Economics: Rehypothecation Heightens Systemic Financial Risk

The swift implosion of MF Global highlights a common practice used by aggressive speculators, one that experts say makes the broader financial system vulnerable to another crisis. It's called rehypothecation, and it allows a firm to essentially pledge the same limited collateral to arrange fresh loans.

MF Global is believed to have used client funds as collateral to borrow money to make bets on the risky sovereign debt of Portugal, Spain and Italy, leading to a daisy chain of securitization, Thomson Reuters Business Law Currents reported. It's akin to using a single home as collateral for several loans and then investing that money to earn dividends before payments are due on the loans.

Over the last decade, the practice has become riskier due to looser regulations. In 1934, U.S. lawmakers limited rehypothecated funds to investments in U.S. Treasury, state and municipal instruments, but those rules were relaxed from 2000 to 2005, allowing brokers to use client funds to make riskier bets on foreign bonds and sovereign debt.

Rehypothecation has been practiced for decades, but the systemic risks grow as the leverage increases. At the height of the financial crisis, the credit multiplier was 4, according to the IMF, and $1 trillion in hedge fund assets had been transformed into $4 trillion of pledgeable collateral at banks. The problem comes when everyone wants the money back.

Many of Wall Street's most prominent players "have been piling into re-hypothecation activity with startling abandon," reported Thomson Reuters Business Law Currents, essentially creating "what may be the world's largest ever credit bubble." Among them are Goldman Sachs ($28.17 billion rehypothecated in 2011), Wells Fargo ($19.6 billion), JPMorgan ($546.2 billion) and Morgan Stanley ($410 billion).

More alarming is the lack of transparency about such rehypothecations, which are off-balance-sheet transactions. Because they don't appear on a firm's ledger of revenues and expenses, a significant amount of liability may be hidden. Thus, it is not clear how much in rehypothecations is tangled up with risky sovereign debt. U.S. banks hold $181 billion in the sovereign debt of Greece, Ireland, Italy, Portugal and Spain, according to the Bank of International Settlements, but that total does not include off-balance-sheet transactions.

For more, see MF Global Collapse Spotlights Practice That Heightens Systemic Financial Risk by Marcus Baram and Catherine New, December 22, 2011 at The Huffington Post.