Goldman, et. al. Suffer From The Same Malady That Collapsed Lehman and MF Global, Worlds 1st and 8th Largest Bankruptcies!

Reggie Middleton's picture

I have been doing a series of TV interviews focusing on risk in the
banking system. Of note is the topic of the latest discussion, which is
basically how MF Global collapsed while losing $1.2 billion of customer
funds. The answer to the question appears to be in hypethecation, and
re-hypothecation of securities - actions whose counterparty risks lay
off balance sheet. Reuters reports MF Global and the great Wall St re-hypothecation scandal

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.

Hence, when MF Global conceived of its Eurozone repo ruse, client funds
were waiting to be plundered for investment in AA rated European
sovereign debt, despite the fact that many of its hedge fund clients may
have been betting against the performance of those very same bonds.


well as collateral risk, re-hypothecation creates significant
counterparty risk and its off-balance sheet treatment contains many
hidden nasties. Even without circumventing U.S. limits on
re-hypothecation, the off-balance sheet treatment means that the amount
of leverage (gearing) and systemic risk created in the system by
re-hypothecation is staggering. 

transactions are off-balance sheet and are therefore unrestricted by
balance sheet controls. Whereas on balance sheet transactions
necessitate only appearing as an asset/liability on one bank’s balance
sheet and not another, off-balance sheet transactions can, and
frequently do, appear on multiple banks’ financial statements. What this
creates is chains of counterparty risk, where multiple re-hypothecation
borrowers use the same collateral over and over again. Essentially, it
is a chain of debt obligations that is only as strong as its weakest

collateral being re-hypothecated to a factor of four (according to IMF
estimates), the actual capital backing banks re-hypothecation
transactions may be as little as 25%. This churning of collateral means
that re-hypothecation transactions have been creating enormous amounts
of liquidity, much of which has no real asset backing. 

The lack of balance sheet recognition of re-hypothecation was noted in Jefferies’ recent 10Q (emphasis added): 

 “Note 7. Collateralized Transactions
pledge securities in connection with repurchase agreements, securities
lending agreements and other secured arrangements, including clearing
arrangements. The pledge of our securities is in connection with our
mortgage?backed securities, corporate bond, government and agency
securities and equities businesses. Counterparties generally have the
right to sell or repledge the collateral.Pledged securities that
can be sold or repledged by the counterparty are included within
Financial instruments owned and noted as Securities pledged on our
Consolidated Statements of Financial Condition. 
We receive securities as collateral in connection with resale agreements, securities borrowings and customer margin loans. In
many instances, we are permitted by contract or custom to rehypothecate
securities received as collateral. These securities maybe used to
secure repurchase agreements, enter into security lending or derivative
transactions or cover short positions. 
At August 31, 2011 and
November 30, 2010, the approximate fair value of securities received as
collateral by us that may be sold or repledged was approximately $25.9
billion and $22.3 billion, respectively. At August 31, 2011 and November
30, 2010, a substantial portion of the securities received by us had
been sold or repledged. 

We engage in securities for securities
transactions in which we are the borrower of securities and provide
other securities as collateral rather than cash. As no cash is
provided under these types of transactions, we, as borrower, treat these
as noncash transactions and do not recognize assets or liabilities on
the Consolidated Statements of Financial Condition. 
securities pledged as collateral under these transactions are included
within the total amount of Financial instruments owned and noted as
Securities pledged on our Consolidated Statements of Financial

to Jefferies’ most recent Annual Report it had re-hypothecated $22.3
billion (in fair value) of assets in 2011 including government debt,
asset backed securities, derivatives and corporate equity- that’s just
$15 billion shy of Jefferies total on balance sheet assets of $37


weak collateral rules and a level of leverage that would make
Archimedes tremble, firms have been piling into re-hypothecation
activity with startling abandon. A review of filings reveals a
staggering level of activity in what may be the world’s largest ever
credit bubble. 

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). 

is lending confined to between banks. Intra-bank re-hypothecation is
also possible as evidenced by filings from Wells Fargo. According to
disclosures from Wachovia Preferred Funding Corp, its parent, Wells
Fargo, acts as collateral custodian and has the right to re-hypothecate
and use around $170 million of assets posted as collateral. 


volume and level of re-hypothecation suggests a frightening alternative
hypothesis for the current liquidity crisis being experienced by banks
and for why regulators around the world decided to step in to prop up
the markets recently. To date, reports have been focused on how Eurozone
default concerns were provoking fear in the markets and causing
liquidity to dry up. 

have been focused on how a Eurozone default would result in huge losses
in Eurozone bonds being felt across the world’s banks. However,
re-hypothecation suggests an even greater fear. Considering that
re-hypothecation may have increased the financial footprint of Eurozone
bonds by at least four fold then a Eurozone sovereign default could be

banks direct holding of sovereign debt is hardly negligible. According
to the Bank for International Settlements (BIS), U.S. banks hold $181
billion in the sovereign debt of Greece, Ireland, Italy, Portugal and
Spain. If we factor in off-balance sheet transactions such as
re-hypothecations and repos, then the picture becomes frightening.

it gets worse. You see, Lehman's collapse was much larger than that of
MF Global, and did much more damage. On top of it, it was marred with
obvious and purposeful misrepresentation, yet they broke no signficant
laws or regulations...


