million to the bank, you take it to a custodial bank. (not the Lehman-ish side) The repo is done between the custodian and the prime broker. (in most cases, it’s your MF, PF, 401k, whom are the actual client, thus the most common repo’s are “Tri-party Repos” = Client/custodian/broker)

    The Lehman-ish side is always working short cash, which is why they always need funding for their days trading.

    So with the massive pools of money that the custodians are sitting with (because these client side operations need to have XXXX amount liquid due to fund requirements, and the net subs/redm which has been for sooooooo long been typically a huge daily inflow (subs) due to the ponzinomics of perma-growth / 401k/MF/PF inflow) that money needs a home for the nightly basis.

    So this repo is an “OVERNIGHT” cash loan.

    Here’s is where there is a HUUUUUUUGE divergence on understanding. Where a cash “deposit” in the fractional reserve world of banking has a multiplier effect, (10% fraxRes of typical US bank, where $1 = $10 as the article mentions) this overnight loan does not have the same ability to go back and forth to create the multiplier. Instead it’s just covering the short cash position that the broker has from the day’s trading.

    On the collateral side, The same is 100% true.

    The multiplier doesn’t have the time to multiply due to the duration of the trade. The collateral (which is tracked by the custodians through products like Repoedge) are very specifically assigned. (the banks, BNY, JPM, State Street whom are probably about +90% of this track this since it’s their livelihood)

    ***term repo’s could give the “time” needed for multipliers to take effect, but it’s just not the case.***

    OK, so that collateral, (which I want to say is “valued that night” @ 102-105% of the loan, so no one is holding crashing assets) gets hyp/re-hyped on the “off the books” side, since it’s not being used back and forth to create a fraxRes multiplier.

    Typically, the collat is being used to back the CDS side of the days “net” moves. (now Bear Stearns whom was a “bad boy” I suspect was doing this up to 130-150% of the CDS net… which is an enormously SMALL multiplier.)

    So, as I see it, this isn’t a big banking issue.

    What it comes down to is this… Any broker, whom is always working with a negative figure, whom gets their daily funding pulled, will come instantly crashing down. That repo cash (nightly investment funding) can sometimes “freeze” because the collateral side has a scare. (The scare could be a: whole market scare, or the Broker doesn’t have good collateral which was the case in Lehman.)

    Simply put, this will force the broker to sell as many assets as needed to then cover their cash needs. (…and the cannibals in this industry INSTANTLY figure out whom is going to get eaten, so the entire market swirls in those moments as the forced liquidation has to sell into the falling knife market)

    …and on the collateral side, the custodians grab hold of all those pieces of collateral, and sell them off (in that same falling knife market) to get as much of their cash back for the redemption of the repo funding they lent out.

    Thus, when the liquidation hits, (lehman/MFGlobal) the cash that goes out to cover that days operations, the lost assets sold in the falling market, the lost collateral sold in the falling market, leads to an evaporated bank account.

    The issue here with MFG is about commingling, not the banking process.

    Too many people hera this “new term” hyp/re-hyp, and are afraid of it (so it has to be “bad”) …but it’s just a working mechanism of the market that needs to be better regulated. (and I hate being such a “regulation” nut)

    All the best, Rich H / Miss America

  25. SH

    I read this article the first time around and I got it. The second time I could not grind it out. Also, my pops had a currency trading account with a sub of MF and lost some money, not big, and dealt with some bs, but what stood out was this statement.

    “An aside: one of the peculiarities of mathematical economics, as opposed to mathematics, is the relative frequency of “theorems”. In mathematics, theorems are as rare as unicorn droppings, things of near-holy awesomeness; in mathematical economics, by contrast, they occur horribly frequently, like depictions of unappealing sexual acts in the oeuvre of the Marquis de Sade.”

    Absolutes are very easy to attack and since I was a math major I was like that is bs. However, 10 hours later, I’m thinking I was good at math because calculus was mechanical and I was a master of Euclidean geometry which is nothing but proofs. Axioms and proofs.

    So, in the end, I only remember the law of large numbers, which is a proof and then the central limit theorem. It’s funny ten years later. I now agree.

    Does anyone else know what theorems there are?

    1. SH

      The application of Brownian motion to financial markets may not be math or a theorem, but as with this article, it should be noted that just because MMTers naysay the same equations and play down reserve requirements because no one borrows, there’s still some truth to it.

      1. SH

        I’ve been milling on this one all week like a moron. Five days later, I don’t feel like I missed the boat.

        Here they are.

        The funny thing they miss is this one.

        You get Riemann sums and then you make the theoretical jump to integrals. That was sophomore year. I was more interested in football, but I remember the jump. If we don’t know limits, we got nothing.

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