Post-Lehman, reduced rehypothecation results in higher funding costs for financial institutions

TO BE NOTED: From All About Alpha:

"This Earth Day - Reduce, Reuse, Rehypothecate Apr 16th, 2009 | Filed under: Today's Post

It turns out that in the financial ecosystem, re-using collateral is good for the environment. This according to a new IMF working paper.

Unfortunately, the demise of Lehman put a crimp in things and discouraged such recycling. Says the working paper:

“…rehypothecation was acknowledged to be positive for the global financial system, prior to Lehman.” (our emphasis)

The report, titled “Deleveraging After Lehman - Evidence from Reduced Hypothecation” concludes that the practice of rehypothecation dropped off just as hedge funds began to think the unthinkable: what if their own prime broker went belly up?

This is a valid concern. As The Independent wrote last fall:

“Funds have found that assets such as equities whose recovery from the prime brokerage division should have been straightforward are in doubt because of “rehypothecation”. The small print of the contracts said that Lehman could use the securities itself, including lending them out to short sellers. This meant the assets were reclassified as unsecured, putting them further down the queue for repayment and raising the prospect of big losses. Hedge funds may have up to $70bn in Lehman prime brokerage accounts, with the value of rehypothecated non-cash assets estimated at $22bn.”

The new IMF working paper (by Manmohan Singh of the IMF and James Aitken of UBS) finds that the collateral held by prime brokers that is eligible for rehypothecation fell not just because Lehman bought the farm, but also because clients of other major prime brokers pulled in the reigns - reducing the assets made available for rehypothecation. As the table from the paper shows, the total rehypothecatable assets held by the largest 4 prime brokers fell from about $3.1 trillion in May 2008 to $1.1 trillion only 6 months later…

As Singh and Aitken argue, rehypothecation has been hit by a bit of a double-whammy. Not only have investors opted for segregated accounts (that would prevent their assets from being rehypothecated), but less securities lending has reduced the supply of rehypothecatable assets:

“…reduced rehypothecation is being accompanied by reduced securities lending. The decline in the amount of collateral thus flowing from the securities lending operations of the major custodians from end-2007 to end-September 2008 is about $737 billion, which could have been pledged and possibly repledged.”

Indeed, the table below from the report shows a precipitous drop in securities lending (due to the unwillingness of major investors to lend out their stocks, but no doubt also in large part due to short bans).

So Lehman seems to have put a chill into the rehypothecation game, and the concurrent reduction in securities lending compounded the problem. The authors of this paper say that if institutional investors and hedge funds don’t loosen up on their requirement for segregated (nonrehypothecatable*) accounts, the financial environment will suffer…

“If collateral could not be rehypothecated, though, the entire financial system would be put at risk as this was the basis of so much activity in the system. Post-Lehman, reduced rehypothecation results in higher funding costs for financial institutions that have until recently been able to use their client money/collateral.”

"Deleveraging after Lehman—Evidence
from Reduced Rehypothecation
Manmohan Singh and James Aitken
WP/09/42

