Wednesday, December 14, 2011

Part 2: Hyper-Hypothecation Madness

"A prime broker need not even require that an investor sign all agreements with a European subsidiary to take advantage of the re-hypothecation loophole. As a result of these peripheral agreements, all or most of clients’ assets find their way down to a '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 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.'  With these transactions taking place off-balance sheet it is difficult to pin down the exact entity used to re-hypothecate such large sums of money. Matters get even worse when we consider what has for the last 6 years counted as collateral under re-hypothecation rules. Despite the fact that there may only be a quarter of the collateral in the world to back these transactions, successive U.S. governments have softened the requirements for what can back a re-hypothecation transaction. As well as collateral risk, re-hypothecation creates significant counterparty risk and its off-balance sheet treatment contains many hidden nasties. Even without circumventing U.S. limits on re-hypothecation, the off-balance sheet treatment means that the amount of leverage and systemic risk created in the system by re-hypothecation is staggering. Re-hypothecation transactions are off-balance sheet and are therefore unrestricted by balance sheet controls. Whereas on balance sheet transactions necessitate only appearing as an asset/liability on one bank’s balance sheet and not another, off-balance sheet transactions can, and frequently do, appear on multiple banks’ financial statements. What this creates is chains of counterparty risk, where multiple re-hypothecation borrowers use the same collateral over and over again. Essentially, it is a chain of debt obligations that is only as strong as its weakest link. With collateral being re-hypothecated to a factor of four (according to IMF estimates), the actual capital backing banks re-hypothecation transactions may be as little as 25%. This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing. Engaging in hyper-hypothecation have been Goldman Sachs ($28.17 billion re-hypothecated in 2011), Canadian Imperial Bank of Commerce (re-pledged $72 billion in client assets), Royal Bank of Canada (re-pledged $53.8 billion of $126.7 billion available for re-pledging), Oppenheimer Holdings ($15.3 million), Credit Suisse (CHF 332 billion), Knight Capital Group ($1.17 billion),Interactive Brokers ($14.5 billion), Wells Fargo ($19.6 billion), JP Morgan($546.2 billion) and Morgan Stanley ($410 billion). The volume and level of re-hypothecation suggests a frightening alternative hypothesis for the current liquidity crisis being experienced by banks and for why regulators around the world decided to step in to prop up the markets recently. To date, reports have been focused on how Eurozone default concerns were provoking fear in the markets and causing liquidity to dry up. Most have been focused on how a Eurozone default would result in huge losses in Eurozone bonds being felt across the world’s banks. However, re-hypothecation suggests an even greater fear. Considering that re-hypothecation may have increased the financial footprint of Eurozone bonds by at least four fold then a Eurozone sovereign default could be apocalyptic. U.S. banks direct holding of sovereign debt is hardly negligible. According to the Bank for International Settlements (BIS), U.S. banks hold $181 billion in the sovereign debt of Greece, Ireland, Italy, Portugal and Spain. If we factor in off-balance sheet transactions such as re-hypothecations and repos, then the picture becomes frightening."- Adapted from a Thomson Reuters article by Christopher Elias. Written with contributions from Jack Bunker and Nanette Byrnes. This article was first published by Thomson Reuters’ Business Law Currents.