The Lunacy of Unlimitted Re-Hypothecation

[JimBowie1958]

Why The UK Trail Of The MF Global Collapse May Have "Apocalyptic" Consequences For The Eurozone, Canadian Banks, Jefferies And Everyone Else | ZeroHedge

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).

This asymmetry of rules makes exploiting the more lax UK regime incredibly attractive to international brokerage firms such as MF Global or Lehman Brothers which can use European subsidiaries to create pools of funding for their U.S. operations, without the bother of complying with U.S. restrictions.

In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation.

Wow, the possibilities of money laundering alone are kind of mind-boggling.

Isnt it funny how bankers can simply make up cash out of thin air and never get charged with counter-feiting?

 

[Widdekind]

Hypothecation - Wikipedia, the free encyclopedia

"Hypothecation" means pledging collateral for a loan, until the loan is fully repaid. That collateral is "hypothetically" bought and controlled by the lending bank, until the loan is fully repaid.

"Re-Hypothecation" means the bank can turn around and lend, against that collateral. So, the bank had money, and lent it out, to somebody who pledged collateral. Then, with that loan on their books, they re-lend again, against the collateral they "bought hypothetically" with the money. Some "double counting" can occur, if-and-when the loan is partly repaid, so that the bank only partly owns the collateral -- yet is able to lend against more of that collateral, than it owns, even up to the entire amount, of the original loan / all of the collateral.

 

[itfitzme]

Hypothecation - Wikipedia, the free encyclopedia

"Hypothecation" means pledging collateral for a loan, until the loan is fully repaid. That collateral is "hypothetically" bought and controlled by the lending bank, until the loan is fully repaid.

"Re-Hypothecation" means the bank can turn around and lend, against that collateral. So, the bank had money, and lent it out, to somebody who pledged collateral. Then, with that loan on their books, they re-lend again, against the collateral they "bought hypothetically" with the money. Some "double counting" can occur, if-and-when the loan is partly repaid, so that the bank only partly owns the collateral -- yet is able to lend against more of that collateral, than it owns, even up to the entire amount, of the original loan / all of the collateral.

This idea of re-loaning seems to go way back to the days of simply gold coin and some guy with a bank vault, where the gold coins could be stored securely. I haven't heard the modern process described in the level of detail that I find satisfactory. Unfortunately, the more generalized explanations quickly open up to multiple interpretations.

In the old gold coin-bank vault example, as I read it, it is fairly simple. Bob has a bunch of gold coins that he deposits with the bank, having then stored securely. The bank now can loan out the gold coins to Chuck who uses them for payment to buy cattle from Doug. Being a small community, Doug deposits the gold coins right back at the bank. Now, the bank has the gold coins again and can loan them out to Edward who uses them to purchase something.

In our more modern system, the community is pretty large, spanning the globe. And while Chuck may not deposit them back into the same bank, there is someone else redepositing funds from some other bank.

Is that the basic idea here?

 

[Widdekind]

the key is the bank's Balance Sheet. Deposits, for which banks are liable (like an accounts payable), are their "liabilities" (L); cash, loans (like accounts receivable), or other assets (collateral), are their "assets" (A).

"Re-hypothecation" is where a bank has a balanced Balance Sheet; and their assets include a collateralized loan (say $1000). As that loan is paid back, their asset column shifts, from "all loan" ($1000), to "part loan part cash" ($500 loan, $500 cash). But, when the loan is not repaid fully; and because the borrower could "hypothetically" default, in which "hypothetical" case the bank would wind up with a $1000 collateral (some jewels, say); then, the bank can "pretend" that it has $1000 cash-value in its A column. So, it really has ($500 loan outstanding + $500 cash repaid), but can act like it has ($1000 cash). Vaguely, "re-hypothecation" allows banks to count collateralized "secure" loans as "Tier I" assets, which are "as good as cash", and can count as legal "cash reserves". Thereby, the bank can lend more of its actual cash, which is now "excess reserves", making more loans, and earning more interest.

Inexpertly, perhaps 'tis better to say, that banks can "lend against" excess cash in reserve -- banks don't lend only cash. Instead, if they have excess reserves, they can generate new deposits (L), facing new loans (A), lengthening their balance sheets, until their new total deposits are at reserve-ratio limit. So, if cash is deposited:

A | L
-------
$1 $1

If the reserve ratio is 10%, then when somebody walks in, wanting a car-loan, the bank can:

A | L
--------
$1 $1 (cash facing original deposit)
$9 $9 (loan facing newly loaned-into-existence deposit)

the bank has assets (A) = $1 cash, $9 loan accounts receivable; and liabilities (L) = $10 deposits. The guy wanting a car walks out with $9 added to his bank account; and a legal debt to the bank, for the same amount. But, in the short-term, with his fattened account, he can buy the new car. So, inexpertly, banks don't take in cash, and then on-lend suitcases of cash. Instead, they take in cash, and then use the same to underwrite new loans (A), the value of which is deposited into the borrower's bank account, as a new deposit (L). In the long-term, the borrower owes the bank. In the short-term, their own deposit account gets a boost. The point being, loans take the physical form, not of suitcases of cash; but of checks, drawn against "loan-fattened bank accounts". The loan (A) balances against the expanded deposit (L) of some one of their customers.

