Urban lingo has the phrase OPM – other people’s money. Banks have developed the art of OPM to the utmost degree. It should really be called other people’s assets because they would hardly stop at mere money. The technique is called rehypothecation. The rehypothecation meaning (and it’s out of control younger twin ‘hyper-hypothecation’) tells all about the moral direction and free reign of bankers. It’s also the slow strangulation of the middle class.
Hypothecation is simply the use of an asset as collateral. Rehypothecation is the use of client assets by a brokerage or financial firm as collateral for the firm’s purposes. The client takes the risk and the firm gets the reward.
Title is still owned by the original party, but it is ‘hypothetically’ controlled by the lender. While it can be compensated, most clients are unaware of the procedure and their assets are used without their knowledge. Of course, it’s in the fine print, but it’s seldom clear. Usually, it’s used against the client – equities are borrowed for short sales against the securities, driving the price down.
It begs the question – who owns the assets in a default scenario, the client or the entity with collateral pledged to it? Collateral has no meaning except to secure a loan in the case of default. If your stock is collateralized for MS to borrow money from JPM, then you can actually lose your assets when MS hits the skids and ‘The Morgue’ collects its collateral. This happened with MF Global and PFG Best. Numerous investors got skinned. We’ll return to that in a bit.
Rehypothecation has different limits in different places. In the US, 140% of the value can be loaned against. In the UK, there is no limit. Client collateral can be used again and again to finance more speculation. London is the banker’s paradise for a very clear reason.
Rehypothecation is very profitable, so all the big houses set up a London office to milk the cow as hard as possible – relocating client assets without their knowledge to the UK. Half the shadow system was based on rehypothecation by 2007.
It was not on balance sheets for several reasons. Not being cash, it didn’t have to be there. But it was a good cash substitute and a great way to make money. This surged up capital to earnings ratios – a hidden way of looking stronger. It looked as if companies made very high returns for capital, but it hid the massive leverage being used.
It’s not pretty either. Up to four times leverage is based on awful collateral. Even Reuters printed, “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.” That’s why Greece is being bolstered, but when Spain, Portugal and the much larger Italy begin to topple, no force may hold it up. In a default, the underlying bonds will be worth precisely zero and the leverage goes to infinity on those bonds. The shadow system is a house of cards.
Before Lehman collapsed, the collateral was about $1 trillion, while the rehypothecation was about $4 trillion. Afterwards, hedge funds balked at the risk and put clauses limiting or preventing the practice into place. Now only ‘muppets’ – average investors who don’t know better – have their assets put on the block.
Singh and Aitken showed that rehypothecation played a central role in the 2008 crisis and subsequent deleveraging. This led to a drying of credit and disappearance of lending between banks and in the general economy.
Markdowns on collateral – called ‘margin spiral’ – can rapidly get out of hand. Most of the asset backed mortgage instruments lost up to 90% of face value in months. The shadow banking system was much larger than previously understood – leading to a distorted, under-evaluation of systemic risk. Rehypothecation allows for pretty shady accounting. Multiple companies can list assets, unlike on-balance sheet assets.
This chart shows the real threat. The entire system rests on $30 trillion in assets. Out of these are created an endless chain of hyper-collateralized assets that are just more debt and promises. When any part of this flow is seriously disrupted, and it will be, global contagion and banking crisis will follow. The system will see increasing problems with increasing frequency and eventual uncontrollable implosion. A real world event happened in 2011.
Rehypothecation Risk and segregated accounts – the MF Global Story
MF Global was a derivatives (options, futures, etc.) broker and a primary bond dealer for the US Treasury. This is an important point. Primary dealers are among the most scrutinized of financial companies. They are supposed to be very conservative in operation, extremely stable, and possess very high integrity – guaranteed by the regulatory authorities.
This company was officially rated triple gold star, completely immune to any solvency and liquidity issues. The lesson is clear – the auditing system is broken. All parties failed in their duties – MF Global was highly leveraged, very risk-prone, and engaged in a number of unscrupulous practices. Clients, including subsidiary clients, lost billions.
Why the checks and balances system failed is less clear. It was either incompetence or willful deception. These are some of the highest paid accounting firms in the world. Either they got to their position through years and years of incompetence, it was a show of one-time incompetence, or they were deliberately and well-paid to do exactly what they did – cover up a financial black hole. How many more MF Globals are out there?
In 2008, the company got a $10 million fine for inappropriate trading activity, blaming it on a ‘rogue trader,’ a recurrent theme in the modern financial world. Liquidity concerns tanked the stock price, then it got another $10 million in fines for bad risk management. The company rehypothecated big-time, betting the farm on Greek debt.
The debt was very high-yield. The firm took out credit default swaps on the bonds, probably hoping for a default with a subsequent massive payout by the swaps contracts. Timing was bad and the hyper-leverage dove-tailed with market concerns – liquidity disappeared for MF Global. To maintain the appearance of solvency and liquidity, they dipped into the customer till.
