By Kevin Brekke, Casey Research
A new polysyllabic term has entered the Wall Street lexicon and is sweeping through the investing world like a brush fire through a dry canyon: “hypothecation.” With its connection to the MF Global bankruptcy and aftermath, it engenders the kind of fear a homeowner might feel while monitoring the approaching flames.
The rise of hypothecation as the lead suspect in the MF Global tragedy has caused a fair bit of confusion about what, exactly, it is – and is not. Proving the idiom that nature abhors a vacuum, the blogosphere has weighed in with all manner of explanations, many of which have been less than accurate.
In an attempt to help our readers get to the heart of the matter, we will briefly review hypothecation – what it is and how it is used – and do so in plain English.
There is considerable ground to cover here, so we will get right into it, starting by defining the term, then discussing the role hypothecation played in the demise of MF Global before turning our attention to the question in the minds of many gold investors – was MF Global re-hypothecating gold bullion? Finally, we’ll have some closing thoughts on the potential implications for us as individual and institutional investors going forward.
The Two Faces of Hypothecation
At its most basic level, anyone who has traded on margin (borrowing money from a broker to purchase stock) or shorted a stock (borrowing shares through a broker that are sold today in the hope of replacing them with shares purchased at a lower price tomorrow and pocketing the difference) has participated in hypothecation.
Hypothecation is a legal term that means “to pledge something as collateral.” In the financial world of stockbroking, to hypothecate shares of stock means they are pledged against a loan from a broker for money to complete a transaction. For the investor, hypothecation necessitates a margin account.
Opening a margin account requires that a broker obtain a signed agreement from the investor. The margin agreement can be part of a standard account-opening agreement, or it might be a completely separate document. It is this agreement that opens the door for the assets in your account to be used for re-hypothecation purposes. Without such an agreement, you will not be able to open a margin account. In other words, if you have a margin account, you are in the game. If you don’t have a margin account, you are strictly an innocent bystander with no legal skin in the game.
It is important that you as an investor understand the terms of trading on margin. Once you trade on margin, any common stock, cash, or securities in your margin account can be considered as collateral for the money you borrow. And if the terms of the margin agreement allow it – almost universally the case – the broker can borrow or loan shares in the investor’s account up to the value of the amount borrowed (the margin).
Here it seems appropriate to mention that hypothecation is sanctioned by the SEC – subject to a host of rules, of course. Yet some of the recent reporting regarding hypothecation makes it sound as though brokers are taking shares from customer accounts for their own use and unbeknown to the customer. Unless the broker is engaging in deliberate fraud, that is not the case.
Most margin account agreements contain language that clearly explains that if a customer trades on margin, one understands that shares or other securities in one’s account – up to the amount of margin – can be borrowed or lent to other customers for shorting or to the broker for other uses. If a customer does not agree with this arrangement, one should not trade on margin. This is standard practice in the stockbroking industry.
Those “other uses” lead us to the second face of hypothecation.
Re-hypothecation
Re-hypothecation is when a broker reuses customer-pledged collateral to back the broker’s own trades and borrowings. It is 100% legal. However, while the practice may be legal, that does not mean it is prudent. Using the same collateral to support two separate borrowing transactions is obviously a risky tactic.
As background, under US Federal Reserve Board Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate an amount up to 140% of the customer’s liability to the broker.
Let’s quickly do the math on that one. If a customer has purchased $1,000 of securities, of which $500 is margined (borrowed), the broker is permitted to re-hypothecate up to $700 of the collateral – $500 x 140%.
Echoing the above, the use of re-hypothecated customer collateral is a common practice among broker dealers.
However, MF Global pushed the envelope on re-hypothecation by arbitraging differences in re-hypothecation regulations between jurisdictions and using off-balance-sheet maneuvers to ratchet its leverage to very high levels – referred to as hyper-hypothecation. The many components of this elaborate scheme, when combined, may make it impossible for MF Global’s clients to recoup any of their losses.
MF Global Goes Offshore
“Give me a place to stand and a lever long enough and I will move the world.” – Archimedes, 220 BCA
Once a leverage junkie, always a leverage junkie. It will help to understand the MF Global collapse if we keep in mind that its leader, Jon Corzine, is an ex-Goldman Sachs (GS) man, and the boys at GS love their leverage. The 140% leverage allowed under the US re-hypothecation regulation just didn’t scratch Corzine’s itch.
The solution: take it offshore.
Corzine decided to extend the lever a few thousand kilometers east and stand in the UK. In the UK, it turns out, there is no limit to the amount that can be re-hypothecated. It is the responsibility of the customer to negotiate the terms of re-hypothecation. Absent that, the broker is free to re-hypothecate 100% of the securities in a customer’s margin account, not just the securities acting as collateral.
The forensic accounting and investigation into the collapse of MF Global and the disappearance of possibly $1 billion or more in client funds is under way, and I do not wish to draw any premature conclusions. But preliminary reports about the investigation suggest that MFG had churned pledged client assets – re-hypothecating collateral several times – and used it to place a massive $6.2 billion bet on European sovereign debt.
It was a bad gamble that sent MFG into history’s dustbin.
This is an arcane and complicated topic, and this article does not attempt to cover every detail. The goal is to provide enough information for a reader to have a better sense of the terms that are probably going to be in the media a lot in the days and weeks just ahead.
