The Canadian customers of MFG got their money back within 10 days of the MFG bankruptcy. The accounts that have lost money are either USA or UK based. In Canada, re-hypothecation is not permitted. I got these comments from a Canadian MFG account holder:
The trustee where segregated MF Global Canada customers' funds were held was RBC Dominion Securities. I don't think any of these funds ever left the trustee in Canada. Likelihood is if they left, the Canadian government would have made the parent Royal Bank of Canada eat up the losses and make full restitution.
We shall see in the coming weeks if, in fact, re-hypothecation is the cause of the problems. I’m convinced it is.
The rules on broker's ability to A) Hypothecate and B) Re-hypothecate in the USA are spelled out in Reg T. This set of rules has been established by our good friends at the Federal Reserve Bank. Let me provide some telling words on this re Reg. T rule 15c3-3: (emphasis mine/Link)
• Except as otherwise agreed in writing by the OTC derivatives dealer and the counterparty, the dealer may repledge or otherwise use the collateral in its business;
• In the event of the OTC derivatives dealer's failure, the counterparty will likely be considered an unsecured creditor of the dealer as to that collateral;
Well there you have it. Reg. T does permit the broker to “repledge” (AKA re-hypothecate). In the event of default by the broker, the counterparty will be considered an unsecured creditor. (AKA customers lose money). And SIPC provides zero protection to account holders in the event of a broker default.
For me, there is sufficient information to conclude that Reg. T is flawed and must be changed. I have to believe there is any army of lawyers over at the Federal Reserve looking into this as I write and they are struggling with what they can do to “fix” the problem.
For sure a fix is required. MFG has not, as yet, morphed into a systemic problem. But we are getting closer by the day. The Fed is aware of this. The risk is that customers start to withdraw funds and assets from other brokers. The deleveraging this would cause would be catastrophic. A significant chunk of the shadow banking system (about $10 trillion) is dependent on the liquidity that is created by hypothecation. (The situation is bigger and more problematic in the UK)
I’m re-doubling the bet this AM. If Reg. T is confirmed to be the source of customer losses at MFG then Reg. T will have to be gutted. The changes will have to take place fairly quickly. The consequences across all markets of these changes could prove to be a devastating blow.
The nice folks at the FRB are having a big meeting this week. Reg. T and MFG will almost certainly be on the agenda. I have to believe all those smart folks at the Fed have figured out that we have a problem. We may well get some announcement on this topic by Friday.
Any changes to Reg. T will have profound effects on global markets. Not only the exchanges/asset prices will be affected, this has the potential to derail the global economy. We are already in a very dangerous liquidity situation. If the Fed is forced to change margin rules, liquidity will dry up for an extended period of time. Forced changes in Reg. T will prove to be a Black Swan event.
Note:
Should we get a confirmation of the foregoing discussion and the Fed is forced to react and make regulatory changes, there will be significant long term implications for the Fed. The Fed will have to shoulder the blame for the flaws in Reg. T. They will also have to take responsibility for the broader economic consequences that will surely follow those changes.
The possibility exits for the Fed to lose any credibility they may still have in the US and abroad. The completely unregulated Federal Reserve may lose its independence as a result. There are big downsides to significant revisions to margin rules. The upside is that the Fed’s supreme power over the global economy would be finally checked.
.
Posts
There's not a person trading that didn't think their account was either covered by insurance or 'segregated'. And the industry was more than happy to leave us with that impression.
ReplyDeleteWe now learn that our funds can by taken from us legally and with ease.
How can we not call this a giant scam?
I don't care if the fine print said re-hypothecate. Nobody knew what re-hypothecate meant and we were led to believe that our money was insured or segregated.
Scam.
the banks have shown they will ultimately act in their complete self-interest. It must be presumed they will take customer funds/assets in a worst case scenario when they are attempting to defend the entity.
ReplyDeleteUnwinding the hypo/rehypothecation game, given the estimates involved, would likely send shockwaves through the markets; this is an absolutely frightening time for investors worldwide - damned if they do, damned if they don't.
