By Christopher Elias (UK)
BusinessLaw Research Note: This version of the article has been modified fromthe original to make it clear that re-pledged collateral may come fromstraight repos and not just re-hypothecation. Some of the financialfigures from banks' disclosures have been adjusted accordingly.
(Business Law Currents) A legal loophole in international brokerage regulations means that few, if any, clients of MF Globalare likely to get their money back. Although details of the drama arestill unfolding, it appears that MF Global and some of its Wall Streetcounterparts have been actively and aggressively circumventing U.S.securities rules at the expense (quite literally) of their clients.
MFGlobal's bankruptcy revelations concerning missing client money suggestthat funds were not inadvertently misplaced or gobbled up in MF’s dyinghours, but were instead appropriated as part of a mass Wall Stmanipulation of brokerage rules that allowed for the wholesaleacquisition and sale of client funds through re-hypothecation. Aloophole appears to have allowed MF Global, and many others, to use itsown clients’ funds to finance an enormous $6.2 billion Eurozone repobet.
If anyone thought that you couldn’t have yourcake and eat it too in the world of finance, MF Global shows how you canhave your cake, eat it, eat someone else’s cake and then let yourclients pick up the bill. Hard cheese for many as their dough goesmissing.
FINDING FUNDS
Currentestimates for the shortfall in MF Global customer funds have nowreached $1.2 billion as revelations break that the use of client moneyappears widespread. Up until now the assumption has been that the fundsmissing had been misappropriated by MF Global as it desperately soughtto avoid bankruptcy.
Sadly, the truth is likely tobe that MF Global took advantage of an asymmetry in brokerage borrowingrules that allow firms to legally use client money to buy assets intheir own name - a legal loophole that may mean that MF Global clientsnever get their money back.
REPO RECAP
Firsta quick recap. By now the story of MF Global’s demise is strikinglyfamiliar. MF plowed money into an off-balance-sheet maneuver known as arepo, or sale and repurchase agreement. A repo involves a firm borrowingmoney and putting up assets as collateral, assets it promises torepurchase later. Repos are a common way for firms to generate money butare not normally off-balance sheet and are instead treated as“financing” under accountancy rules.
MF Global useda version of an off-balance-sheet repo called a "repo-to-maturity." Therepo-to-maturity involved borrowing billions of dollars backed by hugesums of sovereign debt, all of which was due to expire at the same timeas the loan itself. With the collateral and the loans becoming duesimultaneously, MF Global was entitled to treat the transaction as a“sale” under U.S. GAAP. This allowed the firm to move $16.5 billion offits balance sheet, most of it debt from Italy, Spain, Belgium, Portugaland Ireland.
Backed by the European FinancialStability Facility (EFSF), it was a clever bet (at least in theory) thatcertain Eurozone bonds would remain default free whilst yields wouldcontinue to grow. Ultimately, however, it proved to be MF Global’sdownfall as margin calls and its high level of leverage sucked outcapital from the firm. For more information on the repo used by MFGlobal please see Business Law Currents MF Global – Slayed by the Grim Repo?
Puzzlingmany, though, were the huge sums involved. How was MF Global able to“lose” $1.2 billion of its clients’ money and acquire a sovereign debtposition of $6.3 billion – a position more than five times the firm’sbook value, or net worth? The answer it seems lies in its exploitationof a loophole between UK and U.S. brokerage rules on the use of clientsfunds known as “re-hypothecation”.
RE-HYPOTHECATION
Byway of background, hypothecation is when a borrower pledges collateralto secure a debt. The borrower retains ownership of the collateral butis “hypothetically” controlled by the creditor, who has a right to seizepossession if the borrower defaults.
In the U.S.,this legal right takes the form of a lien and in the UK generally in theform of a legal charge. A simple example of a hypothecation is amortgage, in which a borrower legally owns the home, but the bank holds aright to take possession of the property if the borrower shoulddefault.