Segregated accounts are (were) considered sacrosanct. It was a line even the banks wouldn’t cross. If they did, the system would have been exposed as hopelessly corrupt. Taking customer funds without asking is simply stealing, even if the intent is to return the funds. On October 31, 2011, the company admitted that $891 million in customer funds was transferred to cover huge losses, including an odd $175 million transfer directly to JP Morgan. The true amount is not well-disclosed, nor is the length of time the malpractice occurred.
MF Global was using a complicated internal and external trade. Their London branch was doing a repo with the New York branch taking the other side – the reverse repo. A repo is a short-term sale with an agreement to buy back later. Repos are supposed to fund short-term liquidity needs, but they also allow for funny accounting games.
The company used a fiction – an internal repo to maturity – to game the regulations. It was a simple one to spot, but the regulators ignored it. In this case, it was to provide a booked profit to make the business look more solvent. But the trade had a two-day shortfall in the window before maturity when the bonds were sold externally.
This, combined with the default risk, put an unendurable liquidity crunch on the business. This became public knowledge, investors withdrew funds, lenders pulled back, and the death-spiral sank the ship, disappearing billions in client funds.
Analyst Chris Whalen calls it outright theft. Clients lost gold, bonds, currency and other assets. HSBC even filed suit against JP Morgan over $850,000 in gold held from MF Global. MF Global seems to have been pledging client gold – the ultimate backstop asset – against its creditors’ claims. There would be no lawsuit between two such entities otherwise.
Rehypothecation of Gold and Silver
This leads to a nasty potential revelation. If one is doing it, usually they all are. Again and again, this is proved – like in the LIBOR rigging. The question is whether and how much of the GLD and SLV exchange traded funds (HSBC is the custodian) are backed by physical gold. The metals can be rehypothecated to more than their market value.
It may have multiple claims, and with the wording of the funds, the clients will be last in line. These funds are the biggest privately held stocks of silver and gold in the world. We’ll look at this in much more detail in the manipulation section.
Lehman and Bear Stearns were larger than the MF Global crisis. Customers were made whole in both cases before any other proceedings. This shows the extent of systemic strain at this point. Customer accounts are now needed to feed the beast.
It exposes the problem in public view. Trust is beginning to fall off the cliff, which the mega-banks have wanted to avoid. They need to the money to stay where it is – on their ledgers – to keep leverage from upending their balance sheets. It’s proof of desperation.
And, in a footnote of corruption, the customers are being charged storage fees on their stolen metals – otherwise they forfeit any settlement claims on them in future. Meantime, the prices of the metal dropped precipitously, so the cash settlement was far less. And naturally, the assets were frozen, preventing the legitimate owners from selling them.
Commingling of funds is the ultimate crime in brokerage activities. No one was prosecuted. Ann Barnhardt closed down her financial firm based on the handling of MF Global, with the following letter, edited for brevity:
Barnhardt Capital Management has ceased operations… I could no longer tell my clients that their monies and positions were safe in the futures and options markets – because they are not. And this goes not just for my clients, but for every futures and options account in the United States. The entire system has been utterly destroyed by the MF Global collapse.
The futures markets are very highly-leveraged and thus require an exceptionally firm base upon which to function. That base was the sacrosanct segregation of customer funds from clearing firm capital, with additional emergency financial backing provided by the exchanges themselves. Up until a few weeks ago, that base existed, and had worked flawlessly.
Jon Corzine STOLE the customer cash at MF Global. …[Regulators’] reaction has been to take a bad situation and make it orders of magnitude worse. Specifically, they froze customers out of their accounts WHILE THE MARKETS CONTINUED TO TRADE, refusing to even allow them to liquidate. …The risk exposure precedent … has destroyed the entire industry paradigm.
…MF Global is almost certainly the mere tip of the iceberg. The Chicago Mercantile Exchange did not immediately step in to backstop the MFG implosion because they knew and know that if they backstopped MFG, they would then be expected to backstop all of the other firms in the system when the failures began to cascade – and there simply isn’t that much money in the entire system. In short, the problem is a SYSTEMIC problem, not merely isolated to one firm.
…The futures and options markets are no longer viable. …The system is no longer functioning with integrity and is suicidally risk-laden. The rule of law is non-existent, instead replaced with godless, criminal political cronyism.Ann Barnhardt, 2011 letter to investors
1.42 million ounces of silver went missing in the scandal – vaporized funds, the mainstream media called it. But it went somewhere, to someone. It was stolen. The bad bets, Jim Willie explained, put pressure on the Comex. People wanted delivery of their silver futures contracts. JP Morgan could not fulfill these contracts legally.
On Dec. 12, 2011, HSBC filed a lawsuit to prevent an MFGlobal client from taking delivery on physical gold and silver from the Comex. The metals were doubly owned, confirming the critics claims. It’s difficult to sort out what really happened – probably by intent.
MF Global lost precious metals it was supposed to deliver. JPMorgan apparently was being hammered by margin calls on a number of derivative bets getting out of hand. Their reserves were scraping bottom. The silver and gold futures calls for delivery had put the bank in a tight squeeze. They held onto the MFGlobal metals that were supposed to be sent, putting them into their own account.
