Posted on 12/09/2011 9:58:44 PM PST by Para-Ord.45
Why The UK Trail Of The MF Global Collapse May Have "Apocalyptic" Consequences For The Eurozone, Canadian Banks, Jefferies And Everyone Else
In an oddly prescient turn of events, yesterday we penned a post titled "Has The Imploding European Shadow Banking System Forced The Bundesbank To Prepare For Plan B?" in which we explained how it was not only the repo market, but the far broader and massively unregulated shadow banking system in Europe that was becoming thoroughly unhinged, and was manifesting itself in a complete "lock up in interbank liquidity" and which, we speculated, is pressuring the Bundesbank, which is well aware of what is going on behind the scenes, to slowly back away from what will soon be an "apocalyptic" event (not our words... read on). Why was this prescient? Because today, Reuters' Christopher Elias has written the logical follow up analysis to our post, in which he explains in layman's terms not only how but why the lock up has occurred and will get far more acute, but also why the MF Global bankruptcy, much more than merely a one-off instance of "repo-to-maturity" of sovereign bonds gone horribly wrong is a symptom of two things: i) the lax London-based unregulated and unsupervised system which has allowed such unprecedented, leveraged monsters as AIG, Lehman and now as it turns out MF Global, to flourish until they end up imploding and threatening the world's entire financial system, and ii) an implicit construct embedded within the shadow banking model which permitted the heaping of leverage upon leverage upon leverage, probably more so than any structured finance product in the past (up to and including synthetic CDO cubeds), and certainly on par with the AIG cataclysm which saw $2.7 trillion of CDS notional sold with virtually zero margin. Simply said: when one truly digs in, MF Global exposes the 2011 equivalent of the 2008 AIG: virtually unlimited leverage via the shadow banking system, in which there are practically no hard assets backing the infinite layers of debt created above, and which when finally unwound, will create a cataclysmic collapse of all financial institutions, where every bank is daisy-chained to each other courtesy of multiple layers of "hypothecation, and re-hypothecation." In fact, it is a link so sinister it touches every corner of modern finance up to and including such supposedly "stable" institutions as Jefferies, which as it turns out has spent weeks defending itself, however against all the wrong things, and Canadian banks, which as it also turns out, defended themselves against Zero Hedge allegations they may well be the next shoes to drop, as being strong and vibrant (and in fact just announced soaring profits and bonuses), yet which have all the same if not far greater risk factors as MF Global. Yet nobody has called them out on it. Until now.
As Reuters points out, it was not so much the act of creating "repos-to-maturity" that imperiled MF Global, but what is a secret gold mine for those privy to it - the process of re-hypothecation of collateral.
[h]ypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.
In the U.S., this legal right takes the form of a lien and in the UK generally in the form of a legal charge. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default.
In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital).
Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.
Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.
But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated.
In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation.
Keen to get in on the action, U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules.
Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organisation.
Potentially as simple as having MF Global UK Limited, an English subsidiary, enter into a prime brokerage agreement with a customer, a U.S. based prime broker can immediately take advantage of the UK’s unrestricted re-hypothecation rules.
This is exactly what Lehman Brothers did through Lehman Brothers International (Europe) (LBIE), an English subsidiary to which most U.S. hedge fund assets were transferred. Once transferred to the UK based company, assets were re-hypothecated many times over, meaning that when the debt carousel stopped, and Lehman Brothers collapsed, many U.S. funds found that their assets had simply vanished.
A prime broker need not even require that an investor (eg hedge fund) sign all agreements with a European subsidiary to take advantage of the loophole. In fact, in Lehman’s case many funds signed a prime brokerage agreement with Lehman Brothers Inc (a U.S. company) but margin-lending agreements and securities-lending agreements with LBIE in the UK (normally conducted under a Global Master Securities Lending Agreement).
These agreements permitted Lehman to transfer client assets between various affiliates without the fund’s express consent, despite the fact that the main agreement had been under U.S. law. As a result of these peripheral agreements, all or most of its clients’ assets found their way down to LBIE.
And now we get back to the topic at hand: MF Global, why and how it did precisely what Lehman did back then, why it did this in London, and why its failure is a symptom of something far more terrifying than merely investing money in collapsing PIIGS bonds.
( EXCERPT)
Hell, it may have apocalyptic ramification here in the USA!