You say--------In Canada, re-hypothecation is not permitted.-------- I have a question. Re hypothecation is not allowed, but is hypothecation allowed? My understanding is that re-hypothecation is not allowed in Canada or the U.S., but these companies are conducting their activities in the U.K. If RBC has over $50 billion dollars invested in the shadow banking system overseas, then we would need a much more definitive statement from them covering all of these bases before we could breathe a sigh of relief.
ReplyDeleteApart from COMPLETELY misstating the law, decent post.
ReplyDelete"I have to believe all those smart folks at the Fed have figured out that we have a problem."
ReplyDeleteI have to believe that the FED knew early that they had a problem, the idea that millions were missing, stolen, was always a large scale MSM generated cover story. The FED status quo has been to manage investor expectations using the MSM there recent interest in financial bloggers shows a heighten concern that internet publishing is impacting financial media propaganda.
If the Fed doesn't do the right thing, then individuals should force the issue. I just researched my long standing reliable/reputable garden variety stock broker's customer account account agreement. In it is the following:
ReplyDeletePolicies. 7. Pledge of Securities and Other Property
We may pledge, re-pledge, hypothecate or re-hypothecate,
either separately or together with Securities of
other customers, all Securities and Other Property
that you, now or in the future, carry, hold or maintain
in your Margin and Short Account. The value of the
Securities and Other Property we pledge or re-pledge
may be greater than the amount you owe us, and we
are not obligated to retain in our possession and
control for delivery the same amount of similar
Securities and Other Property. 8. Loan Consent
You agree that Securities and Other Property held in
your margin account, now or in the future, may be
borrowed (either separately or together with the property
of others) by us (acting as principal) or by others. XXXX may place any security held in your Account
into the Margin Account portion of your Account.
I made a change as a reult of this. It appears to me that if you hold any margin account you are at risk of a MFG moment.
Bruce, are there any solutions here? Do we know to what degree brokerages borrow while pledging client assets as security? And which ones do it?
ReplyDeleteDavid,
ReplyDeleteHave spoken at length to my broker, US broker dealers are allowed to re-hypothecate up to 140% of the funds which you have borrowed from them. The clear message that I received is that they can and do re-hypothecate every available borrowed dollar to 1.39999999999 times across all accounts. They then pool those assets and pledge them in overnight repo market. My conclusion is that, given the 30-50% haircut imposed upon equities, the chain of re-hypothecation is shorter because the "half-life" of the assets is less. On bonds, the chain can be long and the churning massive. I am sure the implications are much mroe dire for UK-based broker dealers. For equities, I am not sure if they are actually repo'ed or if they are simply used as a profit center for stock lending, trade execution before settlement, etc. They use this to lower their cost of funds firmwide, which they claim enables them to offer more competitive lending rates on securities (although I doubt the majority of this is passed on to clients).
I posted the earlier "anonymous" comment with the excerpt from my client brokerage agreement. I also spoke with the firm at length. I was "told" that the re-hypothecation applied only to margin loans. However the excerpts I included would suggest that the risk is present if you just have a margin account even if you don't have a current margin loan. Somebody else may read it differently but I was unwilling to take the risk and removed the margin feature from all my accounts.
ReplyDeleteDavid, the solution is to invest in stocks or bonds without using a margin account. If you do that, the broker cannot pledge or hypothecate your assets. Additionally, invest in funds that do not lend out their securities, and thereby take in counterparty credit risk and collateral risk.
ReplyDeleteThe solution for investing in futures and fx is to only use FCM's that have a policy of running a flat book with minimal proprietary risk and a solid balance sheet.
Ryan Burke,
ReplyDeleteThank you for that explanation. I agree that the formula is 1.4.
But since you seem to understand this better than most (including me) I have a knock on question.
Does the .40 have a multiplier? Is there a daisy chain of this or is it a one time re-leverage?
David Merkel,
ReplyDeleteI know from your many comments you a sophisticated investor, yet you ask these questions.
That is the real problem here. You don't know the answers for something that should be completely understood.
I don't understand this. As of two weeks ago I did not know the word re-hypothecation. That I don't know this cold is what scares me. If we don't understand the implications of this, very few do.
Anyway, I'm not sure of the recommendation about buying stock in a non margin account. I think the issue is you have to look at the agreement you signed when the account was opened (or updated).
If you signed your name to something that reads like the following I think there is some risk.
