Rehypothecation should be banned – or at least capped

Hypothecation occurs when assets are used as collateral against a loan. The asset is the insurance the lender has if the debtor defaults on repayment, in such an event the asset can be seized by the lender to cover the cost of the lost investment.

The asset used as collateral by the initial borrower is seen as an asset of the lender and can be used as collateral for a second time by the lender. When this happens it is known as rehypothecation and allows banks to liquidate assets and make further investments.

Rehypothecation can be beneficial to the banking system because it speeds up the lending process and provides asset backing to loans. However there are some drawbacks. The main one being debtors, who undertake the initial loan and whose assets are used in rehypothecation, are not always aware the asset they have used as collateral has been rehypothecated.

Another problem arises from the value of the asset, which can fall as well as rise. If the value of the asset falls below the loan repayment requirement, it would not be sufficient to cover the invested sum causing bad debt. This is true for hypothecation too however the bad debt is now spread across two debt obligations.

The final problem and perhaps the worst, there is no limit on how much an asset can be rehypothecated in the UK. There is a limit in America of 140% of the asset value and in Canada, it is banned entirely. Perhaps it is time the UK followed suit and at the very least put a cap on the level of rehypothecation.

As the UK is currently in a downturn and asset values are currently falling, it might be prudent to introduce a limit of 60% – 80% of the current value of the asset if rehypothecated. This should reduce the risk of bad debt if the asset used as collateral loses value, assuming the debtor defaults.

Such a limit could be a suggestion for the new banking regulations put forward by the coalition government. By putting a cap on the level of rehypothecation allowed it could stop contagion of bad debt in the worsening financial crisis.

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  • JW

    Hi Peter
    I am trying to square your rationale for defending the City against a new tax and yet impose a rehypothecation cap.
    Most of the world’s hypothecation goes through London,ie AIG wouldn’t have gone down without its arm in the UK.
    Imposing a cap would most assuredly drive a lot of business out of the City, personally I think for the better. Why is this ‘good’ but a tax ‘bad’?

  • Peter Morgan

    Rehypothecation is something that is likely to spread a debt domino. If the assets are rehypothecated above 100% the potential loss when the default occurs exceeds the amount of the collateral. Meaning someone will lose out, the more rehypothecation the more the loss.

    In relation to the business rehypothecation makes for the UK the comment you made makes me think you have still missed the point of my other post. The fact of the matter is it is not the trade or the commissions the city makes that is its true benefit to the country, it is the stock of investment which is held. There are daily changes in demand for currency due to trade which will impact on the currency. However the main factor I am discussing in the long term ‘Shift’ of the stock investment which is held. If the large pension funds, insurance funds etc decide to transfer the investments they have away from the UK it will create a huge shift, not small daily fluctuations, that will have a terminal impact on the value of the currency.

    If you look at the changes in currency on a daily basis they at the most change by a percent. Money does not ‘Shift’ over night it takes a long time, at least weeks or months. The daily fluctuations and the demand and the commission you say would come from the administration of rehypothecation are nothing compared to the stock of investments. My fear is if the financial transaction tax was implemented the stock would transfer due to long term wealth deterioration. The cap on rehypothecation would merely reduce the commissions in the city. Also the risk the rehypothecation creates is worth the loss to the city. The introduction of the financial transaction tax to support the failing Euro is not worth the risk.

  • JW

     Perhaps I am being ‘thick’.
    Most of the world’s hypothecation goes through London, so the teams of non-UK banks involved with this are based in the UK, with all the second order indirect ‘trickle down’ wealth that may create plus the commission of course. Clearly a cap would stop this in its tracks. Also a tax on each transaction would have a similar effect.
    Turning to your other point, investments designated in sterling may ‘drift’ away if there is a transaction tax. These are the only relevant investments surely, as those designated in other currencies don’t add to sterling strength. Where exactly would sterling denominated investments ‘drift off’ to?
    Also your argument is based on a strong sterling is ‘good’ because of the cost of imports in particular raw materials, oil etc. Surely the BoE has been doing its best to deflate the strength of sterling against other currencies including the dollar to try to ‘rebalance’ the economy? As well as buying Bonds, isn’t this one of the reasons for QE?

  • Peter Morgan

    You keep saying hypothecation. It is rehypothecation. Hypothecation is the initial use of collateral. Rehypothecation is the use of that collateral again for the bank to borrow money against that asset for a second, third or fourth time etc.

    You say that the UK receives rehypothecation from abroad. This is not possible and is what I am saying in the article. Other countries have limits on rehypothecation and the rehypotheation can only occur in the country the asset has been hypothecated in. Therefore your argument that the UK rehypothecates for other countries is unfounded. Please link a source proving otherwise if there is one.

    You have got the idea of the investment currency mechanism wrong. You are saying that products based in sterling would be less desirable. The currency IS the product. When people make transactions they need a medium of exchange the value of the medium of exchange is as important as the asset it self. If the value of the medium of exchange changes the purchasing power changes. This means you have made or lost money simply by holding a currency. Holding the currency therefore becomes a product in itself and its ability to maintain its value is of great important to its ability to exchange itself for goods.

    This is really what people are looking for when they invest in the pound. The security of the currency in itself. Anything that makes the currency less stable or diminishes its ability to exchange makes it less attractive. By making the pound and the UK less attractive to investor for whatever reason will have a detrimental effect on the pound as a medium of exchange. As the financial service industry makes up a large percentage of the GDP. Anything that deters investment in the UK will damage the economy and the pound. The pound will become less stable less goods could be bought with it and you investors have made a loss.

    If the pound becomes less stable and its ability to purchase goods diminish people will look for better mediums of exchange. This will lead to a ‘Shift’ in investment away from the pound.

