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 reused 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 money-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 U.K., where there’s 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 (NYSE:GS), Canadian Imperial Bank of Commerce (NYSE:CM), the Royal Bank of Canada (NYSE:RY), Credit Suisse Group (NYSE:CS), Wells Fargo (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 that the big firms are worth saving at the expense of Main Street investors, the big financial firms don’t seem the slightest bit concerned that they’re playing with our money.
However, I find this deeply troubling on a lot of levels. So how can you protect yourself from this?