Hyper what?
How many of you have heard the financial term ‘Hypothecation’? Microsoft word hasn’t – the bug-prone program constantly tells me to check the spelling. If it’s also new to you, take note because you may be hearing a lot more about it and it could impact your portfolio.
Prior to the collapse of MF Global, it’s unlikely that many in the investment world would have ever heard of the terms; ‘hypothecation’ or ‘re-hypothecation. If you hold any dollars in an international brokerage / trading account, especially one where your funds are dispatched to somewhere in the UK, hypothecation may be the canary in the mine.
MF Global was allegedly using client-segregated monies for its own trading activities – a practice that is for obvious reasons, not practiced in most countries. The trading brought a 230-year old firm to its knees in a matter of weeks and resulted in the freezing of client funds. Funds thought to be ‘segregated’ and separate from the working capital of the firm, weren’t. But is MF Global an isolated case or is a practice that levers clients funds widely practiced and one that could undermine the financial system?
What the MF Global collapse has uncovered is that laws designed to prevent to access to ‘segregated’ accounts are being circumvented. Some firms may have also shifted accounts to countries where it is legal to access client’s funds for the firms trading activities. When you thought the only risk was that of your trade or investment selection going wrong, think again.
Hypothecation is, in simple terms, the practice of a borrower putting up collateral to secure a debt. An example of this is the typical purchase of a house. The buyer puts down a 20% deposit and borrows the remaining 80%. In this case the borrower has put up some cash and the house (at an agreed value) as collateral to cover the debt until the mortgage is paid off. Until such the borrower retains ownership of the collateral. Thus the collateral (both the deposit and the house) remains “hypothetically” controlled by the creditor, usually a bank. If the borrower can’t afford to meet agreed repayments (default), the creditor can take possession of the collateral and sell it to recover its assets. That’s Hypothecation – hypothetically the borrower owns the house, but in fact, they don’t until all loans are paid off. The same goes for securities purchased on margin.
With the basics out of the way we return to MF Global. Surprisingly hypothecation occurs when an investor puts their capital into a trading account to buy and sell securities such as CFD’s, Futures, Options, Commodities, etc.
And that should be that. Your money sits in your segregated trading account as collateral covering your positions – margined or not – until such as a time that you suffer an inability to pay back your debt to your broker (creditor) – if you ever do. And that is as we know it in Australia. MF Global here in Australia appears to have followed that procedure. But has it done so in the UK and the US? And how do others behave?
The practice and rules regulating hypothecation vary depending on the jurisdiction in which the trading account exists. In the US for example, the legal right for the creditor to ONLY take FULL ownership of the collateral if the debtor defaults is classified as a lien – a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation.
In the UK however, these rules are more than a little different. In the US there are some breaks, re-hypothecation is capped at 140% of a client’s debit balance. In the UK however, there is no limit on the amount of a clients funds that can be re-hypothecated, except if the client has negotiated an agreement with their broker that includes a limit or prohibition. UK brokers can ‘REUSE’ collateral put up by clients to secure their own trading activities and borrowings through a little unknown process called Re-hypothecation! While you may think that your ‘segregated’ capital is being used only as collateral for your own trading activities and borrowings / margin, a firm such as MF Global who operates out of the UK, can re-use their clients collateral to back their own trades and borrowings! Are you thinking credit card on credit card, gearing on gearing, leverage on leverage? And how do excessively leveraged position usually work out? Not well generally.
In the industry it’s referred to as “fractional reserve” synthetic liquidity creation by Prime Brokers. The IMF in their 2010 paper The (sizable) Role of Rehypothecation in the Shadow Banking System” Manmohan Singh and James Aitken state: “Mathematically, the cumulative ‘collateral creation’ can be infinite in the United Kingdom”. They add that courtesy of no re-hypothecation haircuts one can achieve infinite “shadow” leverage and the creation of a large shadow banking system.
Gary Gorton in his 2009 paper “Haircuts” about systemic risk in the repo market (something I used to teach for the Securities Institiute of Australia) suggests that banks’ reliance on the repo market constitutes a systemic fragility which renders the entire banking system prone to runs: “Gorton predicts the crisis was not a one-off event and it could happen again”.
