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.
News and Related Story Links:
- Money Morning:
Should You Worry About Europe's Back Door Bank Run?
- Money Morning:
Don't Buy Into Europe's Latest Rescue Effort – The Continent's Banks Are About to Go Bust
- Money Morning:
Now's Not the Time to Buy Bank Stocks – Now's the Time to Short Them
- Money Morning:
Derivatives: The $600 Trillion Time Bomb That's Set to Explode
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 High Velocity Profits, 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.