© 2009 International Monetary Fund WP/09/42
IMF Working Paper
Monetary and Capital Markets Department
Devleveraging after Lehman—Evidence from Reduced Rehypothecation
Prepared by Manmohan Singh and James Aitken1
Authorized for distribution by Udaibir S. Das
March 2009
Abstract
This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those
of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published
to elicit comments and to further debate.
Rehypothecation is the practice that allows collateral posted by, say, a hedge fund to their prime
broker to be used again as collateral by that prime broker for its own funding. In the United
Kingdom, such use of a customer’s assets by a prime broker can be for an unlimited amount of the
customer’s assets. And moreover, there are no customer protection rules (such as in the United
States under the Securities Act of 1933). The paper shows evidence that, following Lehman’s
bankruptcy, the extent of rehypothecation has declined substantially, in part because investment
firms fear losing collateral if their prime broker becomes insolvent.. While less rehypothecation
reduces counterparty risk in the system, it also reduces market liquidity.
JEL Classification Numbers: G21; G28; F33; K22; G18; G15
Keywords: Rehypothecation; Lehman’s bankruptcy; Counterparty risk; Liquidity risk
Author’s E-Mail Address: msingh@imf.org; james.aitken@ubs.com
1 Manmohan Singh is a Senior Economist with the International Monetary Fund and James Aitken is an
Executive Director with UBS. The authors wish to thank Darrell Duffie, Kimberly Summe, Paul Mills,
Herve Ferhani, Mahmood Pradhan, and Peter Stella for their comments. The views expressed are our own
and not of the IMF or UBS. We are responsible for any errors or misinterpretations.
2
Contents Page
I. Introduction ..........................................................................................................................3
II. Rehypothecation in the United States and the United Kingdom..........................................3
III. Rehypothecation After Lehman’s Bankruptcy ....................................................................5
IV. Conclusion ...........................................................................................................................7
References...............................................................................................................................11
Tables
1. Collateral Received that can be Pledged is Decreasing .........................................................6
2. Securities Lending by Major Custodians...............................................................................6
Appendix
1. Securities Exchange Act’s Rule 15c3–3 ................................................................................9
3
I. INTRODUCTION
Rehypothecation means that the collateral posted by a prime brokerage client (e.g., hedge
fund) to their prime broker can be used as collateral also by the prime broker for its own
purposes.2 Every Customer Account Agreement or Prime Brokerage Agreement with a prime
brokerage client will include a blanket consent to this practice unless stated otherwise.
Market sources suggest that rehypothecation of assets has historically been a cheaper way of
financing the prime business than turning to the repo market.3 In Section II we describe the
differences between rehypothecation rules in the United States and in the United Kingdom.
In the United Kingdom and Europe, such use of a customer’s or hedge fund’s assets by a
prime broker can be for an unlimited amount of the customer’s pledged assets. However,
there are no customer protection rules such as those offered under the Securities Act of 1933
in the United States. In Section III, we show evidence that, following Lehman’s bankruptcy,
rehypothecation is becoming much more limited. While this may reduce counterparty risk, it
can in turn aggravate global liquidity risk. In the concluding section, we highlight the need to
discuss reduced rehypothecation as it is likely to continue.
II. REHYPOTHECATION IN THE UNITED STATES AND THE UNITED KINGDOM
A defined set of customer protection rules for rehypothecated assets exists in the United
States, but not in the United Kingdom. This difference meant that when Lehman Brothers
International (Europe) filed for insolvency, there was no statutory protection available to
those customers as the United Kingdom insolvency regime is not specific to entity type. In
the United States, however, the Securities Investor Protection Act (SIPA) of 1970 provides
for certain procedures that will apply in the event of the insolvency of a broker-dealer.
Hence, the customers of Lehman Brothers Inc. (U.S.) could potentially be treated more
advantageously than the U.K. customers of Lehman Brothers International (Europe) in terms
of the timing and identification of the return of rehypothecated assets. The customer
protection rule is designed to work in conjunction with the Federal bankruptcy scheme for
broker-dealers created by SIPA.
2 According to IMF WP 08/258, rehypothecation was acknowledged to be positive for the global
financial system, prior to Lehman.
3 Empirical work to test this hypothesis has been absent or very limited, but may be very relevant if
rehypothecation loses ground in the near future. Repos have a cost that can be higher if there is failed
delivery; rehypothecation is a legal assignment and thus is/was costless (until Lehman’s bankruptcy
especially in United Kingdom).
4
In the United Kingdom, rehypothecation can be for an unlimited amount of the customer’s
assets and there are no customer protection rules such as Rule 15c3–3 in the United States.4
