The MF Global bankruptcy has brought to light a very reckless, insane practice that has become common with deal-brokers over the past few years. It is called re-hypothecation.
The word hypothecation is the legal term for when a borrower pledges collateral to secure a loan. We hypothecate our homes to the bank when they advance us a mortgage. We get to keep legal title to the property in our name, but if we default on the loan, the bank has the right to take the property. The same concept applies in margin accounts. You may own $500 of stock in your account, but if you have borrowed $200 of the money on margin with your broker, your net equity in the account is $300 and your broker holds your hypothecation for $200.
Over the past few years however, a slackening of prudent rules and regulation allowed broker-dealers to step through a dangerous loop-hole allowing them to hypothecate assets belonging to their clients “as if they belonged to the broker”. This means that a US broker-dealer (like MF Global) was able to transfer their client assets to other firms as collateral for the firm’s own margined trading accounts and not count this as a liability on their firm balance sheets. In the above example, a US broker/dealer is able to re-hypothecate or put forward as collateral $280 of their clients’ assets being (140% x $200 margin= $280). For European firms based out of the UK, the rule is even more lax, they are able to re-hypothecate not just a multiple of the margin owed, but THE ENTIRE asset value held in the client accounts for the firms’ own trading activities. In other words, UK regulation loop holes, would allow the broker in the above example to swap out the full $500 of client assets as collateral for the firms own speculations. [Remember those tighter bank regulations that David Cameron opted out of the EU deal last week to avoid? this would be one of the key areas he was looking to protect for his City of London base.]
It gets worse. US broker/dealers found a brilliant way to get around the limit of only being able to re-hypothecate their clients’ margin balances. Some swapped their client assets to UK brokers who could then advance them leverage on 100% of the client assets. Which the US brokers directed into–you guessed it–European sovereign debts. In many cases this meant that brokerage clients would be trying to bet against defaults in the Euro credit markets while unknowingly holding those very bonds in their broker custodian accounts.
This insane risk and activity has accounted for up to half the activity of the so-called “shadow banking system” over the past 5 years. “Shadow’ alright. The clients are completely in the dark while broker/dealers have been speculating on “free money” from their clients. The brokers keep the profits when they occur. But as MF Global clients have recently learned, when the firms bet wrong and blow up [a completely predictable outcome using this kind of reckless leverage and speculation] the UK brokers are entitled to keep the client assets as if it were capital belonging to the US-based firm.
All of this is deemed possible by virtue of a little-noted paragraph of legalize in client account agreements that reads something like this:
“Pledge of securities and other property. You may pledge, repledge, hypothecate, or re-hypothecate, without notice to me, all securities and other property that you hold, carry or maintain in or for any of my margin or short accounts. You may do so without retaining in your possession or under your control or for delivery the same amount of similar securities or other property. The value of the securities and other property that you may pledge, repledge, hypothecated, or re-hypothecate may be greater than the amount I owe you, and any losses, gains or compensation that result from these activities will not accrue to my account.”
What is not said here, is that if the firm blows itself up from over-leverage, your client capital can actually vanish with it.
A recent Reuters article: MF Global and the great Wall Street re-hypothecation scandal points out that the firms engaged in this activity have been all the usual suspects of Goldman Sachs, JP Morgan, Wells Fargo, Morgan Stanley et al., but also Royal Bank of Canada and CIBC.
If you have margin accounts, you should check your account application and check with your broker/dealer to see if they are re-hypothecating your assets, and if so, how specifically they are using your money.