He also addresses the relationship between confidence and liquidity suggesting when “confidence” is lost, “liquidity dries up” and concludes the financial crisis was a manifestation of an age-old problem with private money creation, banking panics. ‘Haircuts’ are the functional equivalent of information arbitrage: “When all investors act in the run and the haircuts become high enough, the securitized banking system cannot finance itself and is forced to sell assets, driving down asset prices. The assets become information-sensitive; liquidity dries up. As with the panics of the nineteenth and early twentieth centuries, the system is insolvent.” “Liquidity requires symmetric information, which is easiest to achieve when everyone is ignorant. This determines the design of many securities, including the design of debt and securitization.”
What Gorton says is that the increasing complexity of banks and the securities they issue is motivated by the need to obfuscate the masses and distract them from what is really occurring.
Let’s say a hedge fund (who is managing your money) puts up $100,000 collateral to support a leveraged position of $1,000,000. If the broker then re-hypothecates that $100,000 and uses this to support the same level of leverage, the firm is in a position where just $100,000 in collateral (not theirs) is supporting $2,000,000 in leveraged market positions.
A move of just 5% on $2,000,000 equates to $100,000 in profit and both you and your broker make $50,000 each. A move however of 5% against a $2,000,000 position can however wipe most of the collateral – and such moves are not uncommon today. While a single trade will unlikely bring down a broker’s diversified trading book, if all trades move in unison (remember US house prices were never expected to all decline at once), as was the case when MF Global traded European bonds, you can see how quickly everything can unravel.
And remember, while the broking firm enjoys all of the trading profits and fees, the clients bear the risk. If the broker loses, they file for bankruptcy, leaving clients holding an empty can. This appears to be what transpired at MF Global. It’s the ultimate privatization of profits and socialization of losses. And according to an increasingly vocal group of experts it could all happen again if a sovereign defaults.
And now you also have the reason why Central Banks around the world are applying a policy of ‘price stability’ or ‘price support’ in asset markets like the stock market – everyone is leveraged to the hilt.
It has been estimated that in 2007, re-hypothecation accounted 50% of the worlds Shadow banking system and the IMF estimated that US banks received $4 trillion of funding from the UK from re-hypothecation using just $1 trillion in clients funds, funds being levered several times over. In this light, don’t think for a moment that MF Global is alone in using client’s funds to trade and borrow for their own trading activities.
It appears in the current market environment that the first question you should ask is not whether or not your investment idea will work out correctly, it’s more a question of whether the money you put into your broker sponsored account will ever come back.
And now that re-hypothecation is exposed, I wonder how many assets have been double, tripled and quadruple-counted. An expose on this subject by Reuters about this subject following the collapse of MF Global, revealed that “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).”
And if you are wondering what the implications are, it may not be what you think. Initially there will be the denials and then, if Prime Brokers have to recall all the stock they lent out, imagine the global short covering rally?
And meanwhile the Euro crisis related elimination of deficit spending could force banks into administration or liquidation, which in turn causes assets to be marked down to market and pressure on equities. We invest in interesting times…but don’t forget highest quality stocks at substantial discounts to intrinsic value.
Posted by Roger Montgomery, Value.able author and Fund Manager, 12 December 2011.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Prasad
:
off topic, but Roger any thoughts on JBH downgrade?
Roger Montgomery
:
Yes, will work on a blog post shortly. We sold it all from the fund at $15.50 and did write about it in advance for our fund investors.
Darren
:
Sorry this may sound like a stupid question, but when you have a margin loan with the big Aussie brokers i.e. e-trade, comsec etc, who owns the shares?
If your broker went bust would you be in a situation like the people trading on MF globals platforms?
Cheers.
Brad
:
In most cases you own the shares (they’re registered in your name in CHESS) and the lender (which is generally the CHESS sponsor) has a mortgage over them.
If the bank we’re to go broke, yur debt would probably be purchased by another institution.
Opes Prime, for example, had a very different model whereby they owned the shares via a custodian and you received a statement.
Effectively you gave them cash and shares and they gave you a PDF.
Roger has been going on about counter party risk and it is very important that retail investors understand this concept.
Roger Montgomery
:
Good reminder Brad. Thanks.
Brad
:
BTW, I think most would agree the govt made the correct call blocking Singapore Stock Exchange takeover of ASX.
