How Banks Are Using Your Money to Create the Next Crash

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In 2008, reckless credit default swaps nearly obliterated the global economy. Now comes the next crisis – rehypothecated assets.

It's a complicated, fancy term in the global banking complex. Yet it's one you need to know.

And if you understand it, you will get the scope of the risks we currently face – and it's way bigger than just Greece.

So follow with me on this one. I guarantee that you'll be outraged and amazed – and better educated. You'll also be in a better position to protect your assets at the end of this article, where I'll give you three important action steps to take. So follow along…

Their Profits on Your Money

Few people know this, but there's a process through which banks and trading houses are leveraging your money to increase their profits – just like they did in the run-up to the last financial crisis. Only this time, things may be worse, as hard as that is to imagine.

Consider: In 2007 the International Monetary Fund (IMF) estimated that this form of "leverage" accounted for more than half of the total activity in the "shadow" banking system , which equates to a potential problem that would put this insidious little practice on the order of $5 trillion to $10 trillion range. And this is in addition to the bailouts and money printing that's happened so far.

Wall Street would have you believe this figure has gone down in recent years as regulators and customers alike expressed outrage that their assets were being used in ways beyond regulation and completely off the balance sheet. But I have a hard time believing that.

Wall Street is addicted to leverage and, when given the opportunity to self-police, has rarely, if ever, taken actions that would threaten profits.

Further, what I am about to share with you is one of main the reasons why Europe is in such deep trouble and why our banking system will get hammered if the European Union (EU) goes down.

And w hat makes this so disgusting – take a deep breath – is that it's our money that's at stake. Regulators like the Securities and Exchange Commission (SEC) and their overseas equivalents are not only letting big banks get away with what I am about to describe, but have made it an integral part of the present banking system.

Worse, central bankers condone it.

As you might expect, the concept behind this malfeasance is complicated. But it's key to understanding the financial crisis and to avoiding a possible global recession in 2012 and beyond.

What we're talking about is something called "rehypothecation."

Most people have never heard the term, but trust me, you will shortly. Let me explain what this is, and why you need to know about it. Then, I'll offer three ideas to trade around it.

What Does Hypothecation Mean?

Hypothecation is what it's called when a borrower pledges collateral as a means of securing a debt. The borrower retains ownership of the collateral but it is hypothetically under the control of the creditor who can seize possession of the collateral if the borrower defaults.

If you own a house and have a mortgage, you have hypothecated it to your mortgage company, for example. This means that you still own it, but in the event of a default, your bank or your mortgage company (the creditor) can take ownership and do what it wishes.

"Re hypothecation" varies slightly when it is applied in the financial markets.

For example, if you put a buck in your checking account and the bank has to keep 10% of that in reserve, it can loan out $0.90. But then, if somebody else deposits $0.90, the bank can loan out $0.81 cents or 90% of the total assets on deposit. And so on, until literally all the money on deposit is effectively hypothecated to another entity. This is why banks are constantly seeking new depositors – to feed the hypothecation machine and their profits.

Obviously a buck is still a buck no matter which way you cut it, so cash does count for something. But at the end of the day, any banks can create a daisy chain of rehypothecated assets that results in as much as $10 in new checking accounts and rehypothecated assets against every $1 in actual deposits. Perhaps more.

If you're a brokerage house, the process is similar. Have equities, the collateral gets posted and used accordingly. Bonds, same thing. The brokers will reuse them by rehypothicating them at their discretion while making sure a fraction of the actual underlying value remains in reserve as collateral.

Typically, banks and investment houses have rehypothecated customer assets to back their own trades, their own borrowing, and their own operations.

Just like your house, which can be seized if you don't pay up, assets on deposit with a broker may be sold by the broker (hypothecated) if investors fail to keep up with margin payments or if the securities drop in value and the investors in question fail to respond to requests to boost their collateral – all at the broker's discretion depending on their margin and clearing requirements.