The following is the language used for two different MFG accounts. They are different, but the same. These are what to look for in your own brokerage docs:
8-Within the limits of applicable law and regulations, you hereby authorize us to lend either to ourselves or to others any securities or other property held by us in your margin account together with all attendant rights of ownership and to use all such property as collateral for our general loans. Any such property, together with all attendant rights of ownership, may be [pledged, repledged, hypothecated or rehypothecated either separately or in common with other such property for any amounts due to us thereon or for a greater sum and we shall have no obligation to retain a like amount of similar property in our possession and control.
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.”
Bruce,
ReplyDeleteWhat you quoted for MFG is almost word for word what I excerpted from my run of the mill stock brokerage firm with a margin account feature and printed in my earlier comment under "anonymous".
So if these people have been using investors collateral as collateral for themselves, who's to say that they haven't been doing the same thing with our mortgage deeds ownership? If the collateral is never transferred to the MBS investor pool... then it's an asset for the holder... Right?
ReplyDeleteBruce, you said:
ReplyDelete"That is the real problem here. You don't know the answers for something that should be completely understood.
I don't understand this. As of two weeks ago I did not know the word re-hypothecation. That I don't know this cold is what scares me. If we don't understand the implications of this, very few do."
That is the essential problem. Likely most of MFG's customers didn't have the resources to spend $$'s on an army of lawyers to review the contracts.
Ultimately, it's faith customers have in the entity itself, such as the former MFG. No bankruptcy, no problem. Problem, who knows, even those following the Jeffries of the world on a day to day basis, what the true risk is in these entities. No one knows what's going on behind the scenes, London in particular. MFG collapse happened very quickly so an entity could look good on paper one day yet collapse soon thereafter.
Bruce,
ReplyDeleteI was told specifically that (1) the only accounts that could be re-hypothecated were margin accounts, and (2) that the broker-dealer was only entitled to leverage 140% of the amount being borrowed in any margin account. The firm was explicit that they re-hypothecate religiously right up to 1.399999x. At 1.40000001 the regulators jump all over them, but they will take it as many decimal places as they can. So one should assume that any margin borrowings are absolutely re-hypothecated right up to the limit.
My interpretation is that there is a daisy chain, but I wonder how this is possible with only overnight repos. Is it possible for many of the same firms to all claim the same collateral as their own overnight, or is this only possible for longer duration repos? How could one re-hypothecate a client's assets on anything more than an overnight basis? This is the part of the equation that I am having trouble understanding.
Clearly, the issues are larger in London and the B-D I spoke to was quick to point out that they do not use PLCs to maximize leverage.
I appreciate your concern, Bruce, but the problem of fixing reg T faced by this army of lawyers is nothing that can't be solved by the harem of Wall Street lap dancers.
ReplyDeleteSeriously, the Greenspan mantra is; free markets reign... and no-margin broker will rise from the ashes.
We wanted cheap margin, we got it.
Is there any connection between the rehypothecation daisy chain and the Fed's decision last week to extend dollar swaps?
ReplyDeleteI think you are missing an even bigger number. inflation! If you calculate inflation at deficit/debt you are running a $260 billion additional hole in the trust fund.
ReplyDeletesteelhouse/twoplustwo
This talk of rehypothetcation makes the system look no more secure than onine poker sites.
ReplyDeleteThis is an amazing post. It's like reading Michael Lewis ... stating out loud, and SIMPLE TO UNDERSTAND ... How Wall Street "designs" what they think are "cash cows" to their bonus structure ... But then they LOSE THE WHOLE HOUSE.
ReplyDeletePeople won't invest!
Years ago, it drove me nuts that my Schwab statements said, on page 3 ... that I also had "margin" status.
I went NUTS! I never, ever, buy on margin! And, I told them if they didn't take this off ... they'd lose my business. So, I no longer have "margin status" on my portfolios.
But, wow. Imagine losing everything, because brokerage houses can gamble. And, when they go bust they owe you nothing at all.
Also, as an aside, while I couldn't imagine WHY Jon Corzine testified in Congress ... without using the 5th ... Now I can see the circus was a ruse. He wanted to deflect attention away from Rule "T" ... over at the Feds.