If it succeeded it would have meant CHESS would have been owned and controlled by a foreign company – unacceptable for Australia’s national security.
Michael Horn
:
I have been surprised to see a myriad of small transactions occurring in relation to TGA, and I wondered if they were shares hypothecated to margin lenders, and then sold by the lender when when investors did not respond to margin calls, because I could hardly imagine investors, or traders, bothering to transact such small parcels.
Roger Montgomery
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High frequency algorithmic trading…
Michael Horn
:
Yip – I had always assumed it was algorithmic trading, but it surprises me to see so much of it in TGA’s transactions, which is a relatively small company. Perhaps its the relatively small size of TGA that may push institutions wanting to invest a few million in it to buy in dribbles so as not to distort the market via their buying pressure.
I write this not because I want a response, but I thought it might be a topic on which one day you could write a blog post from the value-investor perspective.
On another matter, some weeks ago I questioned the media blathering of self-styled economists who implied that bank lending rates had a tight nexus with the RBA’s target cash rate, and the use of words like “pass on” and “pass through” that implied the banks sourced funding from the RBA for onward lending to households and businesses. I am feeling rather smug that recent published comments seem to vindicate my views on this matter. They must have read your blog – post hoc ergo propter hoc. Indulging in ego stroking is an inexpensive indulgence.
Roger Montgomery
:
Well done Michael. Well done indeed. Keep posting!
Rob M
:
Good clarification from IB here:
“Recently, much has been written about the safety of customer assets held by brokers and we believe that customers are justified in their concerns. And so, we are writing to help clarify your understanding of how brokers are permitted to operate and, in particular, how Interactive Brokers protects its customers assets while servicing their needs to trade on margin.
To start, and so as not to leave any confusion as to the position of IB vis-à-vis the Thomson Reuters news article, IB DOES NOT, in any way:
1. Circumvent U.S. securities or commodities rules at the expense of our customers;
2. Invest customers’ segregated funds in foreign sovereign debt or utilize in-house repurchase agreements;
3. Commingle or utilize customer segregated assets for proprietary operations;
4. Enter into agreements which are designed to take advantage of supposedly unrestricted U.K. re-hypothecation rules; or
5. Engage in transactions deemed as “hyper-hypothecation”.
More specifically, regarding hypothecation and the level of such activity at IB:
– The hypothecation and re-hypothecation of customer assets is a standard and essential practice, which U.S. brokers employ in the course of financing customer activity. The rights to do so are longstanding, have been explicitly provided by regulation and one should not be surprised to see boilerplate consent language in each broker’s customer agreement acknowledging this. For example, a customer who incurs a margin debit by virtue of the fact that they have purchased securities with only partly their own money, thereby relying upon the broker to lend them the funds to pay the balance at settlement, subjects a portion (up to 140% of the amount borrowed, also referred to as the margin debit) of those securities to a lien on behalf of the broker. The lien is also known as hypothecation. The broker, in turn, may pledge or re-hypothecate the securities upon which they have a lien to replace the cash. In the case of IB, this re-hypothecation typically takes place in the form of a stock loan. In simple terms, IB borrows money from a third party, using the customer’s margin stock as collateral, and it lends those funds to the customer to finance the customer’s purchase.
– Similarly, a customer who carries a futures position must place a margin deposit with IB. IB may pledge the customer’s cash deposit to a futures clearing house in support of the margin required on that position.
– While IB is not in a position to comment on the practices of others and whether they comply or fail to comply with these regulations, or do so in a manner which introduces unwarranted risk to the firm and its customers, we can state unequivocally that we comply with all regulations and utilize investment policies that tend to be more conservative than those permitted under the regulations.