Now here's where it starts to get sticky.

Let the Leverage Games Begin

SEC Rule 15c3-3 allows broker dealers to rehypothecate assets equal to 140% of clients' liabilities to meet their financial obligations to customers and other creditors.

Here's an example.

If a client has $10,000 in securities on deposit and a debt deficit of $2,000, the net equity is $8,000. This means the broker-dealer could rehypothecate up to $2,800 of client assets to finance its own activities – often without notice.

Not only is this legal, it's common practice specified in the fine print of most brokerage agreements.

If you've ever traded on margin, chances are you're in the game whether you want to be or not because any common stock, cash, or other securities – even gold and Chinese yuan – can be used as collateral that the broker can hypothecate or rehypothecate.

And that's where the real games begin.

Remember our checking account example? It's the same thing here. Assets in brokerage accounts can be used and re-used in such a way the credit multiples far outweigh the actual assets in the accounts. In effect, rehypothecated assets become part of a daisy chain, for lack of a better term, wherein one company's liabilities become another's assets.

If there is a hiccup anywhere in the chain, the effect is one of instant collateral collapse as everybody in the chain is forced to buy back, or recall, their assets. The effect is not unlike a colossal global "short" on world markets.

Imagine what happens if something goes wrong and everybody wants their $10 back, but find that there is only $1 in actual cash.

I believe this is what Federal Reserve Chairman Ben Bernanke and his counterparts at the ECB are so concerned with and why they are obsessed with liquidity. Everybody knows that too much debt caused this mess, but what they don't realize is that it's the use of rehypothecated assets that make collateralizing it nearly impossible barring massive injections and printing.

Here's why. By their very definition, rehypothecated assets are those pledged as collateral against borrowings. That means they support not one, but two separate borrowing transactions – one of the originating firm's tally and one on the borrower's tally – perhaps even more if the broker in question takes its activities offshore to other jurisdictions not bound by the same rules.

Take the United Kingdom, for example, where there is no limit on the amount of client assets that can be rehypothecated. There, brokers have reportedly and routinely rehypothecated 100% of the value of client accounts, not just those assets pledged as collateral.

That's why firms like MF Global, Goldman Sachs Group Inc. (NYSE: GS), Canadian Imperial Bank of Commerce (NYSE: CM), the Royal Bank of Canada (NYSE: RY), Credit Suisse Group AG (NYSE ADR: CS), Wells Fargo & Co. (NYSE: WFC), and Morgan Stanley (NYSE: MS) more frequently establish U.K.-based investment pools and lateral assets from other jurisdictions like the U.S. into them.

Not only does this allow them to skirt the law and limits on their activities here, but it leads directly to the creation of even more leverage and, potentially, higher returns – which is why they do this.

Of course, it also potentially leads to catastrophic losses. But with government bailouts in their back pockets, and central bankers who have by their actions determined the big firms are worth saving at the expense of Main Street investors, the big financial firms don't seem the slightest bit troubled that they are playing with our money.

However, I find this deeply troubling on a lot of levels.

How to Protect Yourself – And Even Profit

You'd think that regulators would have a firm grip on this but they don't. Rehypothecated asset transactions are completely off balance sheet so it's exceedingly difficult to track what moved where and when. Worse, because of the lack of transparency, it's also very complicated to determine which firms – those stateside or those overseas in markets like the U.K. – hold the money.

Allegedly, MF Global couldn't live with the 140% SEC mandate so it began arbitraging differences between rehypothecation regulations in various markets and used off balance sheet entries to ratchet up leverage to obviously unsustainable levels. Now there may be an estimated $1.7 billion in customer money that can't be accounted for in that firm alone.

What makes this especially problematic is that it's tough enough to unwind rehypothecated assets in one country. Now, though, we are facing a situation where the regulators, lawyers and lawmakers may have to unwind rehypothecated assets that are effectively pledged as collateral in multiple transactions in multiple jurisdictions with multiple clearing firms. Absent balance sheet controls and forensic accounting, it's going to be very difficult to determine who really owns what.