From the article:
” Engaging in hyper-hypothecation have been Goldman Sachs ($28.17 billion re-hypothecated in 2011), Canadian Imperial Bank of Commerce (re-pledged $72 billion in client assets), Royal Bank of Canada (re-pledged $53.8 billion of $126.7 billion available for re-pledging), Oppenheimer Holdings ($15.3 million), Credit Suisse (CHF 332 billion), Knight Capital Group ($1.17 billion),Interactive Brokers ($14.5 billion), Wells Fargo ($19.6 billion), JP Morgan($546.2 billion) and Morgan Stanley ($410 billion). “
I read the article at barnhardt.biz this morning. It was short and to the point, covering this situation precisely.
WE’RE ALL GOING DOWN!!
And why Corzine is not in leg irons, I will never know. This is Ken Lay stuff. This is what is wrong with the country. No on goes to jail anymore for their crimes.
Who would have thought that just a young New Jersey boy with a dream would be the one to bring down the entire continent of Europe?
Do you know, or can you guess, at what will happen if Wells Fargo and JPMorgan cease to exist? What happens to the monies owed them, for houses, automobiles, and credit cards?
Oh, my!
“Who would have thought that just a young New Jersey boy with a dream would be the one to bring down the entire continent of Europe?”
I would laugh but instead want to cry.
Could be why Corzine was bullshitting on Capitol Hill?
“I’m not in a position, given the number of transactions, to know anything specifically about the movement of any specific funds..I simply do not know where the money is, or why the accounts have not been reconciled to date.”
Corzine didn`t have to “ authorize “ the raiding of segregated funds because the hypos were being done in an MF branch in the UK ?
I’m reminded of line in a movie, Independence Day, when the Secretary of Defense tells the President (during an alien attack) why the Prez was never told about the dead ETs in the basement at Area 51:
“Plausible deniability.”
I would wager that Corzine knew everything.
“No one goes to jail anymore for their crimes.”
If Corzine was a republican, both the media and the democrats would be demanding that Corzine be crucified on national television.
Oh, not to worry, those debts have been rehypothecated so many times there will be a flock of Simon Legrees chasing the debtors.
The lawyers will be the last ones to get rich before the denouement.
I believe the failed banks, including loans and credit card accts (assets) are taken over by the FDIC and resold to other banks. Customer deposits (liabilities) are insured up to $250,000 per eligible account so they will be taken by whichever bank buys the failed one
If there is an economic collapse, how can “assets” be sold when no one has any money? The FDIC just seizes everything? If none of us are getting our pensions or social security payments, then paying debts will be moot.
Somehow this doesn’t seem right.
This crap has to be dragged out into the light.
Gordon Gekko said the next would be it.
I was referring specifically to banks. The customers deposits in savings, checking and CD accounts is FDIC insured to $250,000 per eligible account.
Pension payments do not come from these accounts as far as I know and SS payments come directly from the government. Any funds invested in brokerage accounts are not covered by FDIC but unless fraud is involved these accounts should not be affected by the collapse of the bank except to the extent the market reaction will cause the shares value to decline due to said collapse. Money invested in brokerage accounts is actually with the institutions which manage the accounts. As an example, if you ask your bank to buy 1000 shares of the fidelity Ginnie Mae Fund the money from your account goes to Fidelity Investments which will use it to buy the 1000 shares in your name. The failure of your bank will not have any effect on the value of these shares except as I mentioned before except as a reaction to the banks failure which in this case could cause the shares to increase in value because the fund invests in 100% government backed securities and obligations to a maturity of about 5 years.
It is unclear if Legree is based on an actual individuals. Reports surfaced after the 1870s that Stowe had in mind a wealthy cotton and sugar plantation owner named Meredith Calhoun, who settled on the Red River north of Alexandria, Louisiana. Generally, however, the personal characteristics of Calhoun ("highly educated and refined") do not match the uncouthness and brutality of Legree. Calhoun even edited his own newspaper, published in Colfax, originally "Calhoun's Landing", renamed the National Democrat after Calhoun's death. However, Calhoun's overseers may have been in line with the hated Legree's methods and motivations.[27]
Interesting write-up of Legree in Wiki. Just thought I'd share it. Uncle Tom's Cabin
Modeled after democrat slave owners. Beating God out of a man, exploiting women and girls, greed. Have the democrats really come into modern life? Are they really all that civilized from the time of Uncle Tom's Cabin.
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