– The Thomson Reuters news article alleged that IB, among other brokers, engaged in a practice that the author categorizes as “hyper-hypothecation” (apparently a term used to describe a process in which a broker alters the risk of one financial instrument into the exposure of multiple other instruments and perhaps multiple counterparties through a daisy-chain series of pledges) at an amount of $14.5 billion. While we are not sure of the author’s source for this number, we would refer interested parties to footnote 10 (“Collateral”) on page 17 of our June 30, 2011 financial statement, which is posted on the IB website (http://www.interactivebrokers.com/d…Unaud_Finls.pdf) and reads as follows:
“At June 30, 2011, the fair value of securities received as collateral, where the Company is permitted to sell or repledge the securities was $16,817,859,287, consisting of $13,022,386,422 from customers, $2,886,934,605 from securities purchased under agreements to resell and $908,538,260 from securities borrowed. The fair value of these securities that had been sold or repledged was $4,526,153,369, consisting of $2,583,920,633 deposited in a separate bank account for the exclusive benefit of customers in accordance with SEC Rule 15c3-3, $761,740,278 securities loaned, $877,478,486 securities borrowed that had been pledged to cover customer short sales and $303,013,972 securities that had been pledged as collateral with clearing organizations.”
A closer examination of this $16.8 billion balance reveals the following:
1. $13.0 billion represents the amount IB is authorized to pledge (largely based upon 140% of customer debit balances), of which only $0.8 billion has been repledged, largely through stock lending.
2. $2.9 billion represents the investment of customer’s cash balances in reverse repurchase agreements where the underlying collateral is U.S. treasury securities. These transactions are conducted with third parties and guaranteed through a central counterparty clearing house (FICC). $2.6 billion of this collateral, technically a repledge (i.e., part of the $4.5 billion “sold or repledged”), is not re-hypothecated and it remains in the possession of IB and held at a custody bank in a segregated Reserve Safekeeping Account for the exclusive benefit of customers. The remaining $0.3 billion represents collateral pledged to clearing organizations.
3. $0.9 billion represents short sale transactions whereby the sales proceeds have been pledged as collateral to fully secure the borrowed securities. These transactions are classified as securities sold (i.e., part of the $4.5 billion “sold or repledged”).
Based upon this information, which reflects prudently risk-managed broker financing transactions, we believe a fair-minded author would have drawn a different conclusion regarding IB and hyper-hypothecation given a minimum level of investigation and contact.”
Roger Montgomery
:
The issue for investors is the unlimited (not limited to 140%) hypothecation in the UK.
Rainsford
:
Thanks Roger, I had not heard of this nonsense.
Roger and others….have you by any chance had a look at the recent float by Fairfax of the NZ company Trade Me (TME)? It’s shares commenced trading yesterday and it is being much publicised in NZ as a chance for small investors to get a slice of the action in a company most of them use often. Using my Value.able experience I see no sign of a high quality company trading at a large discount to IV and wonder how the analysts think it is such a good opportunity. Maybe IPO’s have some different characteristics to be taken into account?.
My read of the numbers is that FFX have set up the company with market cap of about $1 billion, equity of $631 mill (which includes $721 mill goodwill) and debt of $164 mill. Forecast ROE is just 11%. My forecast IV is $1.59 (EQPS 1.59, Payout 80%, RR 10% which is too low). The shares listed at $2.70 and went to $2.90 on day 1.
Fairfax paid $750mill for Trade Me (TME) and have just sold 34% of it for $363.5 mill. Since 2007 the comapny has made net profits totalling $276mill and they have paid themselves dividends of $255 mill. And they still own 64% of the company.
Seems to me it’s a great deal for Fairfax but not so great for other investors.
Keith
Roger Montgomery
:
There are no different characteristics to be taken into account in an IPO. Generally (not always, but usually) you sell something when you have to, or don’t want it any more or the cash you receive is worth more to you and perhaps others than the item being sold. Were any trade buyers interested. “Feed the ducks when they’re quacking” may be one reposte that is fitting.
Rainsford
:
Thanks Roger. An appropriate reposte I think. I did end up with a few but sold them on listing day for the $2.90 so I’m happy.
By the way, Skaffold is awesome. I hope lots of people are signing up ….and please get some NZ stocks on there asap.
Roger Montgomery
:
NZ stocks up next. Global stocks soon too. Every stock, updated automatically daily!
ANTHONY SCELZI
:
So, if my house is mortgaged, it could be hocked without me knowing it and basically taken from me should my lender stuff up ?
Roger Montgomery
:
Check the columns cited!
Matthew Smith
:
Trust and confidence plays such an important part in these broker/dealer relationships.
I stopped using Interactive Brokers for international holdings in late 2006 and now have organised to bear zero custodial risk.