With "re-hypothecation",

A | L
--------
$1 ... (cash facing ...)
$1 ... (loan outstanding facing ...)

is legally as good as

A | L
--------
$2 ... (cash facing ...)

So, legally, the bank has (pseudo-)cash, more reserves, more excess reserves, and so can make more new loans. If the loan is fully repaid, the bank has the actual cash, anyway; if not, the bank keeps the partial payments ($500), and pawns the jewels for ($1000), and, again, has more-than-enough cash on hand, to count as legal cash reserves. Simply stated, albeit inexpertly, "re-hypothecation" counts collateral, as cash (for reserve requirements).

 

[Widdekind]

bank lending depends on depositing (of cash)

trying to keep track of units, both borrowing from, and lending by, banks, are flows of credit-money [$/year]. Over-simplistically, banks attract cash off the street, with their interest-rates; then use the cash to back new loans, to borrowers. Now, interest-rates are the 'price' of credit, reflecting the ratio of demand for credit, to supply of credit. And, since banks rapidly on-lend the excess reserves they accumulate, the "supply of loanable credit" is basically the flow of cash in off the street [$/year]; whilst the "demand for loanable credit" is the flow of loans from banks [$/year]. For example, if banks stopped loaning, then they would still gradually accumulate cash, from the street. So, "supply" would increase, tending to decrease interest-rates, until inflow of cash off the street [$/year] matched outflow of loans [$/year]. Interest-rates match inflow of cash (new deposits) to outflow of loans (new loans), with a "money multiplier" effect.

Historically, for the US, most recessions involve decreasing employment, decreasing wages, & decreasing depositing into banks. Thus, recessions reduce the supply of loanable funds, raising interest-rates (i% ~ D/S). But, during depressions, interest-rates fall, implying that even demand for credit has fallen. So, in a short-term recession, people keep borrowing, even whilst not actively earning -- evidently, they expect recessions to be short. But, in a long-term depression, people even stop borrowing -- evidently, they expect depressions to be long. Inexpertly, the different behaviors of interest-rates, in recessions vs. depressions, implies different psychological estimations of the duration of the downturn. In depressions, for some reason, people stop borrowing, as if not foreseeing any income, in the near future, with which to repay new debts. Perhaps some index, resembling "consumer confidence", remains higher in recessions, such that people keep borrowing through expectedly short downturns. Whereas, in depressions, some ratio of debt to (estimated) future income exceeds some threshold, such that everybody even stops borrowing. High debts (from speculative bubbles) and low estimates of future incomes generate depressions ?

From Richard Koo's concept of "Balance Sheet Recessions", where borrowing ceases, when net-worth is negative; then perhaps there are "Balance Sheet Expansions", when borrowing increases, when net-worth is positive? To get the units to work out, perhaps the demand for credit [$/year] is some fraction per year [1/year] of net-worth [$], defined as the net present value, of assets [$], and (discounted) future income streams [$], less liabilities & (discounted) interest payments [$] (D ~ f NW) ? If so, then net-worth (NW) would be correlated to the rate of borrowing new loans, and to interest rates.

 

[dilloduck]

It's weird how money manipulators work. If I save cash in the bank I get some measly 2% interest on it or something but if they lend the very same cash to someone else it's suddenly important enough to bring in 10-20 % interest rates.

 

[Widdekind]

The "price" (real interest rate) vs. "quantity" (real per capita borrowing) chart for the US credit market seems to show the effect of banking deregulation under Pres. Reagan. Before 1980, the "demand for credit curve" (in real per capita terms) was low; after 1980, the "demand for credit curve" was high. Deregulation seems to have shifted the credit demand curve outwards. At all times, recessions (OPEC oil embargo 1974-75, S&L bubble 1989-95, Housing bubble 2007) restrict credit, such that annual borrowing falls far below trend. Generally, a 2% fall in the real interest rate generates an additional one thousand real (2005) dollars of borrowing per person per year. During downturns, demand for credit retracts to a minimum, of about a thousand real (2005) dollars per capita, perhaps representing some "autonomous" borrowing, for "autonomous" expenditures ? During bubbles, demand for credit can balloon far above trend.

 

[waltky]

Those who disregard the past are doomed to repeat it...