JP Morgan is serving as trustee for the case in spite of their notable conflict of interest – they have liens on substantial assets. This conflict of interest is a spit in the eye of the clients. “Evidence mounts,” Jim Willie explains, “that JPMorgan simply converted 614k ounces of MF Global client silver into JPM licensed vaults.”
Two definitions – eligible means that it meets quality standards for good delivery but is still owned by a private party. Registered means it is available for delivery to satisfy a futures contract. They moved 613,738 eligible ounces into their vaults on Nov. 18. After waiting a week, they changed it to registered. All the silver they held for others soon after the MF Global collapse was converted to JP Morgan ownership.
On Oct. 31st, MF Global publicly filed bankruptcy. The CME made a statement about 1.4 million ounces of silver vanished from the client holdings at MF Global. 627,182 was from banks outside the cartel. It was the first deposit in half a year of any quantity for JP Morgan into their silver vaults.
The futures contracts (covered later), are many times the deliverable amount of silver available. The chart tells all you need to know – there is a massive decline in available silver for delivery. The Comex is approaching a default. They badly needed silver to meet futures deliveries, which are rising aggressively.
One trader, whose account was vaporized, said the freeze came because of stock positions with impossible counterparty risk. To save a few hundred accounts, the holdings of 35,000 commodities customers were stolen. Customer account receipts were immediately confiscated at the beginning of the investigation. This made it very difficult for them to prove their asset claims.
The claim was that the money was missing and could not be found. US regulators accepted this even when it was shown to be a lie. Richard Heis, an administrator of MF Global’s UK division, said, in the US the claim is “nobody knows where the money is. We know exactly where the money is.” Some analysts claim the regulators are throwing up a dust cloud to protect the perpetrators, ticking the clock until the statute of limitations expires.
Rehypothecation and Derivatives
The 2005 bankruptcy reform act elevates derivatives above all other asset classes in a bankruptcy. This puts the banks (holders of 99% of all derivatives) above any other asset holder. In a rehypothecation scenario, the innocent public is pushed underwater and loses. Considering derivatives tower above all other assets by volume, the danger is extreme.
In a true derivative havoc situation, no brokerage-held asset would appear to be safe – MF Global proves it. People would do well to examine the fine print in their pension and 401(k) contracts. If people have cash in an investment account at Morgan Stanley, for example, when the firm goes Lehman, that cash can be used legally to pay off MS’s exploded derivatives. There is even a clawback provision. If the client removed the funds in the weeks beforehand, they can reverse the transfer.
When Bank of America took over Merrill Lynch, they bought a freakish $53 trillion in derivatives onto their balance sheet. By moving that and a pre-existing position ($77 trillion) from the investment to the commercial side, they put it on the FDIC’s insurance list.
According to the Market Ticker, it’s an “armed financial nuclear device… daring anyone to tamper with it.” All banks have the same type of massive systemic risk, deliberately booby-trapping their balance sheet. This is commingling on an extreme scale – the firewall between investments of a bank and client deposits is gone.
The public is held hostage to the potential chaos. Bank CEO’s, the Ticker claims, lie with impunity about the risks. The warning is very clear.
The CME (Chicago Mercantile Exchange) is a non-governmental regulatory body in charge of overseeing MF Global and other such brokerages. Top management wrote a public letter in July, 2012. The group was “appalled by the recent misuse of segregated funds.”
In order to reinstate customer confidence, they proposed revised regulations, including unannounced audits of segregated funds, daily and bi-monthly reporting and electronic confirmations of segregated funds, and CEO guarantees of procedures. “CME Group is committed to making whatever changes are necessary to strengthen customer protections, restore confidence in the futures industry and ensure the effectiveness of these critical markets.”
Unfortunately, the CME reneged on this mission even before the letter. They had an agreement to make investors whole as part of their mandate, but refused to do so. They probably had the money, but according to the organization’s Chairman Terry Duffy, it would set a $185 billion precedent. In other words, expect more MF Globals, beyond the CME’s ability to backstop.
PFG Best repeated the MF Global scenario. The CFTC and other regulators checked out Peregrine Financial and found it in fine shape in January, 2012. The ensuing investigation found that the fraud extended back several years. It turned out that an account listed as holding $225 million only held $5 million.
CEO and owner Russel Wassendorf attempted suicide over the debacle with a hose to the car. Thousands of clients lost money when their claims were illegally put behind the counter-claims of other banks. Again, JP Morgan is in the mix – this time holding the Forex transactions. Segregated accounts were raided, the funds ‘vaporized.’ Someone got them, of course. All customer accounts were frozen. People could not access their own positions, except some selling.
It’s happened before. The National Futures Association signed off on audits of Sentinel Management Group a few weeks before the firm failed in 2007. As people’s monies had been rehypothecated, Bank of NY Mellon filed suit for $312 million to be paid before depository clients. The suit was settled in August, 2012, in favor of BNYM. The clients lost.
The suit sets a pretty frightening precedent – financial firms in bankruptcy can use client funds to pay off their debts. They can legally post client money as collateral and mingle client funds in emergency situations. Barnhardt posted a strident appeal to people to get over their “normalcy bias…get your money out now!”