How to Protect Yourself — and Even Profit
You’d think that regulators would have a firm grip on this, but they don’t. Rehypothecated asset transactions are completely off-balance-sheet, so it’s exceedingly difficult to track what moved where and when. Worse, because of the lack of transparency, it’s also very complicated to determine which firms — whether stateside or overseas — hold the money.
Allegedly, MF Global couldn’t live with the 140% SEC mandate, so it began arbitraging differences between rehypothecation regulations in various markets and used off-balance-sheet entries to ratchet up leverage to obviously unsustainable levels. Now there may be an estimated $1.7 billion in customer money that can’t be accounted for in that firm alone.
What makes this especially problematic is that it’s tough enough to unwind rehypothecated assets in one country. Now, though, we are facing a situation where the regulators, lawyers and lawmakers may have to unwind rehypothecated assets that are effectively pledged as collateral in multiple transactions in multiple jurisdictions with multiple clearing firms. Absent balance sheet controls and forensic accounting, it’s going to be very difficult to determine who really owns what.
As for why this is so serious, try this on for size:
There is conjecture that the actual asset backing for the sum-total of rehypothecated assets may be as little as 25% of the notional value at risk. In other words, a firm with $25 billion in rehypothecated assets may be at risk for $100 billion in instruments that are completely off-balance-sheet and for which there is nothing but thin air backing them up — perhaps a whole lot more depending on how many times the actual assets have been rehypothecated and levered up.
According to Reuters, here’s a partial list of firms and their rehypothecated assets in 2011:
- Goldman Sachs ($28.17 billion).
- Canadian Imperial Bank of Commerce ($72 billion).
- Royal Bank of Canada (rehypothecated $53.8 billion of $126.7 billion available).
- Oppenheimer Holdings (NYSE:OPY) ($15.3 billion).
- Credit Suisse ($353 billion).
- JPMorgan Chase (NYSE:JPM) ($546.2 billion).
- Morgan Stanley ($410 billion).
That adds up to almost $1.5 trillion — and that’s just a partial list of what we know about.
Now queue up your best “Death Star approaches” music.
The mainstream press has reported that EU liquidity is drying up on default fears. But what if they know something else they’re not telling us?
I’m not into conspiracy theories, but I can very easily envision a scenario in which the underlying collateral has been rehypothecated between the various EU/U.S. banks so many times that the actual value at risk may be more than four times the figures disclosed to the public to date.
This is one of the reasons why I have suggested — since the beginning of the EU crisis — we’re looking at several trillion euros before we can even think the EU situation is under control versus the “worst case” 200 billion-euro estimates floated at the time.
Another reason is far simpler. I believe Europe remains in denial, as do our own leaders. Much of the growth over the past 20 years was driven by excess leverage and speculation. Until that’s gone, the markets will demonstrate the kind of reflexive pessimism we’ve seen recently, which has been characterized by short, sharp rallies and generally higher overall volatility.
To think that the EU will miraculously line up, China will suddenly speed up again and the U.S. will suddenly rein in its exploding debt is pure folly.
So how can you trade this?
I can think of a couple of strategies:
- Short specific banks or the broader financial sector as a whole. But be prepared for a bumpy ride. The world’s entire central banking community is playing against you and will do everything it can to prevent a meltdown by sustaining the illusion granted to us by the rehypothecation process.
- As the markets rise on the illusion of a fix, improving data or both, allocate a small portion of capital to put options or inverse funds. If nothing else, you’ll sleep better when the day of reckoning ultimately arrives.
- Remain long with what you’ve already got, but continually ratchet up trailing stops to protect gains. Why the markets rally is not important, but capturing profits as they do is. It is absolutely possible to be a market bull and an economic bear.
This article originally appeared on Money Morning.