What is Rehypothecation?
Hypothecation and rehypothecation are among the esoteric topics that many investors and traders don't encounter in day-to-day conversations. However, due to changes in the regulatory system and in the financial industry over the past decade, it could have devastating consequences under the wrong set of circumstances. Investors, traders, and others need an understanding of hypothecation, the risks it poses, and ways to protect their assets.
Broker Pledges Client Funds Risk
It is not an exaggeration to say that certain investors, traders, and speculators (and perhaps even you) could one day log into a brokerage, commodities, or futures account only to discover that the assets they had spent a lifetime accumulating were gone, seized by the firm's creditors because the broker has pledged client funds as collateral and defaulted on the debt.
In such a situation, the lost assets would not be protected by SIPC insurance. While partial recovery may be possible through the bankruptcy courts, there are no guarantees. The process would undoubtedly take years, and it could be extraordinarily stressful.
What Is Hypothecation?
The term hypothecation refers to taking certain assets and pledging them as collateral for a debt—collateral that can be seized in the event of a default. For example, if you buy a home and take out a mortgage, you are entering into a hypothecation agreement because, while you retain the title to the house, failure to pay the mortgage can result in the bank or the lender seizing it.
Different types of hypothecation agreements are regulated in different ways. In the United States, it's generally easier to seize a car than it is a home, the latter of which requires a much more specific and drawn-out series of legal events as society has deemed it inadvisable to routinely throw people out into the streets at a moment's notice.
What Is Rehypothecation?
When the person or institution to whom or which you have pledged collateral—most often securities—turns around and borrows money using the collateral you gave the person or institution as their own collateral, this is rehypothecation.
Imagine that you borrow money and hand over the collateral. The original lender then turns around and borrows money, repledging your collateral as his own collateral. Your lender no longer enjoys ultimate control over the collateral or what can be done with it; his lender does. This is made possible by something known as "Federal Reserve Board Regulation T", or 12 CFR §220—Code of Federal Regulations, Title 12, Chapter II, Subchapter A, Part 220 (Credit by Brokers and Dealers).
The arrangement can result in substantial problems if things go wrong, especially because of something known as "regulatory arbitrage." In such a case, a brokerage house plays by the rules of the United States or the rules of the United Kingdom and can effectively remove any or all limits to a number of rehypothecated assets it has access to, in order to borrow money and fund its own risky bets on stocks, bonds, commodities, options, or derivatives. When this happens, it is known as hyper-hypothecation.
Brokerage Account Rehypothecation
Imagine you have $100,000 worth of Coca-Cola shares parked in a brokerage account. You have opted for a margin account, meaning you can borrow against your stock if you desire, either to make a withdrawal without having to sell shares or to purchase additional investments. You decide you want to buy $100,000 worth of Procter & Gamble on top of your Coke shares and figure you'll be able to come up with the money over the next three or four months, paying off the margin debt that is created.
You put in the trade order and your account now consists of $200,000 in assets ($100,000 in Coke and $100,000 in P&G), with a $100,000 margin debt owed to the broker. You will pay interest on the margin loan in accordance with the account agreement governing your account and the thin-margin rates in effect for the size of the debt. (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.)
Pledging Funds to Your Broker
Your brokerage firm had to come up with the $100,000 in case you wanted to borrow in order to settle the trade when you bought Procter & Gamble. (The investors on the other side of the table weren't going to give up their 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. The guarantee covers the event 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. In this unthinkable event, 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.
How Brokers Get Margin Lending Funds
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 your broker issued corporate bonds, knowing it can earn a spread between its interest expense rate and what it charges its 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.
Seizing Rehypothecated Assets
Imagine something happens that causes the brokerage house to fail. Maybe management loads up on leveraged bets. This happens more often than you think. Besides 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 another party to whom or which the assets have been rehypothecated will have first dibs on the collateral (this was reinforced by a series of court rulings since 2012, which put these entities' interests above the interests of clients).
These entities are 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 find some, if not all, of your cash, stocks, bonds, and other assets gone.
From Account Holder to Creditor
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, but this whole setup is perfectly legal—you end up paying someone else's bills.
Under the regulations of the United States, it should be possible for clients with margin accounts to know that their potential exposure to a rehypothecation disaster is limited. For example, 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 move money and have indeed done so 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 all of your assets.
MF Global Bankruptcy Shows Rehypothecation Dangers
MF Global was a major publicly traded financial and commodities broker with more than US$42 billion in assets and nearly 3,300 employees. It was run by Jon Corzine, the 54th Governor of New Jersey, a United States Senator, and the former CEO of Goldman Sachs.
Beginning of the Problems
In 2011, MF Global decided to make a speculative bet by investing $6.3 billion in 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 the company to come up with large amounts of cash to meet its collateral and other requirements.
Pulling From Client Accounts
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 (i.e. rehypothecation).
When the whole thing fell apart and the company was forced to seek bankruptcy protection, clients discovered that the cash and assets in their account—money they thought belonged to them and secured by debts on which they hadn't defaulted—were gone. MF Global's creditors had seized them, including the rehypothecated collateral.
After the Chips Fell
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. This resulted in an initial recovery and return of 93 percent of customer assets.
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, with their money tied up in legal fights as they held their breath to see if it would 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.
Protect Against Rehypothecation
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, simply open 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 derivatives such as stock options, a bit more inconvenient at times as you must have sufficient cash levels within the account to cover settlements and any potential liabilities (e.g., if you are going to write put options, these need to be fully secured cash puts). But it is worth putting up with the inconvenience for the 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.