Financial Crisis Offers Lessons for Future
September 11, 2012 - Four years ago, the collapse of Lehman Brothers, a huge financial firm, marked the start of the worst recession in decades. Frightened investors dumped stocks, banks stopped lending, the economy shrank, and millions of people lost jobs, homes, and savings. The crisis prompted financial firms and regulators to make changes intended to prevent another financial disaster. But some experts say it could happen again.

Since the crisis, committees investigated what went wrong, regulators demanded that banks take less risk, and Congress passed new laws. Many of the regulations that spell out the practical details of these laws are still being written, amid intense lobbying by financial firms and other interests.
Prosecutions for alleged fraud have frustrated one key investigator who says they have mostly targeted low-ranking people. Bart Dzivi, was Special Counsel to the Financial Crisis Inquiry Commission. "They have not really focused on trying to round up the senior officers at the major institutions who may have had criminal culpability," he said. Dzivi says the investigations have been under-funded and inadequately staffed.

Author John Taft says it will take more than prosecutions and new laws to clean up the financial industry. He is CEO of RBC Wealth Management and wrote a book titled Stewardship which examines the lessons from the crisis. Taft says Wall Street lost its way when firms stopped focusing on clients and pushed purely for profit. “That’s when we got in trouble. The culture of Wall Street was broken going into the financial crisis and it has not yet been fixed," he said. Author and college professor Craig Columbus says Wall Street is still plagued by over-confidence and arrogance. "That’s an element of hubris, that there is this notion that there are no limits, there are no boundaries to human imagination and capabilities, and I think that is clearly wrong," he said.

In his book God & Man On Wall Street, Columbus says the public still distrusts the financial industry even though stock prices have rebounded from severe losses. Investors dumped stocks out of fear that more huge financial firms might go bankrupt, including some that were so large that their failure could damage the economy. Boston University finance teacher Mark Williams wrote Uncontrolled Risk, and is still worried about the impact of faltering financial giants. "We are worse off then we were. From the standpoint that we have concentration risk. The big banks are just getting bigger," he said.

Larry McDonald is co-author of the best-selling book Colossal Failure of Common Sense. He says it is time to strengthen regulatory agencies and staff them with courageous people who can match wits with the sophisticated leaders of top financial firms. "You need a risk-taker to manage some of these decisions, because risk-takers know how to manage risk-takers," he said. McDonald says four years after the Lehman crash, the risks to the economy are "higher than ever."

Source

 

[expat_panama]

...funny how bankers can simply make up cash out of thin air...

One thing is to understand that this is how the world's been for hundreds, if not thousands of years. Another is to see how this is a good thing. What I'm finding on these threads is that too many people can't see and understand the process and cling to a blind hatred and a willful ignorance.

 

[EdwardBaiamonte]

It's weird how money manipulators work. If I save cash in the bank I get some measly 2% interest on it or something but if they lend the very same cash to someone else it's suddenly important enough to bring in 10-20 % interest rates.

as a liberal you lack the IQ to understand capitalism. Here's how it works: if you want to go heavily into debt to make lots of risky loans you are free, just like the banks, to do it.

If you want 100% safety and 2% interest you are free to do that too!


If you are a liberal or communist you want the government to regulate everything only because you lack the IQ to understand how capitalist experimentation and creative destruction works.

 

[EdwardBaiamonte]

...funny how bankers can simply make up cash out of thin air...

One thing is to understand that this is how the world's been for hundreds, if not thousands of years. Another is to see how this is a good thing. What I'm finding on these threads is that too many people can't see and understand the process and cling to a blind hatred and a willful ignorance.

Yes exactly, if the government has a role it might be in a law requiring that complete information be provided so that everyone knows their counterparties total leverage.

 

[JimBowie1958]

Those who disregard the past are doomed to repeat it...

Financial Crisis Offers Lessons for Future
September 11, 2012 - Four years ago, the collapse of Lehman Brothers, a huge financial firm, marked the start of the worst recession in decades. Frightened investors dumped stocks, banks stopped lending, the economy shrank, and millions of people lost jobs, homes, and savings. The crisis prompted financial firms and regulators to make changes intended to prevent another financial disaster. But some experts say it could happen again.

Since the crisis, committees investigated what went wrong, regulators demanded that banks take less risk, and Congress passed new laws. Many of the regulations that spell out the practical details of these laws are still being written, amid intense lobbying by financial firms and other interests.
Prosecutions for alleged fraud have frustrated one key investigator who says they have mostly targeted low-ranking people. Bart Dzivi, was Special Counsel to the Financial Crisis Inquiry Commission. "They have not really focused on trying to round up the senior officers at the major institutions who may have had criminal culpability," he said. Dzivi says the investigations have been under-funded and inadequately staffed.