As for why this is so serious, try this on for size.

There is conjecture that the actual asset backing for the sum-total of rehypothecated assets may be as little as 25% of the notional value at risk. In other words, a firm with $25 billion in rehypothecated assets may be at risk for $100 billion in instruments that are completely off balance sheet and for which there is nothing but thin air backing them up — perhaps a whole lot more depending on how many times the actual assets have been rehypothecated and levered up.

According to Thompson Reuters, here's a partial list of firms and their rehypothecated assets in 2011:

  • Goldman Sachs Group Inc. ($28.17 billion).
  • Canadian Imperial Bank of Commerce ($72 billion).
  • Royal Bank of Canada (rehypothecated $53.8 billion of $126.7 billion available).
  • Oppenheimer ($15.3 billion).
  • Credit Suisse Group AG ($353 billion).
  • JPMorgan Chase & Co. (NYSE: JPM) ($546.2 billion).
  • Morgan Stanley ($410 billion).

That adds up to almost $1.5 trillion — and that's just a partial list of what we know about.

Now queue up your best "Death Star approaches" music.

The mainstream press has reported that EU liquidity is drying up on default fears. But what if they know something else that they're not telling us?

I'm not into conspiracy theories, but I can very easily envision a scenario in which the underlying collateral has been rehypothecated between the various EU/US banks so many times that the actual value at risk may be more than four times the figures disclosed to the public to date.

This is one of the reasons that I have suggested — since the beginning of the EU crisis — that we're looking at several trillion euros before we can even think the EU situation is under control versus the "worst case" 200 billion-euro estimates floated at the time.

The other is far simpler. I believe Europe remains in denial, as do our own leaders. Much of the growth over the past 20 years was driven by excess leverage and speculation. Until that's gone, the markets will demonstrate the kind of reflexive pessimism we've seen recently that's characterized by short, sharp rallies and generally higher overall volatility.

To think that the EU will miraculously line up, that China will suddenly speed up again, and that the U.S. will suddenly rein in its exploding debt is pure folly.

So how can you trade this?

I can think of a couple of strategies:

  • Short specific banks or the broader financial sector as a whole. But be prepared for a bumpy ride. The world's entire central banking community is playing against you and will do everything it can to prevent a meltdown by sustaining the illusion granted to us by the rehypothecation process.
  • As the markets rise on the illusion of a fix or improving data or both, allocate a small portion of capital to put options or inverse funds. If nothing else, you'll sleep better knowing that these things will explode when the day of reckoning ultimately arrives.
  • Remain long with what you've already got, but continually ratchet up trailing stops to protect gains. Why the markets rally is not important, that you capture profits as they do is. It is absolutely possible to be a market bull and an economic bear.

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About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

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  1. doktor don | January 4, 2012

    Finally! Someone with the intellectual acume' to explain, in a way that one can understand, how the leveraging schemes on Wall Street work. In theory, this over-leveraging might work if there was fidelity and honesty among BOTH Investors, Borrowers, and the Financial Guru's on Wall Street. Of course, that will never exist, thus the whole scheme is bound to Crash, as the Writer here so accurately describes.

    One of the Best Articles I have read on the subject; and, a real service to the Minions in the Field, whose money the Predators are risking – – or, should I say, gambling with on a daily basis.

    For this practice to be unregulated, one must conclude that the Government is a Co-conspirator in the greatest scam of all times. Republic or Representative Democracy? Forget it! Witness an, "Oligarchy Rising." The Crash of 2008, and the Great Wall Street Heist, seems to have only embolded the Predatory Capitalists. Is there no real hope?

  2. Allen Jones | January 4, 2012

    This article is entertaining and informative. However, the only solutions offered are trades in accounts that can be hypothecated and re-hypothecated. Why not convert margin accounts to cash accounts not allowing hypothecation?

