How MF Global Collapsed by over Hypothecat​ing and Who is Next?

Sam CK,  my good friend and classmate in secondary school back at St. Michael's Institution, is a prolific finance writer. I think he wrote a goodie on hypothecating. A worthwhile read. Does this apply in Malaysia? Maybe we should have a lot more transparency as I do think this happens a lot in "local stockbroking firms".  When you as clients pledge your shares for margin facility, do you know if the broker uses your shares for something else? If we are not transparent, we will only ask question when the whole thing blows up in our face. Are there parameters, are these parameters being regulated rigorously? Is this an unregulated issue? How does it differ from broker to broker? Is the information available to SC on a regular basis? Can we know as well? Or is this totally forbidden (think not).

By: Sam_Chee_KongDec 13, 2011 - 06:24 AM

Another month another new implosion. Europe really seems to be stuck in a financial black hole, unable to free itself out of it. Before we even have time to digest all those exotic treasury products like CDO,CDS,MBS, ALT-A, Sub-Prime, Swaps and , now there is this new toy called ‘Hypothecation’.

What is Hypothecation ?

Hypothecation is the practice where a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral, but it is "hypothetically" controlled by the creditor in that he has the right to seize possession if the borrower defaults. A common example occurs when a consumer enters into a mortgage agreement, in which the consumer's house becomes collateral until the mortgage loan is paid off.

The detailed practice and rules regulating hypothecation vary depending on 
context and on the jurisdiction where it takes place. In the US, the legal right for the creditor to take ownership of the collateral if the debtor defaults is classified as a lien.

Re-hypothecation is a practice that occurs principally in the financial markets, where a bank or other broker-dealer reuses the collateral pledged by its clients as collateral for its own borrowing or in a process call Churning.

In the US, re-hypothecation is capped at 140% but in Europe it is unlimited or up to the imagination of the borrower. What does it mean when it is capped at 140%?

Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets. 

But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500). 

Hypothecation is similar to a Margin Lending Account with no limit. To illustrate, our normal Margin Lending Account will only lend as much as the securities or cash that is deposited. How much to lend is up to the discretion of the Broker’s Risk Management Department. If you are having just cash then you may get leveraged up to 200%. But if you are pledging securities then the amount to be leveraged depends on the value and risk factor associated with the securities, normally less than 100%.

For simplicity, say MF Global purchased $5 million of Irish bonds. It would then use these same Irish bonds as collateral for a loan of €5 million (or thereabouts) under the repo with an obligation to repurchase the bonds at the end of the repo. When the Irish bonds matured it would be due to receive €5 million - a sum which it would use to pay off the repo at the end of the transaction.

How MF Global Hypothecate its Customer’s funds

MF Global is an outfit whose business model is based on earning interest on it’s customers funds. Financially it has never been on the smooth ride and actually struggling for quite a while.  In 2007 it earned about $2 billion from its operation but dropped to about $500 million in 2010 due to the fact that interest rates are falling all over the world due to the on going financial crisis. Governments of the world tried to prop up their economies by reducing their interest rates and hence this hits the bottom line of  MF Global.

With income dropping, MF Global needed to do something, next come the new CEO Jon Corzine, the former New Jersey Governor and Goldman Sachs CEO, to turn around the business

Since there is a lax in the British regulatory control, US companies such as MF Global and Lehman Bros are able to take advantage of this loop hole by forming their UK subsidiaries. By forming MF Global UK, it will be able to take advantage of the UK’s unrestricted or no statutory limit rule to maximize its re-hypothecation.

As a result, a customer’s assets in the US can be transferred to the UK for re-hypothecating without them knowing. This may explain why more than $1.2 billion of MF Global customer’s funds in the US are missing because it already transferred it to its subsidiary in the UK.

This is actually what happened to Lehman Bros and through their UK subsidiary Lehman Bros International Europe transferred most of the customer’s assets in the US to Europe. It is then re-hypothecated many times and when the market turned against them Lehman Bros collapsed.

How MF Global collapsed  

Initial investigation reveals that much of MF Global’s debt is attributed to it’s exposure  to the repos or repurchase agreements in European Sovereign Debt instruments, in this case bonds. Repos is another way for bank to raise capital by selling bonds to investors and later to repurchase at a higher price they need to pay for the bond price plus the interest rate (or repo rate).

This can be described as following, say the repo rate is 1% and the bond yield is 5%. Then by using the clients money and other collaterals such as stocks, MF Global is able to hypothecate the amount that is available to purchase the Eurozone bonds. 
The interest rate due for the repos (the repo rate) was 1% and the coupon payable for the bonds 5%. This would give MF Global a 4% profit for doing nothing but sitting in between the two trades. Further, provided the bonds paid more than 1% then the cost of the repo would be covered and the transaction would generate a profit with virtually no cost for MF Global.