Author John Taft says it will take more than prosecutions and new laws to clean up the financial industry. He is CEO of RBC Wealth Management and wrote a book titled Stewardship which examines the lessons from the crisis. Taft says Wall Street lost its way when firms stopped focusing on clients and pushed purely for profit. “That’s when we got in trouble. The culture of Wall Street was broken going into the financial crisis and it has not yet been fixed," he said. Author and college professor Craig Columbus says Wall Street is still plagued by over-confidence and arrogance. "That’s an element of hubris, that there is this notion that there are no limits, there are no boundaries to human imagination and capabilities, and I think that is clearly wrong," he said.

In his book God & Man On Wall Street, Columbus says the public still distrusts the financial industry even though stock prices have rebounded from severe losses. Investors dumped stocks out of fear that more huge financial firms might go bankrupt, including some that were so large that their failure could damage the economy. Boston University finance teacher Mark Williams wrote Uncontrolled Risk, and is still worried about the impact of faltering financial giants. "We are worse off then we were. From the standpoint that we have concentration risk. The big banks are just getting bigger," he said.

Larry McDonald is co-author of the best-selling book Colossal Failure of Common Sense. He says it is time to strengthen regulatory agencies and staff them with courageous people who can match wits with the sophisticated leaders of top financial firms. "You need a risk-taker to manage some of these decisions, because risk-takers know how to manage risk-takers," he said. McDonald says four years after the Lehman crash, the risks to the economy are "higher than ever."

Source

All the same, I prefer Icelands approach to the banking crisis rather than Greece and Spain andItaly's and Portugals and Irelands which bailed out failing banks and are in a collapsing situation now that I dont see how they will extricate themselves from.

 

[JimBowie1958]

...funny how bankers can simply make up cash out of thin air...

One thing is to understand that this is how the world's been for hundreds, if not thousands of years. Another is to see how this is a good thing. What I'm finding on these threads is that too many people can't see and understand the process and cling to a blind hatred and a willful ignorance.

Yes exactly, if the government has a role it might be in a law requiring that complete information be provided so that everyone knows their counterparties total leverage.

Or maybe do like the Constitution says and mint real money in precious metals and not script I.O.U.'s

 

[EdwardBaiamonte]

One thing is to understand that this is how the world's been for hundreds, if not thousands of years. Another is to see how this is a good thing. What I'm finding on these threads is that too many people can't see and understand the process and cling to a blind hatred and a willful ignorance.

Yes exactly, if the government has a role it might be in a law requiring that complete information be provided so that everyone knows their counterparties total leverage.

Or maybe do like the Constitution says and mint real money in precious metals and not script I.O.U.'s

not our subject. Even with a gold standard there is no law against borrowing using the gold as collateral

 

[expat_panama]

...funny how bankers can simply make up cash out of thin air and never get charged with counter-feiting?

One thing is to understand that this is how the world's been for hundreds, if not thousands of years. Another is to see how this is a good thing...

Yes exactly, if the government has a role it might be in a law requiring that complete information be provided so that everyone knows their counterparties total leverage.

Or maybe do like the Constitution says and mint real money in precious metals and not script I.O.U.'s

--all transactions made using shiny pieces of metal? You know, the founding fathers didn't look like this...

...they used paper money just like modern man, like we've been doing for a few thousand years now..

 

[Mad Scientist]

...funny how bankers can simply make up cash out of thin air and never get charged with counter-feiting?

Yes exactly, if the government has a role it might be in a law requiring that complete information be provided so that everyone knows their counterparties total leverage.

Or maybe do like the Constitution says and mint real money in precious metals and not script I.O.U.'s

--all transactions made using shiny pieces of metal? You know, the founding fathers didn't look like this...

...they used paper money just like modern man, like we've been doing for a few thousand years now..

You leave out one VERY IMPORTANT FACT ExPat.

Back then our money supply was controlled by the states THEN Congress after the adoption of the Constitution.

Who controls it now? Private Banks (Known to you and me as The Federal Reserve)

We didn't have hardly ANY Inflation and Dollar Devaluation until the Banks took over the job.

 

[expat_panama]

...funny how bankers can simply make up cash out of thin air...

OK, we're talking fractional reserves:

...this is how the world's been for hundreds, if not thousands of years. Another is to see how this is a good thing...

...the Constitution says and mint real money in precious metals and not script I.O.U.'s

Ah, we all agree that "money out of thin air" is a good thing and we're changing the subject to metal money

...the founding fathers... ...used paper money...

...money supply was controlled by the states THEN Congress after the adoption of the Constitution. Who controls it now? Private Banks (Known to you and me as The Federal Reserve)?...

Super! We all agree that paper money and "money out of thin air" are both terrific. Now we seem to be running over to what, the idea that the Federal Reserve is not a federal agency?



Let's post a topic schedule here. Next stop is we'll be jumping over to maybe like global warming?