  • JW

     Apologies for missing off the important ‘re’ in my last response.
    AIG went under because of their London branch rehypothecating their assets. I don’t believe most of their assets were UK based or sterling based. This is the case with most US financial organisations.
    I agree with your statements that people are ‘buying’ sterling when investing in sterling based assets, its self evident.
    My point is that this is ‘hot money’. It can go anywhere. At the moment some of it is attracted to sterling because after the USD there is little choice. However it is significant that even with all its problems the Euro is holding up well against GBP and USD. The ability to ‘print your own money’ is important in lowering yields and buying your own debt, but not in maintaining value for investors who can move in and out of currencies at will.
    I stick with my view that pampering to this ‘hot money’ is not sensible. The part of the financial services affected by the trade you describe is a relatively small percentage of the sector and should not dominate the currency strategy that affects all the economy.

  • http://profile.yahoo.com/I3M3T4FROR2YOXY4EIGIBMECWE Richard Sharpe

    Peter – I see we agree on the risk from rehypothecation. Can you outline to readers which assets in a bank are subject to hypothecation and rehypothecation. Is it just accounts trading on margin with a debit balance? And if so what happens when a UK bank with rehypothecation value greater than margin value goes under. Are the other assets at risk? The reason I ask is to make it clear what would happen if say large Greek defaults hit a UK bank that had rehypothecated by large multiples.

  • Peter Morgan

    Thank you Richard for this response. I think this is what I am alluding to in the article. The risk of the financial crisis in particular the exposure to Greece and the Euro in general is enormous. All assets are under threat and rehypothecation just makes it compounded because there are many debts backed up against one asset. If the market is stable it doesn’t matter, if it defaults it becomes catastrophic.

    To answer your question. I don’t know how much exposure we have and how much the rehypothecation can affect the UK. However from what I remember at University the bank can call in its debts at any time. Potentially meaning any asset used as collateral could be seized if the default occurred. It is also not a direct link. Banks own other banks that have investments in Greece. Dexia is a prime example they have exposure to Greek debt. If they weren’t bailed out then investors in them would lose out, then whoever invested in them. It is a chain. It would be like dominos collapsing.

    I think it would be impossible to work out the exposure due to this. But it is high. It is worse if the other PIIGS default, which will inevitably happen, imo.

    Thank you for your comment.

  • http://pulse.yahoo.com/_Q2ISSOVYIGDG2ACG4C7ADSNQQQ Silver Surfer

    Peter this is a very important topic so let me be more specific than Richard above. The question we all need an answer to is which assets are used as collateral. I’ve asked my bank in writing here in the USA and they sent me a copy of the account agreement which states it’s assets on margin accounts with a debit balance. Is this the same in the UK? OR, ARE UK BANKS USING A WIDER CLASS OF ASSETS AS COLLATERAL?

  • Peter Morgan

    Hi Silver Surfer.

    There is no limit on rehypothecation in the UK or any kind of protection for the assets that are rehypthecated. According to a recent IMF report, which I have linked this could be a serious problem (page 4 first sentence). You are right this is an important topic more so than even I appreciated. The paper linked explains little research has been done on it and there is confusion on the subeject expecially on an international level.

    The problem is not so much created money but investments made have been backed up against the same collateral time and time again. If the default was to occur compounded losses would be suffered even in the US. Anyway as you have an interest you can look at the paper. I have to warn you though it is scary reading.
    Peter
    http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf

    Thank you.

    Peter.
     

  • http://pulse.yahoo.com/_Q2ISSOVYIGDG2ACG4C7ADSNQQQ Silver Surfer

    Peter Thanks. I’ve read page 4.

    Holy Cow!!!!!!!!

    This explains Tim Geithners comments last year.

  • JW

     I am surprised you are surprised. This was a fundamental part of the 2008 process with AIG’s downfall. And has been subject of many commentaries since.

  • Peter Morgan

    Hi JW

    What I am so surprised about is they still don’t know how much exposure there is and how the UK have not done anything like other nations to stop contagen.

    If you read the article I link about you will see that there has not been much research done on the area and the exposure of the UK to Europe and the subsequent exposure of the US from the UK makes the UK a doorway for debt contagen from the EU to the US.

    Please read the paper I have linked and if you get the change read FSA 10 9 consultancy paper too. In short my biggest surprise was the lack of protection the UK has if default occurrs.

    Thank you for you comment.
     

  • http://pulse.yahoo.com/_Q2ISSOVYIGDG2ACG4C7ADSNQQQ Silver Surfer

    JW – I don’t think the global markets are at all clear about the risk created by rehypothecation. As for AIG, I didn’t see one mention of rehypothecation risk in the Wall St Journal in 2008 or 2009, or elsewhere in the US press. The subject of rehypothecation came up because of speculation about the collapse of MF Global.

    Can you confirm what Peter and I read into section II of the IMF report, p4, which indicates there is no ring fencing of assets in UK investment banks, i.e. that a wide class of assets beyond assets held on debit in Margin Acccounts are at risk.

  • JW

     Silver Surfer
    Yes I confirm that, its also true of UK-based subsidiaries of US Banks and ‘shadow banking’ entities located in the UK. I have seen estimates of this of many tens of trillions of dollars.

  • JW

     Hi Peter
    Yes I have read that report. The link attached is also informative.
    http://www.zerohedge.com/news/shadow-rehypothecation-infinte-leverage-and-why-breaking-tyrrany-ignorance-only-solution

  • JW

     Hi Peter
    There are some interesting details in the attached SEC papers re JPM.
    http://www.sec.gov/divisions/corpfin/cf-noaction/14a-8/2010/sistersofcharity031910-14a8.pdf