In investment banking, assets depositedwith a broker will be hypothecated such that a broker may sellsecurities if an investor fails to keep up credit payments or if thesecurities drop in value and the investor fails to respond to a margincall (a request for more capital).
Re-hypothecationoccurs when a bank or broker re-uses collateral posted by clients, suchas hedge funds, to back the broker’s own trades and borrowings. Thepractice of re-hypothecation runs into the trillions of dollars and isperfectly legal. It is justified by brokers on the basis that it is acapital efficient way of financing their operations much to the chagrinof hedge funds.
U.S. RULES
Underthe U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, aprime broker may re-hypothecate assets to the value of 140% of theclient's liability to the prime broker. For example, assume a customerhas deposited $500 in securities and has a debt deficit of $200,resulting in net equity of $300. The broker-dealer can re-hypothecate upto $280 (140 per cent. x $200) of these assets.
But in the UK, there is absolutely no statutory limit onthe amount that can be re-hypothecated. In fact, brokers are free tore-hypothecate all and even more than the assets deposited by clients.Instead it is up to clients to negotiate a limit or prohibition onre-hypothecation. On the above example a UK broker could, and frequentlywould, re-hypothecate 100% of the pledged securities ($500).
Thisasymmetry of rules makes exploiting the more lax UK regime incrediblyattractive to international brokerage firms such as MF Global or LehmanBrothers which can use European subsidiaries to create pools of fundingfor their U.S. operations, without the bother of complying with U.S.restrictions.
In fact, by 2007, re-hypothecationhad grown so large that it accounted for half of the activity of theshadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund(IMF) calculated that U.S. banks were receiving $4 trillion worth offunding by re-hypothecation, much of which was sourced from the UK. Withassets being re-hypothecated many times over (known as “churn”), theoriginal collateral being used may have been as little as $1 trillion – aquarter of the financial footprint created through re-hypothecation.
BEWARE THE BRITS: CIRCUMVENTING U.S. RULES
Keento get in on the action, U.S. prime brokers have been making judicioususe of European subsidiaries. Because re-hypothecation is so profitablefor prime brokers, many prime brokerage agreements provide for a U.S.client’s assets to be transferred to the prime broker’s UK subsidiary tocircumvent U.S. rehypothecation rules.
Undersubtle brokerage contractual provisions, U.S. investors can find thattheir assets vanish from the U.S. and appear instead in the UK, despitecontact with an ostensibly American organisation.
Potentiallyas simple as having MF Global UK Limited, an English subsidiary, enterinto a prime brokerage agreement with a customer, a U.S. based primebroker can immediately take advantage of the UK’s unrestrictedre-hypothecation rules.
LEHMAN LESSONS
Infact this is exactly what Lehman Brothers did through Lehman BrothersInternational (Europe) (LBIE), an English subsidiary to which most U.S.hedge fund assets were transferred. Once transferred to the UK basedcompany, assets were re-hypothecated many times over, meaning that whenthe debt carousel stopped, and Lehman Brothers collapsed, many U.S.funds found that their assets had simply vanished.
Aprime broker need not even require that an investor (eg hedge fund)sign all agreements with a European subsidiary to take advantage of theloophole. In fact, in Lehman’s case many funds signed a prime brokerageagreement with Lehman Brothers Inc (a U.S. company) but margin-lendingagreements and securities-lending agreements with LBIE in the UK(normally conducted under a Global Master Securities Lending Agreement).
These agreements permitted Lehman to transferclient assets between various affiliates without the fund’s expressconsent, despite the fact that the main agreement had been under U.S.law. As a result of these peripheral agreements, all or most of itsclients’ assets found their way down to LBIE.
MF RE-HYPOTHECATION PROVISION
Asimilar re-hypothecation provision can be seen in MF Global’s U.S.client agreements. MF Global’s Customer Agreement for trading in cashcommodities, commodity futures, security futures, options, and forwardcontracts, securities, foreign futures and options and currenciesincludes the following clause:
“7. Consent To Loan Or PledgeYou hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate, loan,or invest any of the Collateral, including, without limitation,utilizing the Collateral to purchase or sell securities pursuant torepurchase agreements [repos] or reverse repurchase agreements with anyparty, in each case without notice to you, and we shall have noobligation to retain a like amount of similar Collateral in ourpossession and control.”
