The Shadow Banking System Is Slowly Imploding

Thorvald Grung Moe | December 9, 2011

Lessons from the bankruptcy of MF Global — the 8th largest in US history

Yesterday, CEO Jon Corzine of MF Global appeared before the House Agricultural Committee. The hearing was a reminder that despite well intended legislation, including the Dodd-Frank Act, the speculative behaviors that brought down AIG and Lehman are still considered fair business deals in the financial sector.

Recent reports on the financial crisis in Europe confirm that MF Global was not an isolated case. The extent of speculative positions among banks have reached mind-boggling proportions, with OTC derivatives now standing at over $700 trillion (!) and increasing rapidly.  Banks in Europe are currently scrambling for funds as their regular sources of funds are rapidly drying up. Several analysts point to the fragility of the shadow banking system as a key determinant of the ongoing liquidity crisis, where virtually unlimited leverage seems to be the norm rather than the exception.

According to a Reuter’s report yesterday, the bankruptcy of MF Global shows how the London OTC market has been used by AIG, Lehman, and now MF Global to accumulate layers and layers of leverage on only a tiny bit of capital. The process of re-hypothecation is behind all of this, with especially lax rules in London permitting, for example, the finance arm of AIG—AIG Financial Products—to run up a CDS position of $2.7 trillion just before the firm collapsed in 2008.

Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations, much to the chagrin of hedge funds. 

Over the years regulators gradually relaxed the quality requirements for such re-hypothecation, from initially only treasuries, to eventually money market funds, and now foreign sovereigns. This was the legal basis for the legitimate trades MF Global was engaged in, buying AAA European sovereign paper, despite their hedge fund clients probably shorting the whole sector. Eventually MF Global lost trust in the market and couldn’t meet the liquidity run when clients wanted their money back all at the same time (“classic bank run”). This then led to a scramble for cash, in the process also compromising client accounts. But, as several commentators have pointed out, the basis for their implosion was speculative trades on the basis of this process of re-hypothecation, leading up to a leverage ratio of close to forty.

As Minsky noted in this 1986 book (“Stabilizing an Unstable Economy”): “The introduction of additional layering in finance, together with the invention of new financial instruments designed to make credit available by tapping pools of liquidity, is evidence of the increased fragility of the system.”

This hyper-hypothecation has become huge, with some of the largest players being Goldman Sachs ($28.17 billion re-hypothecated in 2011), Canadian Imperial Bank of Commerce (re-pledged $72 billion in client assets), Royal Bank of Canada (re-pledged $53.8 billion of $126.7 billion available for re-pledging), Oppenheimer Holdings ($15.3 million), Credit Suisse (CHF 332 billion), Knight Capital Group ($1.17 billion),Interactive Brokers ($14.5 billion), Wells Fargo ($19.6 billion), JP Morgan($546.2 billion) and Morgan Stanley ($410 billion).

Re-hypothecation transactions are off-balance sheet and are therefore unrestricted by balance sheet controls. Whereas on-balance sheet transactions necessitate only appearing as an asset/liability on one bank’s balance sheet and not another, off-balance sheet transactions can, and frequently do, appear on multiple banks’ financial statements. What this creates is chains of counterparty risk, where multiple re-hypothecation borrowers use the same collateral over and over again. Essentially, it is a chain of debt obligations that is only as strong as its weakest link.

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 has created enormous amounts of liquidity, much of which has no real asset backing.

This system may now be about to implode as more and more counterparties are winding down their exposure, running for cash or gold, and preparing for the final countdown. But it may not be direct exposure to sovereign debt which is the biggest problem for banks right now. It may be the multiple exposures via this chain of re-hypothecation that was misused for huge one-sided bets on assets whose price could go either way, ref. LTCM.

As Corzine’s hearing showed yesterday, the failure of MF Global was a huge speculative bet that failed, with counterparties pulling their funds, putting the firm in a liquidity squeeze, and eventually bankruptcy. The sad effect of MF Global’s collapse was that client funds were compromised in the final days of the collapse, but before it was put in bankruptcy (this was different from the Lehman case, where client funds were made whole).  How this could have happened and who is responsible remain to be clarified.  But as one of the congressmen noted in the hearing yesterday, “…this is yet another example of the financial industry leveraging ordinary people’s monies.”


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