  3. Glen Weiberg | January 4, 2012

    again & again, another doomsday report. have i become stoic ,who cares? or is it real this time?

  4. ron salvino | January 4, 2012

    to Keith Fitzgerald, I read your comments on rehypothecation and have to ask, what banks should be considered for a savings account –large banks and which ones, or small community banks? Or just by gold and silver?

    Thank you for taking the time to write the article. I was under the impression that Royao Bank of Canada, an old bank, was very safe.

    Rpm Salvino

  5. Observer | January 4, 2012

    I hold two inverse stocks, EUO and DRR that short the Euro. It is interesting the way they always go up on days when everything else goes down. So I guess that I am already doing some of what you are advocating.

  6. Johny | January 4, 2012

    This is a great article ? Lets scar everyone like during the great depression and then everyperson will be lined up at the banks to take out their money. Creating the problem that this article is intending too avoid. Way to go social media.

  7. Robert PMO | January 4, 2012

    Rehypothecation is a serious matter, but we have been living with it for decades and will for many more decades.

    Anytime there has been a potential problem with this system the central banks print money and bail out the system.

    It stinks, but the consequences of stopping this game are just too horrible so the game will carry on.

  8. Ed | January 4, 2012

    Why do you tell us this stuff. I was just getting it together for the new year. Although it couldn't happen to a nicer bunch of…people than those at CIBC. Oh well. First week in January, and the average temperature is -5C here in this part of British Columbia. It hit +10C last night ( 5C over the record ) so I guess we should be ready for anything.
    Ed the Grocer

  9. jrj90620 | January 4, 2012

    Excellent article.Maybe it also explains why there is so much inflation(despite govt's phony inflation statistics).There must be much more liquidity around than advertised or all these people,here in So California,couldn't afford to keep paying high prices for fuel, food,clothing and everything else(except maybe consumer electronics).Lucky for all these countries, that these debts are 100% fiat and central banks can print them away.Expecting all these currencies to continue declining and real assets' fiat prices to increase.

  10. Benton H Marder | January 4, 2012

    I cannot imagine why you have not advised your readers to allocate substantial funds to precious metals and to take physical delivery, not to leave the metals in any outside storage. Otherwise, you and your readers are going to be left holding the bag—or vulnerable to 'clawback' provisions. Get real, man!

  11. David | January 4, 2012

    Keith you have a trading service.Stocks held without direct registration are @ risk as well.Why did you not advise on that???Benton is exactly right,based on all the printing and global debasement of currencies,the best option is owning physical precious metals that you hold yourself.NO COUNTERPARTY RISK.Its really that simple for such a time as this.

  12. Ian | January 4, 2012

    Ditto Benton! The only way of getting out of this mess is to become your on central bank, and hold precious metals that don't carry any bankers liability. Metals is about the only bull market anyway.

  13. Septagon | January 4, 2012

    Multiplacation of money is something the financial system has been doing for a very long time, here in Australia we have a couple of animals called an Emu and a Kangaroo they apear on our coat of arms if you observe these animals they are unable to move backwards the whole system is going to move forward wheather we like it or not so look out for hyperinflation this is the one to watch.

  14. Malcolm Rawlingson | January 4, 2012

    Keith, Great article. It is an upside down pyramid and it will eventually fall over. Sure your readers above can be in denial but we all know it is happening because the massive debt burdens of countries and people can only have been created by a scheme such as this. This "wealth" has not been worked for or earned it has been manufactured out of thin air and will disappear into thin air soon enough. I tend to agree with Benton H Marder that investing in real assets like gold (I prefer silver), coins stamps or other tangible things that have real value is the better way to go. When this thing collapses as it inevitably will hard assets are what will really matter. I always find it a bit foolish to shoot the messenger – the folks above need to listen to what you say. They may not like it but that does not make the message wrong. Thanks again. Malcolm

