First, we got special purpose entities (SPEs) with Enron.
Then, collateralized debt obligations (CDOs) with the real estate market collapse.
And now, thanks to the MF Global (Other OTC: MFGLQ.PK) bankruptcy filing – the eighth-largest in U.S. history – we need to add another dirty word to our Wall Street lexicon…
What’s that you say? Well, it’s the process of hypothecating something again and again and again, of course.
Still confused? Let’s take the time to break down what it really means… Then, in a future column, I’ll explain how its abuse led to MF Global’s ultimate demise.
Hypothecation is when a borrower pledges collateral to secure a loan. The simplest example is a home mortgage. Our house becomes collateral to secure the loan. And until that loan is paid off, our creditor has the right to seize possession of the house if we default.
On Wall Street, an example of hypothecation is a margin account. An investor pledges collateral – cash or securities – in order to borrow money to purchase more assets. In this setup, the broker has the right to seize (sell) the pledged securities if the investor fails to respond to a margin call.
Moving onto re-hypothecation: It’s when the collateral pledged by the original borrower is reused as collateral by the bank or broker for its own borrowing.
In other words, you pledge your home as collateral to get a loan from the bank. Then the bank uses your home, too, to get a loan of its own from another bank. And then the other bank uses your home, too, to get a loan of its own, etc., etc.
As Reuters says, “Essentially, it [re-hypothecation] is a chain of debt obligations that is only as strong as its weakest link.”
We don’t need to guess what could possibly go wrong with using the exact same collateral over and over and over again, do we? Nope. Because we know what happens. Disaster. As in the 2008 financial crisis.
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You’ve probably already heard that Wall Street used too much leverage to speculate in the years preceding the financial crisis. (Some firms were borrowing $30 to $40 for every $1 in assets.) Well, re-hypothecation was one of the financial tricks used to facilitate such aggressive speculation.
Leading up to the crisis, U.S. banks used re-hypothecation to secure $4 trillion in funding, on just $1 trillion in original collateral, according to the International Monetary Fund (IMF). That’s more like hyper-hypothecation. And once a few “links” in the chain broke, the whole system collapsed.
This Can’t Be Legal? But it Is!
You’re probably asking yourself, how could all this possibly be legal? But it is under the U.S. Federal Reserve Board’s Regulation T and SEC Rule 15c3-3. Of course, the regulations never intended for re-hypothecation to end like this.
Originally, the regulations only allowed funds acquired via re-hypothecation to be used to purchase super-safe assets – U.S. Treasury, state and municipal obligations. But in 2000, the regulations were relaxed, allowing re-hypothecated funds to be used to buy less than super-safe assets – like repurchase agreements (repos) and foreign bonds, among others.
As you might expect, Wall Street quickly moved to exploit the changes to ratchet up the risk. And if that wasn’t bad enough, they also discovered a loophole between U.S. and U.K. regulations.
In the United States, re-hypothecation is capped at 140%. In the United Kingdom, however, there’s no statutory limit on the amount that can be re-hypothecated.
To take advantage of the discrepancy, brokers – like the now defunct Lehman Brothers – simply transferred collateral to a U.K. subsidiary and borrowed away. And the rest is history.
Bottom line: Re-hypothecation is yet another example of Wall Street finding a way to speculate wildly with other people’s money. And all we get for holding the bag of losses is another confusing, dirty word.
Ahead of the tape,