Ponzi Scheme That Makes Maydoof Look Like A Saint - Re-hypothecation.

Yesterday an article in Reuter made me very nervous.  It is rare that an organization that touts itself as "the world's leading source of intelligent information for businesses and professionals" makes a statement that something is "frightening" and that a Eurozone default could be "apocalyptic." 

I am not a not a professional investor, instead I rely on others to help me with investing decisions and I try and read and keep abreast of what is going on in the business world.  But nothing prepared me for this story.  It strikes at the very core of our financial world and makes me think that we only thought we might be safe.  In fact, it appears that the "scheme" created called "re-hypothecation" is a bigger ponzi scheme than even that of , Bernard "Bernie" Maydoof.

Reuters' Christopher Elias has written an article that simply must be read, MF Global Global and the great Wall St re-hypothecation scandal.  He reports:

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.

Is "apocalyptic" (a term which originally referred to a revelation of God's will, but now usually refers to belief that the world will come to an end time very soon, even within one's own lifetime) too strong a word?  Does it strike fear in your heart?  If this article just from anyone, perhaps.  Regardless, it is enough to have made me realize (yet again) that everything is not as it seems.

How could this possibly affect you or me?  What if I told you that it has already affected us.  From Reuter:

This is exactly what Lehman Brothers did through Lehman Brothers International (Europe) (LBIE), an English subsidiary to which most U.S. hedge fund assets were transferred. Once transferred to the UK based company, assets were re-hypothecated many times over, meaning that when the debt carousel stopped, and Lehman Brothers collapsed, many U.S. funds found that their assets had simply vanished.

A prime broker need not even require that an investor (eg hedge fund) sign all agreements with a European subsidiary to take advantage of the loophole. In fact, in Lehman’s case many funds signed a prime brokerage agreement with Lehman Brothers Inc (a U.S. company) but margin-lending agreements and securities-lending agreements with LBIE in the UK (normally conducted under a Global Master Securities Lending Agreement).

These agreements permitted Lehman to transfer client assets between various affiliates without the fund’s express consent, despite the fact that the main agreement had been under U.S. law. As a result of these peripheral agreements, all or most of its clients’ assets found their way down to LBIE.

So they can just take your assets and then whatever you think you owned just disappears.   

Just how broad is the practice?  Does $4,000,000,000,000.00 (4 Trillion Dollars) sound like a small sum?  The International Monetary Fund (IMF) has calculated that U.S. banks at the time of Lehman were receiving $4 trillion worth of funding by re-hypothecation. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation.

“Churn” sounds so much nicer than “Ponzi” doesn’t it?

According to Reuter:

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. 

Bernie would be so proud.

What does this hydra we have created for ourselves mean?

[h]ypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.  In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital).  

Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients ... to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations."

Now here is the part Bernie would truly love.  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 bank's balance sheet, 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.  

But this ponzi scheme gets even worse.

Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker.  

But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation.

Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organization.

Isn’t the idea of a Global Financial System Grand!

Watch for these magic words:

“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.”

So as you watch the Greeks struggle and riot, just realize it maybe your life savings they are fighting about.

Also ask yourself, who the HELL is suppose to be watching out for us and not the banks?