  15. Harilaos Petrakakos | January 5, 2012

    Well, well.
    This is not new. This is as old as the Fed itself.
    The banks have been doing this since early days.
    Therefore the article may be educating the un-initiated and that's all.
    Scary? Not really.
    Doomsday? Not really.
    Why Greece then? Because the Euro was becoming the currency of choice.
    That again an initiated person and one that has had Lester Thorow and others at MIT as professors would have learnt to think the root cause of anything.
    That is why we shall now relax in the financial markets as the dollar becomes the currency of choice and no risk for the FIAT dollars losing their luster.

  16. cl8onb | January 5, 2012

    Dear Shah, Why can't we just socialize the financial system? The private interest of banks and financiers is obviously not in the public interest nor fair to the interests of productive capital. Why can we not take the assets (what small real assets there apparently are) into the public domain? After all, those very same assets came from the public in the form of massive bailouts of private debt. The banks and financial houses have already proven that they have failed. If such a thing should transpire in the productive sector, the enterprise would be left to languish. Would not socialization of the financial sector eliminate this graft and criminality and at the same time put us back on a productive footing?

    • stevew | January 8, 2012

      Brilliant idea! I don't know if it will eliminate the graft and criminality but who cares as long as it cripples the efficiency at which it can destroy the economy. Of course there isn't a chance this scenario would happen. The puppets will never control the puppeteers.

  17. Jay Hollenkamp | January 5, 2012

    The issue is leveraging. 1) How do we calculate the risk? 2) How much is definitely too much? and 3) How do we prevent it from happening without us knowing it?

    Rehypothecation is a tempest in a teapot because if we answer the three questions above, an intimate understanding of rehypothecation is unnecessary.

  18. BRET HOLMES | January 5, 2012

    Dear Readers:

    Thank you very much for taking the time to read Keith's report and to post comments.

    Keith read each and every comment and asked me to respond. We realize that this is an unpleasant topic. But our role here at Money Morning isn't to ignore bad news, or overplay good news. We are here to present the facts. We're here to provide you with the information and insight that you need to protect what you have, and enhance it, if possible. We want to warn you of pending problems, even as we detail the very best profit opportunities long before Wall Street ever would.

    Our goal is to help investors make informed decisions.

    As for gold and other hard assets, the Money Morning team, including Chief Investment Strategist Keith Fitz-Gerald, has continually reinforced the need for such investments in various forms bth as a means of hedging value and absolute returns. We're on record as having first recommended gold when it was trading at $770 an ounce — not long after we launched Money Morning.

    And you can see where gold ran to after that.

    Thanks again for your comments. We hope you'll keep them coming.

    Respectfully yours;

    William (Bill) Patalon III
    Executive Editor
    Money Morning & Private Briefing

  19. PARMOD SEHGAL | January 6, 2012

    Reading your article one get a a feeling that that the world is sitting on a financial atom bomb which can explode any time.

  20. Steve Roth | January 6, 2012

    Let me see if I have this right, in simple terms:

    Charles Schwab and Co. (or whoever) is holding $10,000 of my Apple stock for me. They have to give it to me if I ask for it.

    They borrow $10,000 from Deutsche Bank, saying "if we don't pay it back, we'll give you Steve's Apple stock." (They're allowed to *do* that? It's my stock, not theirs.)

    The problem arises if both I and Deutsche Bank want the Apple stock at the same time.

    That about right?

  21. captaindoc | January 8, 2012

    this explains why the governments jump at the chance to pump money into the banking system to "save it". if the banks fail on such a large scale as listed in the article then there would be civil disorder. they know this! this is why there is such support for the police to have weapons, with warfighting ability, that will stop a civil disorder or a an out and out civil war. europe would not have a civil war as they do not have the balls to go against the government, but the united states would start a civil war that could end up as a world disorder.