(see Appendix 1). Rule 15c3–3 prevents a broker-dealer from using its customers securities
to finance its proprietary activities. Under Rule 15c3–3, the broker-dealer may
use/rehypothecate an amount up to 140 percent of the customer’s debit balance (i.e.
borrowing from the broker-dealer).5
Created by SIPA, the Securities Investor Protection Corporation (SIPC) is an important part
of the overall system of investor protection in the United States. SIPC’s focus is very
specific: restoring funds to investors with assets in the hands of bankrupt and otherwise
financially troubled brokerage firms (e.g., Lehman). Since 1970, SIPC has accumulated
almost $2 billion from its members’ assessments that can be used by investors to recover
assets during insolvency.
A key reason why hedge funds may have previously opted for funding in Europe is that
leverage is not capped as in the United States via the 140 percent rule under Rule 15c3–3.
Leverage levels at many U.K. hedge funds, banks and financial affiliates have been higher, as
both United Kingdom (and continental Europe) do not have a parallel to SIPA.6 Thus, prime
brokers and banks would rehypothecate their client’s assets along with their own proprietary
assets as collateral for funding from the global financial system. However, since the U.K.’s
bankruptcy law does not make a distinction between banks and broker-dealers and does not
provide the associated protection from broker-dealers (like SIPA in the United States), hedge
fund assets remain frozen in the United Kingdom, whereas thanks to SIPA, this is not the
case in the United States. Disentangling hedge fund assets from the broker-dealer/banks’
proprietary assets that have been rehypothecated together, will remain an onerous task in the
United Kingdom.
Rehypothecation is allowed only on margin securities in the United States. Fully-paid
securities, which are the securities for which a customer has actually made full payment, are
generally held in the cash account and are not permitted to be rehypothecated. Excess margin
securities, which are that portion of a customer’s margin securities having a market value that
4 A customer includes any person from whom or on whose behalf a broker-dealer holds securities or
cash unless specifically excluded. A customer excludes counterparties to repo and stock lending
agreements.
5 Assume a customer has $500 in pledged securities and a debit balance of $200, resulting in net
equity of $300. The broker-dealer can rehypothecate up to $280 of the customer’s assets (140 percent
x $200).
6 Market sources indicate that there is asymmetry within continental Europe on rehypothecation rules;
however, there is no equivalent to U.S. Sec 15c3–3.
5
exceeds 140 percent of the customer’s debit balance to the broker-dealer, are also not
permitted to be rehypothecated. Margin securities, which are customer securities held in a
margin account and for which the customer has not made full payment, are not subject to the
possession and control requirement, so a broker-dealer can use these securities in its own
business—including rehypothecation—subject to certain limitations.
III. REHYPOTHECATION AFTER LEHMAN’S BANKRUPTCY
Based on recent 10Q reports, rehypothecation is declining rapidly. After Lehman’s
bankruptcy, prime brokers have been demanding more cash collateral in place of securities
(unless they are highly liquid securities). Liquidator PriceWaterhouseCoopers (PWC)
confirmed in October 2008 that certain assets provided to Lehman Brothers International
Europe (LBIE) were rehypothecated and no longer held for the client on a segregated basis
and as a result the client may no longer have a proprietary interest in the assets.7 As such,
investors of LBIE fell within the general body of unsecured creditors. Hedge funds often use
their securities for their own repo trades and financing of their own positions, and are
increasingly seeking to ensure that assets that have not been pledged as collateral are kept in
segregated client accounts, so that prime brokers have absolutely no claim over the assets in
them. Segregated accounts, broadly speaking, includes sweeping non-collateral assets into
custody accounts, restricting rehypothecation rights, using multiple prime-brokers, and
applying for client money protection as under U.K. FSA’s Client Money Rules.8
Some investors have now taken precautionary measures against the practice by taking term
loans from large banks and sweeping assets which are not being used as collateral by the
prime brokers. The (former) investment banks are now showing a trend away from
rehypothecation (Table 1). We measure this from their 10Q and 10K filings by subtracting
the collateral that was pledged from the collateral received. The latest data show that since
end-2007 the decline in rehypothecation (i.e., total collateral received that can be pledged)
by the largest four broker-dealers was $1.774 trillion.
7 There was a case in London in the High Court on September 22, 2008 where the High Court refused
to grant the petitioning hedge fund the return of its assets—despite the fact that their agreement
indicated that Lehman could not use its assets for rehypothecation. In the United Kingdom, it is title
transfer (unlike the United States, where the client retains ownership but the broker would have a
security interest).
8 Some of the astute fund managers in the United Kingdom are already doing so. Brevan Howard’s
Annual Investment Manager Review states: “We limit the rights of prime brokers to rehypothecate
our securities. We move our cash balances away from our prime brokers to segregated custody
