Re-use of collateral is major tool for leveraged finance

Rehypothecation helps explain rapid bank growth in the years leading up to the financial crsis of 2007-2008 and even faster bank deflation since, according to a July 2010 study by International Monetary Fund senior economist Manmohan Singh.

Specifics are hard to come by, as many financial institutions do not report their reuse of collateral and they often operate internationally, so much of the market is invisible, said Singh.

The lack of data on rehypothecation is one more example of how far regulators and the public are from understanding the full impact, and risk, of the shadow banking system and its main financing tool, the repurchase market.

Singh estimated that bank reuse of collateral increased the size of the shadow banking system at its peak in late 2007 by at least 50 percent, or $3 trillion to $4 trillion, something bank regulators might want to watch, he said.

Supervisors of large banks that report on a global consolidated basis may need to enhance their understanding of the off-balance sheet funding that these banks receive via rehypothecation from other jurisdictions.

No kidding.  Hopefully the Treasury’s new Office of Financial Research will take this on.

Rehypothecation means that the repo lender can reuse the securities it gets as collateral from a repo borrower. For example, if a hedge fund borrowed money from Lehman Brothers and put up securities as collateral, Lehman’s traders  could then turn around and use those securities as collateral for their own repo loan from Bear Stearns, which could then repo out the same securities to Merrill Lynch, and so on. 

Financial institutions can also re-use collateral they get in customer margin loans, securities borrowing, derivative and other transactions, according to Singh.

Post-crisis, some hedge funds and other financial institutions are not letting banks rehypothecate their collateral, but that makes their transaction more expensive, Singh said.

From Singh’s paper, “The (sizable) role of rehypothecation in the Shadow Banking System”:

Based on recent 10Q reports (quarterly financial reports to the Securities and Exchange Commission),  rehypothecation declined rapidly post-Lehman. Data show that the decline between end-2007 through end-2009 for “total collateral received that is permitted to be pledged/rehypothecated” by the largest seven U.S. broker-dealers—Lehman, Bear Stearns, Morgan Stanley, Goldman, Merrill and JP Morgan—declined from about $4.5 trillion to $2.1 trillion.

Further reading:

“Web of shadow banking must be unraveled,” by Financial Times managing editor Gillian Tett, August 12, 2010:

A couple of years ago, it occurred to me that the 21st century financial system had come to resemble a huge ball of candy floss (or cotton candy, as Americans might say). For bankers had become so adept at slicing and dicing debt instruments, and then re-using these in numerous deals, they had in effect spun a great web of leverage and trading activity – in much the same way that sugar is spun in a bowl to create candy floss.

(Shadow banking includes money market funds, securities broker-dealers, investment and commercial banks and their holding companies, finance companies and mortgage brokers, issuers of asset backed securities and asset backed commercial paper, derivative product companies, hedge funds, off-the-books businesses variously known as trusts, special purpose entities, special purpose vehicles, variable interest entities, conduits and structured investment vehicles, and any other kind of financial company that borrows short-term and lends long-term outside the federal financial safety net of FDIC insurance and Federal Reserve discount window loans. Much of the borrowing by these shadow bankers is done on the repurchase market.)