Sometimes paying a little more can save you the farm.
Roger Montgomery
:
Indeed!!!
Greg Mc
:
Thanks for explaining that Roger. Until then I thought hypothecation was just one of those words that everyone knew the meaning of but me.
It makes your last sentence more relevant than ever.
Andrew
:
I agree Greg, i was half expecting our blogs resident Dr Matthew to come in and tell us what sort of ailment it is.
Thanks Roger for bringing something to my attention which i didn’t know existed.
Matthew R
:
Hypothecation is to mortgage what dyspnoea is to shortness of breath
Why do we need to make simple things complex? I say K.I.S.S.
Roger Montgomery
:
I though the same thing; credit card on credit card…
Greg Mc
:
Possibly an irregularity of the hypothalamus causing an overheated situation?
Roger Montgomery
:
No individual hypothalamus could be responsible!
David
:
I can’t believe you wrote this a just a week after I started looking into my fairly new relationship with Interactive Brokers – talk about relevant. I joined them because they are by far the cheapest for trades ($6) and margin lending (6%). Our brokers are charging too much with a borrowing rate around 9.5%. Its almost too good to be true. I noticed though that I did not have a HIN and then I started to worry because I then realised that the stock was held by IB and not me. I immediately started to think of MF Global and some of the other broker train wrecks that happened in Australia during the GFC. I asked them several questions about it and I felt relatively reassured. They indicated that they only lend out your stock if you approve them to do so. They also pointed out that they observe SEC rules regarding account segregation and reserve requirements. The accounts also have a $500,000 guarantee from the US government (I still can’t believe they would protect an Australian buying AU stocks only). From memory they also have insurance with Lloyds of London for $30 million per customer. I do not know how this is economical for Lloyds to insure such a large book unless they set and monitor strict covenants and controls, which gives me some more comfort.
On face value I was assuming that each of these statements meant that my stock was quarantined from alternative uses, however your article has made me think twice. Is it possible that they are using my stock as collateral yet claim to be segregating my funds at the same time? I know that a lot of people are starting to use IB in Australia and they seem to be doing a lot of advertising, so I think this topic could be of interest to a number of readers.
Roger Montgomery
:
Thanks for sharing your personal experiences David.
Harley G
:
It explains why they have yet to let an EU member default, why when the euro reached certain key levels they had to float out rumours based on no factual reasoning to help push the market up, why despite the stress going on in the banking system in Europe and the US we still haven’t had a significant fall in equity prices. I think they (EU politicians) genuinely just don’t know what the implications would be of these things happening as the extent of the shadow banking system is hard to grasp.
This was the cause of the crisis in 08. When the assets that were AAA rated (and so were permitted to be used as collateral in repos) went bad and liquidity disappeared because they had been ‘rehypothecated.’
Something else interesting is how HSBC and MF Global are now ‘fighting’ over the assets of a client as the gold he owned has obviously been counted at least twice.
From what I have read this process has been happening in New York for years, and is why when AIG went bust they ended up finding the assets in London. Same thing with MFG when for a period of time the clients assets were missing. The only solution appears to be a change in the laws allowing the brokers to move the client’s assets only IF they have been granted permission to do so. But with all the power the banks have appeared to have over Washington in recent years it seems unlikely unless their is a strong push for it from the majority. I also wonder how long until Australian brokers have to come out with statements to calm investors.
Roger Montgomery
:
interesting Harley…
tom
:
i am so surprised that the UK laws are so lax. Maybe thats why London became the financial capital that it is/was. Because they managed to create the most money from the little they had.
Roger Montgomery
:
many were surprised…
Kerishd
:
Australia’s laws are just as lax as well. The Corporations Act 2001 (Section 981D) is the (scary) bit of legislation that lets your broker play with your money when you give it to him. Ordinary people would think that collateral lodged with your broker is safe, untouched, recoverable, kept segregated and held on trust. But s981D says otherwise…
According to s981D, your broker can use it:
“for the purpose of meeting obligations incurred by the licensee in connection with margining, guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee (including dealings on behalf of people other than the client).”
So when dealing in derivatives with your broker, be aware that your money may be pooled with other people and used for various unknown purposes. Naturally, if this happens and the broker goes bust, don’t expect to get anything back.