Hypothecation
Research for Online Investors

1/19/12

Hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral, but it is “hypothetically” controlled by the creditor in that he has the right to seize possession if the borrower defaults.

Why would anyone hypothecate a loan rather than borrow the money?  Because if you pawn an asset, you have to leave it with the pawn shop.  If you hypothecate an asset, you get to keep the asset.  Evidently Big Banks have learned a few things from pawn shops.  Big bank A will hypothecate their assets to Big bank B for a loan, and everyone continues doing business like nothing ever happened.

Except if something happens, Bank B gets to claim the cash assets without going through bankruptcy court.  You might think “No they can’t!”  But, they can and the FED and FDIC know it.

ZeroHedge had a story last October detailing how Bank of America moved $53 billion worth of derivatives from its Merrill Lynch unit to the retail bank unit. The holding company had been downgraded by Moody’s and Merrill's derivative customers wanted more collateral. By moving them out of the Merrill Lynch unit and into the retail bank the derivative customers had $1.04 trillion in deposits as a backstop.

Bloomberg reported the Federal Reserve signaled that it favored moving the derivatives while the FDIC objected because they would have to pay off depositors in case of a bank failure.  The bank’s stance was that regulatory approval was not needed.

Section 23A of the Federal Reserve Act limits moving derivatives contracts between business units of a bank holding company to prevent Holding Company business units other than the regulated bank from benefiting from the federally guaranteed FDIC insurance and to protect the bank from excessive risk originating at non-bank units.  Bank of America was given an exemption to Section 23A in September of 2010.

Re-hypothecation is fractional reserve banking, except on steroids.  Bank B loaned money to Bank A against Bank A’s assets.  Let’s suppose that Bank B wants to borrow some money, so it goes to Bank C and uses Bank A’s assets that are hypothecated in its loan to Bank A as collateral for a loan from Bank C.  And you see how Bank A’s assets could be guaranteeing a loan downstream to Bank C,D,E or F.

What happens if Bank A defaults to Bank B?  Does Bank B line up in bankruptcy court and detail how much it is owed, with all the other creditors?  NO.  Are Bank B’s claims secondary to bondholders?  NO  In 2005 the U.S. Congress passed and President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA).

An amendment was inserted in the BAPCPA that exempted derivative counterparties.  The U.S. Financial Inquiry Commission investigated the credit crisis of 2008.  Their report observes “derivative counterparties were given the advantage over other creditors of being able to immediately terminate their contracts and seize collateral at the time of bankruptcy.”

One unintended consequence of the derivative exemption in the BAPCPA is the attitude of creditors.  When someone owes you money under normal circumstances, you don’t want to force them into bankruptcy.  You would be thrown in with all other creditors and have to wait on the bankruptcy trustee to report to the bankruptcy court.  Then a judge would allocate the remaining capital according to seniority of the debt.

If you have a hypothecation on bankrupt assets (or other derivative like a re-po) why do you care?  In fact, you can get your hands on their assets immediately if they declare bankruptcy.

The minute Bank B loses confidence in Bank A; Bank B will apply pressure to push Bank A into bankruptcy so they can collect the assets before a bankruptcy trustee is even assigned.  Bankruptcy lawyers may argue that Bank A’s customer’s cash does not belong to Bank B, but possession is 9/10’s of the law.  Lawyers can string this out for months or years while the bank uses the assets to make a profit.

The European Union adapted similar exemptions for derivatives as BAPCPA’s.  As we watch the drama in Greece, remember every creditor does not have the same interest.  Some have sovereign debt from Greece.  These creditors want to help Greece become solvent and collect what they can.  Some have derivatives that guarantee the value of the Greek bonds.  These investors/traders will take nothing less than 100% of face value on Greek debt.  If Greece defaults they will be able to collect on their Credit Default Swaps (CDS).

Some parties have hypothecated loans to eurozone banks that will allow them to seize bank assets in front of other creditors if they cannot be repaid within terms.  If turbulence creates uncertainty, these traders can demand payment.  They have no risk if firms are pushed into bankruptcy.  This creates a fire-sale mentality as banks try to liquidate eurozone bonds and other assets to avoid bankruptcy.  One way or another, the hypothecated lender gets paid.

There is more than $600 million dollars missing from customer accounts in the MF Global Holdings bankruptcy.  Where did the money go?  Lawyers and accountants with the bankruptcy court and CME are examining transactions made during the last week of the company.

The firm’s credit rating had been downgraded by Moody’s on Monday and they reported a large loss on Tuesday.  JP Morgan had syndicated a $1.3 billion dollar loan to MF Global which was drawn down as they fought liquidity problems.

MF Global sold $1.3 billion dollars worth of commercial paper to Goldman Sachs on Tuesday or Wednesday.  This paper had been purchased with customer funds, which was legal.  Moody’s downgraded the company again on Thursday.

Transactions usually settle within one or two days, and MF Global wanted to settle the $1.3 billion sale to GS the same day so the cash would be available to customers that were contacting the company to close their accounts.

In addition to being MF Global’s lender, JP Morgan acted as MF Global’s clearing agent for securities sales.  Reuters reports that two people familiar with the transaction say that JPM was slow to process the trade.  A JPM spokesman said ‘the bank was not able to confirm the information about that trade.’

MF Global still had not received the $1.3 billion from the GS sale on Friday, so they initiated more sales totaling $4.5 billion.  Some of these assets were sold to JPM.

Even though JPM was the purchaser AND the clearing agent, they did not process that sale the same day.  A former MF Global employee said about JPM “They made things that are in normal time’s quite plain vanilla, easy things to do very difficult to do.  What normally works well was taking forever because JP Morgan was dotting every “I” and crossing every “t,”, and they were holding on to as much money as they possibly could under the law.”

MF Global filed bankruptcy on Monday morning Oct. 31, 2011.

If you think this must have been an anomaly, the Financial Crisis Inquiry Commission (FCIC) investigated the Lehman bankruptcy in September 2008.  Guess who demanded more collateral from Lehman ‘to protect its role as counterparty’ in the week prior to Lehman’s bankruptcy?  JP Morgan.  A JPM official told the FCIC he did not believe “the request put undue pressure on Lehman.”  With a straight face.

And now you know how JP Morgan possibly kept $600 million out of MF Global before the bankruptcy trustee took control of the assets.

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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