In itsquarterly report, MF Global disclosed that by June 2011 it had repledged(re-hypothecated) $70 million, including securities received underresale agreements. With these transactions taking place off-balancesheet it is difficult to pin down the exact entity which was used tore-hypothecate such large sums of money but regulatory filings andletters from MF Global’s administrators contain some clues.
Accordingto a letter from KPMG to MF Global clients, when MF Global collapsed,its UK subsidiary MF Global UK Limited had over 10,000 accounts. MFGlobal disclosed in March 2011 that it had significant credit risk fromits European subsidiary from “counterparties with whom we place both ourown funds or securities and those of our clients”.
CAUSTIC COLLATERAL
Matters get even worse when we consider what has for the last 6 years counted as collateral under re-hypothecation rules.
Despitethe fact that there may only be a quarter of the collateral in theworld to back these transactions, successive U.S. governments havesoftened the requirements for what can back a re-hypothecationtransaction.
Beginning with Clinton-eraliberalisation, rules were eased that had until 2000 limited the use ofre-hypothecated funds to U.S. Treasury, state and municipal obligations.These rules were slowly cut away (from 2000-2005) so that customermoney could be used to enter into repurchase agreements (repos), buyforeign bonds, money market funds and other assorted securities.
Hence,when MF Global conceived of its Eurozone repo ruse, client funds werewaiting to be plundered for investment in AA rated European sovereigndebt, despite the fact that many of its hedge fund clients may have beenbetting against the performance of those very same bonds.
OFF BALANCE SHEET
Aswell as collateral risk, re-hypothecation creates significantcounterparty risk and its off-balance sheet treatment contains manyhidden nasties. Even without circumventing U.S. limits onre-hypothecation, the off-balance sheet treatment means that the amountof leverage (gearing) and systemic risk created in the system byre-hypothecation is staggering.
Re-hypothecationtransactions are off-balance sheet and are therefore unrestricted bybalance sheet controls. Whereas on balance sheet transactionsnecessitate only appearing as an asset/liability on one bank’s balancesheet and not another, off-balance sheet transactions can, andfrequently do, appear on multiple banks’ financial statements. What thiscreates is chains of counterparty risk, where multiple re-hypothecationborrowers use the same collateral over and over again. Essentially, itis a chain of debt obligations that is only as strong as its weakestlink.
With collateral being re-hypothecated to afactor of four (according to IMF estimates), the actual capital backingbanks re-hypothecation transactions may be as little as 25%. Thischurning of collateral means that re-hypothecation transactions havebeen creating enormous amounts of liquidity, much of which has no realasset backing.
The lack of balance sheet recognition of re-hypothecation was noted in Jefferies’ recent 10Q (emphasis added):
“Note 7. Collateralized Transactions
Wepledge securities in connection with repurchase agreements, securitieslending agreements and other secured arrangements, including clearingarrangements. The pledge of our securities is in connection with ourmortgage-backed securities, corporate bond, government and agencysecurities and equities businesses. Counterparties generally have theright to sell or repledge the collateral. Pledged securities thatcan be sold or repledged by the counterparty are included withinFinancial instruments owned and noted as Securities pledged on ourConsolidated Statements of Financial Condition. We receive securities as collateral in connection with resale agreements, securities borrowings and customer margin loans. Inmany instances, we are permitted by contract or custom to rehypothecatesecurities received as collateral. These securities maybe used tosecure repurchase agreements, enter into security lending or derivativetransactions or cover short positions. At August 31, 2011 andNovember 30, 2010, the approximate fair value of securities received ascollateral by us that may be sold or repledged was approximately $25.9billion and $22.3 billion, respectively. At August 31, 2011 and November30, 2010, a substantial portion of the securities received by us hadbeen sold or repledged.