accounts at third parties.”
6
Table 1. Collateral Received that can be Pledged is Decreasing
Nov 2005 Nov 2006 Nov 2007 May 2008 Aug 2008 Nov 2008
Lehman 528 621 798 518
Morgan Stanley 798 942 948 953 877 294
Goldman Sachs 629 746 891 869 832 579
Merrill Lynch 538 634 855 865 676 327
JPMorgan /9
Source: 10Q and 10K reports; For Merrill Lynch the column dates are December, June and September instead of
November, May, and August.
Furthermore, reduced rehypothecation is being accompanied by reduced securities lending.
The decline (in absolute dollar terms) in the amount of collateral thus flowing from the
securities lending operations of the major custodians from end-2007 to end-September 2008
is about $737 billion, which could have been pledged and possibly repledged (Aitken, 2009).
The decline in collateral if measured from March 2008 (the peak) is about $814 billion (See
Table 2).10
Table 2. Securities Lending by Major Custodians
(billions of dollars)
Dec 31, 2007 March 31, 2008 June 30, 2008 Dec 31, 2008
Bank of NY $619 $637 $567 $341
State Street $558 $591 $550 $325
JPMorgan $385 $411 $362 $169
Total $1,562 $1,639 $1,479 $825
Source: 10Q and 10K reports
9 JPMorgan’s recent 10Q and 10K reports show an increase in ‘collateral received that can be
pledged’ due to the combined reporting of Bear Stearns and the perception of ‘being close to Fed’
bank. It is difficult to disentangle these and other issues that contributed to a growth in this area for
JPMorgan.
10 Rehypothecation, legally is distinct from repos which includes collateral received from dealer repo
counterparties, among other uses; however, their economic impact is the same for global liquidity
purposes.
7
The above are the three major custodians and not the entire financial system; the reduction,
due to the aversion to rehypothecation and reduced securities lending globally, is likely to be
much higher as the number of investors who are banning the lending of securities by their
custodians continues to grow.
Overall, good collateral is increasingly getting scarce in the present credit crisis (Duffie and
Zhu, 2009). Since December 2007, the recent 10Qs of the large four (former) investment
banks show a reduction of almost $1.8 trillion in ‘collateral received that can be pledged’ i.e.,
a sharp decline in rehypothecated collateral. Also, between the major three global custodian
banks there has been a decline of about $750 billion since December 2007 in collateral
flowing in the global financial system. This decline stems from their own counterparty risk,
mandate constraints from their clients, and the deleveraging that is taking place. This reduced
liquidity of over $2.5 trillion in the United States banking system alone, adds to the cost of
funding in the financial system.
Before Lehman, high grade collateral was encouraged to be pledged, repledged and
rehypothecated. If collateral could not be rehypothecated, though, the entire financial system
would be put at risk as this was the basis of so much activity in the system (Segoviano and
Singh, 2008). Post-Lehman, reduced rehypothecation results in higher funding costs for
financial institutions that have until recently been able to use their client money/collateral.
Thus, one may argue that reduced rehypothecation is a positive development especially if
jurisdictions like the United Kingdom do not have swift bankruptcy resolution (or a SIPC
type institution like in the United States). It is likely that, in the near future, hedge funds will
have to pay increased fees for services of the prime broker if their collateral is now allowed
to be rehypothecated.
While the use of collateral mitigates counterparty risk, it can aggravate funding liquidity risk
because counterparties have to provide additional collateral at short notice if conditions
change.11 During the recent turmoil, shortages of high-quality collateral emerged prompting
special operations by central banks.
IV. CONCLUSION
Having access to high quality collateral did not always guarantee that troubled institutions
could maintain access to wholesale funding, as evidenced in the case of Bear Stearns.
However, presently major financial institutions worldwide have either increased or created
11 The more widely collateralization is used, the more significant this risk becomes, especially as
market prices movements in hedged portfolios result in changes in the size of counterparty credit
exposures.
8
sizable liquidity buffers of high-grade collateral, and cash. This is a rational response in the
aftermath of Bear Stearns, Lehman and AIG.
Following the collapse of Lehman, hedge funds have become more cognizant of the way the
client money and asset regime operates in the United Kingdom. For some, the United
Kingdom provides a platform for higher leveraging (and deleveraging) not available in the
United States.12 For others—especially those affected adversely by the Lehman bankruptcy
—if jurisdictions like the United Kingdom do not provide for swift bankruptcy resolution (or
a SIPC type institution like in the United States) they will limit rehypothecation. The trend so
far from Table 1 is an overall aversion to rehypothecation.
Does reduced rehypothecation encourage secured lending (e.g., repo market)? Adrian and
Shin (2009) show a declining trend in primary dealer repo activity (adjusted for M2) that is
contributing towards the credit crunch.13 In the present financial crisis, overnight inter-bank
banks (e.g., fed funds) rates have dropped with liquidity injections, so repo rates and rebate
rates approach zero, which means that failure to return collateral has a small penalty (at least