  22. Ian | January 8, 2012

    Something nobody is mentioning in all of this!! The US Government only owes money in US$. So therefore they can print or release debt or create treasury bills to pay off this money. ie 1 trillion owed. Make a new paper note say $ 10,000 and hand it to which ever country they owe money to. The Bretton Woods accord 1944 left the US in control of Money world wide by the end of the WW2.
    True it will cause inflation but a certain percentage will be destroyed or lost or whatever. The lost of trust would be dramatic. Yet we already have this. So to some extent the US government is still in control of world trade.
    Other countries trade in US$ so they are more vulnerably to the loss of value of their own country's currency to the US. Who knows how this will affect us all and pan out.

  23. donald cornell | January 8, 2012

    Hard assets?, is not residential real estate a hard asset? people got to live SOMEWHERE, if you buy it right and can rent it to cover your costs, is that not much better than being in cash, or indeed gold/silver which yoyu THINK is SAFE in abank deposit box, which can be seized by the government., did it once BEFORE!!

  24. Arthur Robey | January 8, 2012

    I am too thick to play the market, but it seems to me that you are referring to the Crash Course by Chrismartenson.com

    Sal also explains fractional reserve banking nicely at the Khan Academy.
    http://www.khanacademy.org/video/fractional-reserve-banking-commentary-1?playlist=Banking+and+Money

    By the way, according to this article Silver is in Backwardation. Time to tippy toe to the teller.

  25. Christopher Weingartner | January 8, 2012

    Enjoyed the article in that it was fairly clear to a basic financial thinker like myself, however, can you clarify this paragraph you wrote, especially the part "that results in as much as $10 in new checking accounts and rehypothecated assets against every $1 in actual deposits."?

    "Obviously a buck is still a buck no matter which way you cut it, so cash does count for something. But at the end of the day, any banks can create a daisy chain of rehypothecated assets that results in as much as $10 in new checking accounts and rehypothecated assets against every $1 in actual deposits. Perhaps more."

  26. Karl Kljavin | January 9, 2012

    Thanks for the article.
    All is moor or less clear except, let's say whay they are sawing the branch
    whitch themselves sit.
    Best regards.

  27. JACK DIXON | January 11, 2012

    Makes sense, except for the comment "90% thin air". As long as the loans made are adequately collateralized. The loan the bank makes with the 90% of your money should be made with 80% collateral so that 20% equity remains. Then, even after foreclosure expenses, the bank should be able to recover the 90% of your money. Oh, that's right, that was the traditional system that worked. After the government, in another vote buying scheme, forced banks to lend on inadequate collateral (and creditworthiness), and delivering financial system payoffs like the 140% rule and Freddy/Fannie, this has all come unraveled.

  28. Ian2 | January 13, 2012

    I have been chasing down this idea as well and from what I have learned it doesnt work as you've described for brokerage. There's a limit to the leverage of client assets in the US, as you note, via rule 15c3. However, any dollars in excess of 100% must be segregated. So in your example, yes the broker can pledge shares up to 140% of the debit balance for theoretical leverage of $2800, but anything above $2000 (the $800 that is seemingly starting the dangerous daisy chain) must be set aside in a segregated account and cannot be used to fund the brokers balance sheet. So in the end all the broker is doing is borrowing $2k at a low cost and lending $2k to you via margin and clipping the spread. Your assets are collateral for the loan, but there is no ballooning of leverage this way. UK is different – no 15c3 holding you back – thus the UK subs. Check out the disclosure at Interactive Brokers in their filings – I thought that was some of the better I found.
    So dont freak over customer money creating massive leverage.
    But…the process of re-hypothication does indeed exist outside of customer accounts, where every other AAA asset on the planet has been pledged several times over.

  29. NEo | June 21, 2012

    This is a great article ? Lets scar everyone like during the great depression and then everyperson will be lined up at the banks to take out their money. Creating the problem that this article is intending too avoid. Way to go social media.

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