Thursday, December 8, 2011

Now You See It, Now You Don't

"I simply do not know where the money is."

This is what former MF Global CEO Jon Corzine will tell the House Agriculture Committee on Capitol Hill in his testimony today. Corzine was forced to resign last month amid allegations that his firm improperly commingled clients' funds with its own investment capital. All the money went out the door in some highly leveraged speculation. And never came back.

How can this happen? Reuters correspondent Christopher Elias describes how in a must-read article, MF Global and the Great Wall Street Re-hypothecation Scandal. Now, if "re-hypothecation" sounds to you like something sinister and best not tried at home, you would be absolutely right. But the big banks and brokers do it all the time. In fact MF Global, before it collapsed, warned its customers in its Customer Agreement as follows (and where you see the world "collateral," think anything of yours with cash value):

7. Consent To Loan Or Pledge
You 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 to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.

In other words, Mr. Client, we are going to pledge to someone else what rightfully belongs to you. And you can't opt out. If you want to do business with us, you have to play along. The problem, explains Elias, is that the same collateral gets pledged over and over, from one counterparty to the next:

With collateral being re-hypothecated to a factor of four (according to IMF estimates), the actual capital backing banks' re-hypothecation transactions may be as little as 25%. This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing...Considering that re-hypothecation may have increased the financial footprint of Eurozone bonds by at least four fold, then a Eurozone sovereign default could be apocalyptic. [emphasis mine]

Expounding on the Elias piece, Zero Hedge uses a familiar metaphor to describe the risk to the global economy:

The collapse of the weakest link in the daisy-chain sets off a house of cards that eventually will crash even the biggest entity due to exponentially soaring counterparty risk: an escalation best comparable to an avalanche - where one simple snowflake can result in a deadly tsunami of snow that wipes out everything in its path. Only this time it is not something as innocuous as snow: it is the compounded effect of trillions and trillions of insolvent banks all collapsing at the same time, and wiping out the developed world and the associated 150 years of the welfare state as we know it.

Hyperbole? We shall see.

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