until the new delivery failure penalties are approved and kick in). Thus, there was an
increasing number of delivery failures in the repo market last fall, and such failures are still
continuing, albeit to a somewhat lesser extent. This further disrupts the supply of collateral,
because collateral can then be hoarded at trivial penalties. The resulting deleveraging is
leading to dislocations in the cash bond market (e.g., negative basis).
From a policy perspective, the recent trend depicted in the two tables above is likely to
continue. In the aftermath of Lehman, banking clients such as hedge funds in the United
Kingdom are demanding “segregated accounts” (Sidley Austin, 2008).14 Looking forward,
this may result either in the prime business changing in favor of tri-party repo-financing
and/or assigned custody, or in a move to a U.S. brokerage. In general, if the financial crisis
deepens, there will be an increasing tendency for those providing collateral to counterparties
to ask for it to be segregated from the counterparty’s assets and to place limits on its further
use.
12 Reduced rehypothecation leads to deleveraging (via the proprietary trading desks of the brokerdealer)
that results in further aversion to rehypothecation.
13 Bridgewater, Daily Observations, February 13, highlighting that many foreign central banks are not
keen on lending U.S. Treasuries in the repo market.
14http://www.sidley.com
9
APPENDIX I. SECURITIES EXCHANGE ACT’S RULE 15C3–3
In essence, Rule 15c3–3 of the Securities Exchange Act of 1934 prevents a broker-dealer
from using its customers’ securities to finance its proprietary activities. The rule has three
principal requirements:
• A broker-dealer must maintain possession or control of certain customer securities
(all fully paid securities and excess margin customer securities i.e., securities in a
customer’s margin account that exceed 140 percent of the margin debit in their
account.)
• As to customer cash, a broker-dealer must deposit the cash or “qualified securities” of
like value in a special account known as the “reserve account”. In other words, the
broker-dealer is required to segregate all customer cash or money obtained from the
use of customer property that has not been used to finance transactions of other
customers.
• As to customer securities that are not required to be in the broker’s control (e.g., those
securities posted as required collateral that can be pledged as collateral to third
parties), the broker-dealer is subject to limits on the amount it can borrow against
such securities.
The customer protection rule is designed to work in conjunction with the Federal bankruptcy
scheme for broker-dealers created by SIPA.
A. Customer
“Customer” includes any person from whom or on whose behalf a broker-dealer holds
securities or cash unless specifically excluded.
Customer excludes:
• Subordinated lenders to the broker-dealer;
• Other brokers or dealers and municipal securities dealers or government securities
broker-dealers; and
• Counterparties to repo and stock lending agreements.
A U.S. bank is generally a customer, even if it is affiliated with the broker-dealer. A nonbroker-
dealer affiliate of the broker-dealer, even a subsidiary, can be a customer.
10
B. Control Requirement
The broker-dealer must obtain and maintain physical possession or control of all customer
fully-paid and excess margin securities. A good control location is a U.S. bank. Outside the
United States, securities can be held at a non-U.S. bank, broker or dealer, depository or
clearing agency designated by the SEC. In addition, the SEC has permitted service firms
affiliated with a foreign investment company that performs various services for the fund to
serve as foreign control locations. Control means that the securities are located in an account
in the name of the broker-dealer at a clearing corporation, depository or bank, free of any
lien.
C. Types of Securities
The customer protection rule divides securities held or purchased by a broker-dealer into four
categories:
• “Fully-paid securities”, which are generally held in the cash account into which a
customer has actually made full payment;
• “Excess margin securities”, which are that portion of a customer’s margin securities
having a market value that exceeds 140 percent of the customer’s debit balance to the
broker-dealer;
• “Margin securities”, which are customer securities held in a margin, or any other
Regulation T account for which a customer has not made full payment. Margin
securities are not subject to the possession and control requirement, so a broker-dealer
can use these securities in its own business, subject to certain limitations; and
• Non-customer securities (proprietary positions, for example).
Fully paid securities and “excess margin securities” cannot be rehypothecated (they have to
be “controlled”). A broker-dealer has the right to rehypothecate customer (margin) securities
when the customer pledges those securities to the broker-dealer to support a margin debit.
Under Rule 15c3–3, the broker-dealer may use an amount up to 140 percent of the
customer’s debit balance.
11
REFERENCES
Adrian, Tobias and Shin, Hyun Song, Money, Liquidity, and Monetary Policy, Federal
Reserve Bank of New York, January, 2009
Aitken, James, 2009, The Plumbing, UBS presentation, January 28, 2009.
Duffie, Darrell and Zhu, Haoxiang, “Does a Central Clearing Counterparty Reduce
Counterparty Risk,” forthcoming.
Segoviano, Miguel and Manmohan Singh, 2008, Counterparty Risk in OTC Derivatives, IMF
Working Paper 08/258.
Sidley Austin LLP, Hedge Funds and the U.K. Prime Brokers in the Post-Lehman
Environmnet (December 2, 2008)"