Re-hypothecation is now a dirty word

Recent articles and blog posts have pointed out the evils of re-hypothecation, and by extension all of repo. Many look at the missing cash at MF Global and place the blame on internal repo financing that MF Global may have done with their Futures Commission Merchant (FCM) side, using the Euro sovereign portfolio as collateral. By and large the reporters are getting only part the story right, forgetting that repo involves an exchange of value. Some of the writing is full of bluster and just plain bizarre. Here is one example of a blog post from zerohedge that is painful to read. Others are somewhat less hysterical and more analytical.  A report from Reuters is better done, but still misses some important points.

First, while repos to maturity can be done off balance sheet, the vast vast majority of ”box standard” repos are shorter than the maturity of the underlying collateral (often overnight trades…) and show up on the balance sheet as a secured loan would. While the principal positions in Euro sovereigns may have sunk MF Global, it was likely to have been a small part of their repo business.

If MF Global’s FCM could invest their customer cash via repos with their broker/dealer arm using their ill-fated Euro sovereign debt portfolio, the question is: did they? (The CFTC has already changed the rules on how segregated client cash can be invested. A link to the new rules is here.) MF Global’s FCM would have had to liquidate the Euro sovereign paper they held when their broker-dealer defaulted, absorbing a loss between what the repo trade was initially executed at (plus or minus any margin calls) and the price the paper was eventually sold at. There easily could have been some shortfall after such a liquidation. But $1.2 bio on a $6.3 bio portfolio, even if it was impaired Euro sovereign paper, seems like a lot.

We wonder if the timeline makes sense? There would have been a very narrow window to liquidate the repo collateral – after a repo default/collateral liquidation but before MF Global confirmed the cash shortfall. Most reports say the shortfall was a result of cash transfered from the segregated client accounts to the MF Global broker/dealer. MFG’s accountants hopefully should have known where the money went if there was a collateral liquidation. All of this is inconsistent with the problem being with repos executed between the FCM and the broker/dealer. The repos may be complicit (we’ve written before about the possibility of the missing cash going to pay margin calls) but something doesn’t ring true here.

A couple of the stories look at the turnover in the repo market, quoting IMF research, and come to the conclusion that this “churn” means cash lenders are only covered for a fraction of the cash lent. They conclude there are trillions in super-secret exposure out there. If “A” lends $100 of collateral to “B” in exchange for cash (usually less than the bonds were worth), who in turn lends the paper to “C” who lends to ”D” and so forth, it doesn’t mean that each of those trades isn’t fully collateralized. It does mean there is a daisy chain of transactions that would need to be unwound in a default, but each participant is individually covered. Yes, those default unwinds do get messy and value evaporates in the process. But turnover in repo markets didn’t create the exposure. This is Repo 101 stuff.

The zerohedge blog post is here.

The Reuters report is here.

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