Rehypothecation Could Be the Next Major Investment Disaster

 (When interest rates are low, some traders and speculators take advantage of the spread between asset yields and margin loan rates to engage in something known as cash carry.)

Your brokerage firm had to come up with the $100,000 in cash you wanted to borrow in order to settle the trade when you bought Procter & Gamble.  (The investor on the other side of the table wasn’t going to give up his or her stock certificates unless they walked away with funds in their hand.  Would you?)  In exchange, you’ve pledged 100% of the assets in your brokerage account, as well as your entire net worth to back the loan as you’ve given a personal guarantee (if both companies went bust in some remotely unthinkable scenario – a true mathematical miracle for two of the premier blue chip stocks in the world – and your account balance declined to $0, you’d still have to come up with the money to pay back the margin loan you created, even if it meant going bankrupt yourself).  That is, you and your broker have entered into an arrangement and your shares have been hypothecated.  They are the collateral for the debt and you’ve given an effective lien on the shares.

Where did the broker come up with the money it lent you?  In some cases, the broker might fund the trade out of its own net worth or resources; perhaps it is super-conservatively capitalized and has a lot of current assets with little to no debt sitting around on the balance sheet.  Maybe it issued corporate bonds, knowing it can earn a spread between its interest expense rate and what it charges clients.  Regardless of how the broker funds the loan, there is a good chance that, at some point, it will need working capital in excess of what its book value alone can provide.  For example, many brokerage houses work out a deal with a clearing agent, such as the Bank of New York Mellon, to have the bank lend them money to clear transactions, with the broker settling up with the bank later, making the whole system more efficient.  To protect its depositors and shareholders, the bank needs collateral.  The broker takes the Procter & Gamble and Coca-Cola shares you pledged to it and re-pledges it, or rehypothecates it, to Bank of New York Mellon as collateral for the loan.

What Happens If the Brokerage Firm Fails and the Rehypothecated Assets Are Seized?

Imagine something happens that causes the brokerage house to fail.  Maybe management loads up on leveraged bets.  It happens more than you think.  Aside from the financial institutions that actually collapsed in 2008-2009, there were more than a few that came close and were saved by huge equity infusions that severely diluted stockholders.  One major discount broker had borrowed lots of money to invest in collateralized debt obligations, making leveraged gambles on mortgages that went bad.  It survived but not before clients defected en masse and the business had to bring in a specialist to stabilize operations through the crisis.

In such a situation, the Bank of New York Mellon or other party to whom or which the assets have been rehypothecated have first dibs on the collateral (this was reinforced by a series of court rulings since 2012 which put their interests above the interests of clients).  They’re going to seize the shares of Coca-Cola and Procter & Gamble to repay the money the broker borrowed.  That means you’re going to log in to your account and see some, if not all, of your cash, stocks, bonds, and other assets were gone.  At this point, you are merely a creditor in the bankruptcy hierarchy.  You have to hope there is enough money recovered during the court cases to reimburse you somehow but this whole setup is perfectly legal.  You paid someone else’s bills.

Under the regulations of the United States, it should be possible for clients with margin accounts to know their potential exposure to a rehypothecation disaster is limited; e.g., if you have an account with $100,000 and only $10,000 in margin debt to fund the outright purchase of a long-equity position, you shouldn’t be exposed for more than $10,000.  In reality, that’s not always possible because certain restrictions requiring segregation of fully-paid client assets in place in the U.S. following the Great Depression are not in place in the United Kingdom.  Aggressive brokers can, and have, moved money through foreign affiliates, subsidiaries, or other parties in a way that allowed them to effectively remove the limits on rehypothecation.  That means it’s not just the assets you have borrowed against that could be seized.  They can go after it all.

The MF Global Bankruptcy Illustrates the Dangers of Rehypothecation

MF Global was a major publicly traded financial and commodities broker with more than $42 billion in assets and nearly 3,300 employees.  It was run by Jon Corzine, the 54 Governor of New Jersey, a United States Senator, and the former CEO of Goldman Sachs.

In 2011, MF Global decided to make a speculative bet by investing $6.3 billion for its own trading account in bonds issued by European sovereign nations, which had been hit hard by the credit crisis.  The year before, the company had reported a net worth of roughly $1.5 billion, meaning small changes in the position would result in large fluctuations in book value.  Combined with a type of off-balance sheet financing arrangement known as a repurchase agreement, MF Global experienced a catastrophic liquidity disaster due to a confluence of events.  This disaster forced to come up with large amounts of cash to meet its collateral and other requirements.  Management raided the assets in client accounts, part of which included making a $175 million loan to the firm’s subsidiary in the United Kingdom to pony up collateral to third-parties (rehypothecation, in other words).

When the whole thing fell apart and the company was forced to seek bankruptcy protection, clients discovered that cash and assets in their account – money they thought belonged to them and secured by debts on which they hadn’t defaulted – was gone.  MF Global’s creditors had seized it, including the rehypothecated collateral.

By the time all was said and done, the clients of MF Global had lost $1.6 billion of their assets.  Clients revolted, suddenly caring a great deal about the fine print in their account agreements, and were able to get a sympathetic judge who ultimately approved a settlement of the bankruptcy estate that resulted in an initial recovery of 93% of customer assets being recovered and returned.  Many clients who held out through the multi-year legal process ended up getting 100% of their money back due in no small part to the media and political scrutiny.  They were lucky.  In the meantime, they missed out on one of the strongest bull markets in the past few centuries; their money tied up in legal fights as they held their breath to see if they’d be restored.

One client wrote about his experience with rehypothecation on a personal blog.  He explained that he had an account worth $19,452.22 at MF Global when it declared bankruptcy.  Of this, $1,900 was in “a highly leveraged futures position (a bet against the euro)”, with the remaining $17,552.22 in what he believed to be “a segregated and firewalled account to which no creditor of MF Global had access”.  When MF Global declared bankruptcy, his money went missing.  Only later did he begin to receive recovery from the bankruptcy trustee as checks were sent to him.  This is not a thing you want to experience for yourself.

Protect Yourself Against Rehypothecation By Opening a “Cash Account” at Your Broker

The best way to protect yourself against rehypothecation within an ordinary brokerage account is to refuse to hypothecate your holdings in the first place.  Doing that is simple: Don’t open a margin account.  Instead, you want what is known as a “cash account”, or in some places, a “Type 1 account”.  Some brokerage houses will add margin capability by default unless otherwise specified.  Don’t allow them to do it.

This will make placing stock trades or other buy or sell orders, including for derivatives such as stock options, a bit more inconvenient at times as you must have fully sufficient cash levels within the account to cover settlement and any potential liabilities that could arise (e.g., if you are going to write put options, they are going to need to be fully secured cash puts) but it should make up for it in peace of mind.  Additionally, you’ll have the comfort of knowing you’ll never face a margin call or risk more funds than you have on hand at the moment.

Additionally, keep your cash reserves in an FDIC insured account at a third-party bank or, if you exceed those limits, consider holding Treasury bills directly with the United States Treasury Department.