MF Global and the great Wall St re-hypothecation scandal
12/7/2011

By Christopher Elias (UK)

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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.
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RE-HYPOTHECATION

By way of background, hypothecation 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.

...A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default.
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Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, 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 much to the chagrin of hedge funds.
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U.S. RULES

Under the U.S. Federal Reserve Board's Regulation ... assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.

But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated....On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500).
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BEWARE THE BRITS: CIRCUMVENTING U.S. RULES

Keen to get in on the action, U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules.
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OFF BALANCE SHEET

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 (gearing) 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.
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HYPER-HYPOTHECATION

With weak collateral rules and a level of leverage that would make Archimedes tremble, firms have been piling into re-hypothecation activity with startling abandon. A review of filings reveals a staggering level of activity in what may be the world’s largest ever credit bubble.

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).

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LIQUIDITY CRISIS

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.
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In the midst of rising terrorism and conflicts that have became an issue of global concern, an initiative has been taken by the chief justices, judges and legal luminaries from different countries who gathered for a press conference in the Capital to support the demand for Enforceable International Law. They laid emphasis on the need to elect a world parliament which will frame world laws that will be implemented by a world government and world court will interpret them.

Around 150 participants from 65 countries including India were participating in the 12th International Conference of Chief Justices of the World....

The press conference was headed by Justice AS Qureshi, chairman of the reception committee, New Delhi and a former judge of Gujarat High Court. “World judiciary can force the leaders of the world to come together and form a world parliament to enforce world law and constitute a world government,” shared Justice Qureshi while addressing the legal dignitaries and media at the Constitution Club.

....Qureshi observed, “I’m happy to see that over the last 10 years, there is an increasing participation by judges from Latin America, Asia and Africa. This is the reflection of increasing awareness among the people. But I must say that there is still lack of participation by the European countries. There is an urgent need to realise the importance of unity of humankind and peace in the world. Thus, there is an urgent need for a legally constituted law-making body for enacting enforceable international or world law that is applicable to all the countries of the world at the same time. As only it can ensure unity of humankind...."

Justice Benjamin Odoki, Chief Justice of Uganda, said, “The future of over two billion children in the world can’t be ignored. It is imperative for their bright future that we take steps to enact world law as soon as possible.”

Meanwhile Justice Fredrick Egonda-Ntende, Chief Justice, Supreme Court, Seychelles, observed, “It is a wonderful opportunity for the judges of the world to be a part of a noble cause and to strive for democratic new world order with a world Government.”

The Gold "Rehypothecation" Unwind Begins: HSBC Sues MF Global Over Disputed Ownership Of Physical Gold

(HSBC) is suing MG Global "to establish whether he or another person is the rightful owner of gold worth about $850,000 and silver bars underlying contracts between the brokerage and a client."
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“HSBC has received conflicting instructions regarding ownership and disposition of the property,” it said. “Accordingly, HSBC is exposed to multiple liabilities with respect to the disposition of the properties.”

...is whether gold in the GLD warehouse, supervised by HSBC, is truly theirs, or has it all been hypothecated from some other broker who never really had the asset or the liquidity, and so on in what effectively can be an infinite chain of repledging one asset to countless counterparties.