Lack of Legal Sanction Now Stands as a Roadmap of Unaccountability for Other Investment Firms

Seton Hall University School of Law’s Center for Policy & Research
has issued a report: Lehman Brothers: A License to Fail with Other
People’s Money, which examines in-depth the investigation of Lehman
Brothers’ business practices undertaken by the U.S. Bankruptcy Court 
Examiner in the largest bankruptcy ever filed. The Center focused
primarily on Lehman’s risk management and asset valuation— two aspects
of company worth not readily available or discernible to the investing
public— and notes that Lehman’s conscious violation of internal risk
limitations as well as it’s conscious failure to accurately value assets
was, alarmingly, found insufficient as a matter of law by the Examiner
to trigger legal sanctions against Lehman Brothers or even a reprimand.

the face of mounting losses, Lehman doubled down its bets like a CEO at
a blackjack table gambling with someone else’s pension money, and
backdated risk limits to disguise the truth that its business was
collapsing” commented Professor Mark Denbeaux, Director of the Center
for Policy & Research.  “The truth is, considering the actual value
of the assets they were using to gamble, no self-respecting casino would
have even taken their bet. Of course it all fell like a house of

Fellow and report co-author, Eric Miller agreed, noting, “According to a
Senior Management member with principal responsibility for asset
valuation, they valued assets ‘with a gut feeling’ and, unbelievably,
without even ‘thinking about’ whether or not the assets could be sold
for the values placed on them. There was also a failure to make
appropriate write-downs of realized losses in valuation because of what
another Senior Management member charged with valuation ‘unambiguously
asserted’ was a clear understanding that Lehman had imposed a ‘cap on
such write-downs.’ The end result was not surprising.”

January 2008, Lehman Brothers, heavily invested in by pension plans
such as the California Public Employees’ Retirement System and the New
York State Teachers Retirement Plan, traded at a high of over $65 per
share.  At that time, Lehman reported record numbers of nearly $60
billion in revenue and more than $4 billion in earnings.  However, a
mere eight months later, Lehman’s stock was trading at under $4 per
share, and on September 12, 2008, Lehman filed for Chapter 11
bankruptcy, with losses to investors, both small and large, totaling
billions of dollars.

Bankruptcy Court appointed an Examiner to investigate and report on
Lehman’s business affairs, with particular regard to “any fact
ascertained pertaining to fraud, dishonesty, incompetence, misconduct,
mismanagement, or irregularity in the management of the affairs of the
debtor, or to a cause of action available to the
estate.”  Center Fellow and report co-author, Sean Kennedy noted, “The
Examiner’s findings, taken at face value, reveal that the legal system
that allowed Lehman’s failure, amounting to billions of dollars of other
people’s money, will, without substantive changes to the regulatory
framework, permit similar failures in the future.”

Fellow John Gregorek added, “This lack of legal sanction now stands as a
road map of unaccountability for other investment firms, which, like
Lehman and MF Global, believe they can use economic downturns as a
business opportunity and amounts to a free pass to make deadly
investments with other people’s money.”  

MF Global ran into a liquidity squeeze while betting on the European debt that I have warned my subscribers for two years to avoid like the plague. Lehman did the same betting on real asset derivatives. Goldman is doing the same thing, no?

As excerpted from the model that powers BoomBustBlog subscriber document Goldmans Sachs Derivative Exposure: The Squid in the Coal Mine?


you can see, Goldman traded its derivative book risk for sovereign risk
- just in the nick of time to catch the tail end of a derivative
crisis  & the start of a sovereign debt crisis. Excellent job
fellas! Goldman has literally doubled its sovereign assets, starting the
exact year that I started warning in the Pan-European Sovereign Debt Crisis series.
BoomBustBlog subscribers covered this scenario over a year ago. This
balance sheet capital flows chart shows Goldman ramping up on sovereign
debt risk at EXACTLY the wrong time - now! Whose money are they using to
do this? Silly, most likely yours...

Engaging in hyper-hypothecation have been Goldman Sachs ($28.17 billion re-hypothecated in 2011),

To further illustrate my point, I direct all to the BoomBustBlog subscriber document File Icon Goldman Sachs Q3 update Final wherein you will find on page 8...


Yes, the exposure to that stuff off balance sheet is ratcheting up. Don't say Reggie didn't warn you in advance. Click here to subscribe to our proprietary research. Global REIT pressure reports on tap to come out next...