The only problem for MF Global was that it leveraged itself up on an enormous Eurozone sovereign debt position. This leverage created an exposure that was many times over its asset base. With no balance sheet constraints (repo-to maturity are generally off-balance sheet), MF Global manage to leverage a net long sovereign debt position of $6.3 billion- a position that was more than five times the firm’s book value, or net worth.

MF Global’s mistake was that although it wasn’t exposed to the risk of counter party default on the bonds (because of the EFSF guarantee), it still remained exposed to the ongoing costs of maintaining the transaction, such as margin calls, as well as other transactions such as interest rate on loans from other banks which charge inter bank offer rates.

Leveraging is a double edge sword, if done right it helped to increase returns but if it is done wrong then it will amplify your losses and if not careful will bring you down. With MF Global’s leverage reaching 40 to 1 by the time of its collapse, it didn’t need a Eurozone default to trigger its downfall -all it needed was for these amplified costs to outstrip its asset base.

Another thing is that re-hypothecation transactions are off-balance sheet and are therefore is not an entry in the balance sheet and hence difficult to track. Off-balance sheet transactions can, and frequently do, appear on multiple banks’ financial statements. What this creates is a chain of counterparty risk, where borrowers re-hypothecate using the same collateral over and over again.

According to a letter from KPMG to MF Global clients, when MF Global collapsed, its UK subsidiary MF Global UK Limited had over 10,000 accounts. MF Global disclosed in March 2011 that it had significant credit risk from its European subsidiary from “counterparties with whom we place both our own funds or securities and those of our clients”. 

The IMF estimated that even before 2008, US banks are receiving more than $4 trillion worth of funding from Europe through re-hypothecation. A review of filings from some banks reveals the following.

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-pledged), Oppenheimer Holdings ($15.3 million), Credit Suisse (CHF 332 billion), Knight Capital Group($1.17billion),Interactive Brokers ($14.5 billion), Wells Fargo ($19.6 billion), JP Morgan($546.2 billion), Jefferies ($22.3 billion) and Morgan Stanley ($410 billion). 

In essence the three biggest entities that are involved in the re-hypothecation business are JP Morgan ($ 546.2 billion), Morgan Stanley ($410 billion) and Credit Suisse ($332 billion) and together they add up to more than $1.2 trillion. Another thing to note is that the Canadian banks also accounted for more than $120 billion in re-hypothecation.

Canadian banks are known to be conservative as compared to its US counterparts are able to avoid any scrutiny all this while because all these transactions are off balance and hence not appeared on the balance sheets. This makes it very difficult to detect.

In short, MF Global has set off a chain reaction to events that will be very difficult to comprehend and even with the concerted actions by the central banks of the world will find it difficult to halt the process.
 
Such practice can only happen when there are concerted efforts by different parties due to greed, crony capitalism, moral hazard and corrupted behavior of regulators that eventually led to such a situation.

 
For the part regarding MF Global’s crony capitalism and moral hazard, it had already been pretty much covered in Janet Tavakoli’s article on ‘MF Global Revelation keeps getting worse’, dated Nov 22.

Jon Corzine’s answer to Congress that he doesn’t know where the $1.2 billion in missing money is akin to a rapist telling the judge ‘No your Honour, I didn’t rape her but I just make love to her’

The failure of MF Global with $41 billion in assets is the eighth biggest bankruptcy in U.S. history.

Who is Next?

With MF Global’s collapse, it also help exposed Europe being a fertile ground to breed ‘Financial Terrorist’ or ‘Financial Jihadist’ for that matter, that only know how to unleash the ‘Financial Virus’ or debt instruments that is affecting everybody including themselves.

It also helped to explain why Europe’s financial crisis seems like no end in sight. Even though it had tried various measures but there is not a solution in sight because the problems that is affecting Europe seems much more complex that we thought. Looks like there are many more financial time bombs in the complex world of Structured Financing have yet to explode. 
Jon Corzine during questioning, mentioned that one of the largest institutional shareholders (owners) is Fidelity and this inevitably let us to ask “ Who is Next? ”, to fall in the house of cards.

by Sam Chee Kong
cheekongsam@yahoo.com

Investment Banking with experience in Capital Raising, Hedging and Risk Management.

B.Econs, Flinders University, Adelaide, South Australia
Post Graduate Diploma in Treasury Management, Treasury Management School of New Zealand