Thank you so much for getting the word out! I copied this post ... and sent it to my son. His wife. And, some close friends. Plus, I threw in my accountant. And, others.
I hope this post of yours goes VIRAL!
I'm an advisor at a Canadian brokerage firm. Just had a look at our T&C document and it's essentially as above.
ReplyDeleteBruce,
ReplyDeleteGiven your original post and the comments posted, you might consider a follow up story with any other info you can obtain regarding standard brokerage accounts with and without a margin feature as to the risk of re-hypothecation. I can well imagine there are orders of magnitude more brokerage accounts with margin feature than there are futures (eg MFG) accounts. These are likely unsuspecting potential victims.
As I understand, the City of London has NO LIMIT on the amount of funds which may be re-hypothecated. Which is one reason that all the major banks have a presence there. They merely tunnel their customer accounts through the City of London and voila, they are not bound by the US 1.4 limit. Typically they use 4x...
ReplyDeleteHi Bruce,
ReplyDeleteAn odd scenario - imagine someone at the govt learned MF was going under, and that funds were basically gone.
Rather than sic the FBI/SEC/etc on MF, instead it could be treated as an academic exercise to learn what a subset of the population would do if their funds vanished.
It would be a useful exercise in preparing to nationalize 401Ks & IRAs.
anon @ 9:55am:
ReplyDeletemakes one wonder, no?
Investors will not be able to say they weren't warned. I would presume a large # of MFG customers are now done trading, hedging and/or confident in the banking system and have gone to physical gold.
The question is what other MFG like customers at other brokerages/banks are doing - I suspect the few investors on the ball have shifted mostly out of paper but the vast majority are treating it as business as usual.
We were warned, albeit indirectly.
To anonymous who said: "I'm an advisor at a Canadian brokerage firm. Just had a look at our T&C document and it's essentially as above."
ReplyDeleteAre you saying Canada is not allowed to hypothecate/re-hypothecate or are you saying that brokers ask margin account holders to sign documents that allow for hypothecation/ rehypothecation?
The FED status quo has been to manage investor expectations using the MSM there recent interest in financial bloggers shows a heighten concern that internet publishing is impacting financial media propaganda.
ReplyDeleteThis has as you say the potential to derail the global economy. And they are now caught in the binding of their own karma that whether they turn to the left or right, their days are numbered.
ReplyDeleteThat is incredible! I love this!!! Consequently pleased I just stumbled across your site This is lovely! I stumbled onto your website just a few units back as well as fell in love with this! I have so much fabric and not much about that, this will aid! Many thanks!
ReplyDeletePledging/repledging is done to circumvent segregation rules at futures and securities brokers. Essentially, pleding/repledging has created a fractional reserve system in the brokerage industry and has allowed the growth of both the 700 trillion OTC derivatives market and the 16 trillion (or more) repo market (while world GDP is 60 trillion). Broker-dealers are using customers' funds and assets as collateral in these markets. Therefore, brokers (like Fidelity, Schwab) are misleading customers when they state that customers' funds are segregated. They are not segregated, because customers' funds and securities have been used by its broker as collateral for its own borrowing from a broker-dealer.
ReplyDeleteMoreover, brokers are misleading customers when they state that they can only pledge up to 140% of the loan, because that still means that a customer stands to lose 70% of his assets bought on margin and 40% of his equity, in the case when the purchase on margin followed the 50% federal "Reg T" initial requirement. In that case, with the 140% limit, 70% of the customer's securities are pledged by its broker as collateral for a loan. The broker-dealer takes a de-facto posession of 70% of that customer's assets and repledges them in their entirety (100% of that 70%). In other words, the broker-dealer repledges those assets with no limits, and they become the collateral for the broker-dealer's own loans.
The brokerage industry situation is much worse than the situation at the banking industry, because the banks' fractional reserve system has a reserve coefficient of 10%, which means that the banking system can grow up to 10 times the amount of reserves. However, thanks to pledging/repledging, the brokerage system can grow ad infinitum because there are no limits when the broker-dealers REPLEDGE as collateral the original customer's assets.
Pledging/repledging should be criminalized through legislation. In the meantime, customers should close their margin accounts at securities brokers and their commodities accounts at futures brokers, because their funds are not really segregated anymore due to pledging/repledging.