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
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.
... 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.
...OFF BALANCE SHEET
As 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.
Re-hypothecation 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 link.
With 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
We 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. The 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 Condition.
According 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 billion.
With 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).
Nor 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.
The 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.
Most 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 apocalyptic.
U.S. 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.
Yeah, 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...
SETON HALL LAW REPORT SHOWS LEHMAN BROTHERS BANKRUPTCY COURT EXAMINATION AMOUNTS TO A LICENSE TO FAIL WITH OTHER PEOPLE’S MONEY
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.
“In 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 cards.”
Center 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.”
In 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.
The 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.”
Senior 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?
As 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 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...