It’s the season for gongs, those cheesy “best and worst of the year that was” wrap-ups. Worse even than gongs, a rash of the dreary “what the year ahead holds” stories is upon us.
Never fear, let us save you the effort. Here is what the pundits will say: challenges lie ahead, we are cautiously optimistic, we forecast equities to rise by 10 per cent in 2012. Bank it.
Top down, bottom up, name your methodology, they’ll get there. Year in, year out, any big-city economist, strategist, or anything “ist”, will tell you: “up 10 per cent, difficult environment, cautiously optimistic”.
You can bet on that, but unless you are too big to fail, you can’t bet on the market without risk.
Take Jon Corzine. Corzine has just found out he is not quite big enough to elude failure. His broking firm MF Global took a hairy-chested $US6.3 billion punt on European bonds – a bet more than five times the book value of the firm – and blew up. Worse, MF had gambled $US1.2 billion of its clients’ funds, funds that were supposed to be in segregated accounts, sacrosanct.
And so it was that markets were perturbed again this week, and not just by the usual boondoggling in Europe. Yes, there was the spectre of deflation anew, which hurt asset prices. Speculators even took the long-handle to gold. But there was also Jon Corzine and the latest bogey-word – “re-hypothecation” – which shook the confidence of the trading cognoscenti.
Hypothecation is when borrower pledges capital. Re-hypothecation happens when a broker or a bank redeploys assets pledged as collateral by customers for its own borrowing. The risk is that somebody else controls those assets in the event of default.
So markets were spooked. Why didn’t you tell me about this loophole in international brokerage borrowing rules? Are my funds safe? How about my counterparty’s counterparties? What if I have been re-re-hypothecated? If they can pledge the money in my account to somebody else in cross-border mega-punt … get me out!
Corzine, a former chairman of Goldman Sachs and Democrat Senator, was ducking and weaving last night as Republicans went for his jugular for staying at the Ritz Carlton in Washington despite the vanishing of his clients’ funds.
It was just another show trial on Capitol Hill. For all the corruption and the trillions of dollars lost in the past four years there is yet to be a “perp-walk”.
Same deal here. Babcock, Allco, MFS, ABC, Rubicon. Nary a bad word or a slap on the wrist.
At least they handcuff them from the front when they perp-walk them stateside. But there has been none of that. And MF Global looks unlikely to be the first. Corzine is, after all, a big Democrat donor. Besides, it only got its dealer’s licence from the Federal Reserve earlier this year, one of 22 licences to deal Treasury bonds. And apparently, gearing up client money on the sly and punting it is legal.
Under the Fed’s Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140 per cent of the client’s liability to the prime broker.
In Britain, there is no statutory limit on how much you can
re-hypothecate. All one needs is an office in London and a brass plaque.
According to Thompson Reuters, thanks to this “asymmetry of rules”, by 2007 re-hypothecation had “grown so large that it accounted for half of the activity of the shadow banking system”.
So when you hear that old chestnut from your broker – “there’s a lot of cash sitting on the sidelines” – just be mindful of the daisy-chain of financiers who might stake a claim to that “cash”.
The International Monetary Fund reckons collateral has been “re-hypothecated to a factor of four”.
Nor are Australia’s banks quarantined from this staggering leverage. Hyper-hypothecation highlights how little grip regulators have on the complexities of world finance. Be sure that when it comes to our banks, exposure to re-hypothecations will loom large among the host of toxic gremlins lurking off balance sheet. That’s the problem, it’s all off-balance sheet.
All we know for sure is that, whatever it is, we as taxpayers own it thanks to “too big to fail”.
Not to worry, the world will muddle through. The next couple of months may be interesting though. Christmas is traditionally the time for a rally. It happens most years.
This year though, it may be tricky, what with band-aid solutions to the gaping wounds of Europe, marauding hedge funds and possibly the European Central Bank in holiday mode.
Just a thought, but sovereign bonds are vulnerable to attack. Holiday markets are illiquid. No doubt Jon Corzine’s old firm, Goldman Sachs can do its bit.
It’s latest corporate strategy is to “seed” a bevy of hedge funds with capital. Financed and schooled in the Goldman way – probably heavily re-hypothecated – these evil little mini-me Goldmans are being unleashed on the world, ready to hypothecate all over the place.
For its part, Goldman had hypothecated $US18 billion in capital as of September 2011. It was modest by Wall Street standards, as JP Morgan sold or re-pledged $US410 billion of collateral received under margin loans, derivative transactions, securities borrowed and reverse repurchase agreements.