Weengage in securities for securities transactions in which we are theborrower of securities and provide other securities as collateral ratherthan cash. As no cash is provided under these types oftransactions, we, as borrower, treat these as noncash transactions anddo not recognize assets or liabilities on the Consolidated Statements ofFinancial Condition. The securities pledged as collateral underthese transactions are included within the total amount of Financialinstruments owned and noted as Securities pledged on our ConsolidatedStatements of Financial Condition.
Accordingto Jefferies’ most recent Annual Report it had re-hypothecated $22.3billion (in fair value) of assets in 2011 including government debt,asset backed securities, derivatives and corporate equity- that’s just$15 billion shy of Jefferies total on balance sheet assets of $37billion.
HYPER-HYPOTHECATION
Withweak collateral rules and a level of leverage that would makeArchimedes tremble, firms have been piling into re-hypothecationactivity with startling abandon. A review of filings reveals astaggering level of activity in what may be the world’s largest evercredit bubble.
Fuellinghyper-hypothecation and joining together daisy chains of liabilitythrough the pledging and re-pledging of collateral have been banksaround the world. Once in the system collateral is being pledged andre-pledged over and over again either through sale and repurchaseagreements or re-hypothecation as demonstrated by a review of SECfilings. For instance, Goldman Sachsdisclosed recently that it had re-pledged $18.03 billion of collateral received as at September 2011, Oppenheimer Holdings re-pledged approximately $255.4 million of its own customers’ securities in the same period, Canadian Imperial Bank of Commercere-pledged $72 billion in client assets, Credit Suissesold or re-pledged CHF 332 billion of assets (received under resale agreements, securities lending and margined broker loans), Royal Bank of Canadare-pledged $53.8 billion of $126.7 billion available for re-pledging, Knight Capital Groupdelivered or re-pledged $1.17 billion of financial instruments received, Interactive Brokers re-pledged or re-sold $7.9 billion of $16.7 billion available to re-sell or re-pledge, Wells Fargo re-pledged $19.6 billion as at September 2011 of collateral received under resale agreements and securities borrowings, JP Morgansoldor re-pledged $410 billion of collateral received under customer marginloans, derivative transactions, securities borrowed and reverserepurchase agreements and Morgan Stanley re-pledged $410 billion of securities received.
LIQUIDITY CRISIS
Thevolume and level of re-hypothecation suggests a frightening alternativehypothesis for the current liquidity crisis being experienced by banksand for why regulators around the world decided to step in to prop upthe markets recently. To date, reports have been focused on how Eurozonedefault concerns were provoking fear in the markets and causingliquidity to dry up.
Most have beenfocused on how a Eurozone default would result in huge losses inEurozone bonds being felt across the world’s banks. However,re-hypothecation suggests an even greater fear. Considering thatre-hypothecation may have increased the financial footprint of Eurozonebonds by at least four fold then a Eurozone sovereign default could beapocalyptic.
U.S. banks direct holdingof sovereign debt is hardly negligible. According to the Bank forInternational Settlements (BIS), U.S. banks hold $181 billion in thesovereign debt of Greece, Ireland, Italy, Portugal and Spain. If wefactor in off-balance sheet transactions such as re-hypothecations andrepos, then the picture becomes frightening.
Asfor MF Global’s clients, the recent adoption of an “MF Global rule” bythe Commodity Futures Trading Commission to ban using client funds topurchase foreign sovereign debt, would seem to suggest that it wasindeed client money behind its leveraged repo-to-maturity deal - a factthat will likely mean that very few MF Global clients get their moneyback.
Written with contributions from Nanette Brynes.
(Thisarticle was first published by Thomson Reuters’ Business Law Currents, aleading provider of legal analysis and news on governance, transactionsand legal risk. Visit Business Law Currents online at https://currents.westlawbusiness.com.