How Investor Assets are used for Rehypothecation

According to the CAP Times, “rehypothecation” is a controversial and decades old scheme that carries out out a simple tactic: use one source of capital to finance multiple loans, then use the loan funds to make investments. Hope that the investments will pay off before the loans are due. Many financial institutions have been using investor’s assets to secure multiple loans without their knowledge or consent, often by adding clauses to contracts saying that the firms have the right. This practice is not illegal.

This practice is also called “Repo” or counter-party risk. This means that investor portfolios of stocks, bonds, bank savings or certificates of deposit can be accessed by another party and used as one source of collateral for one or more loans.

This is the equivalent of using a house or car as collateral on multiple loans, putting the borrowed funds into short-term stock market or other investments, then cashing out in time to pay off the loans before the first payment is due. 

In a jaw dropping revelation, Compliance EX, reports that this practice has not been banned. Thus, rehypothecation will continue to be practiced until governments outlaw the practice. 

Three examples of failed rehypothecation schemes came with the MF Global meltdown, the Lehman Brothers crash, and the Long-Term Capital Management failure. All three firms had extensively used investor assets to finance multiple loans that were backed by single sources of commingled capital. When the investments failed, the schemes were revealed.

MF Global actually inserted the authorization into investor contracts, but is now trying to find $1.2 billion of investor money that was comingled with MF Global’s own capital. In the worst decisions ever, MF Global used the money to invest in Eurozone sovereign debts. It is clear how those investment decisions turned out. But MF Global commingled investor and MF Global funds to the point where the investor money cannot be accounted for.

According to the Huffington Post, financial adviser Kelly Jones described the problem this way:

“It makes no sense to use the same collateral for more than one investment unless it’s virtually certain that the single collateral is large enough to make whole all of the counter-parties for multiple smaller investments…”

The risks include potential catastrophic failure, but the perceived gains are enough to take unaware investors along for the unauthorized ride. It is easy to let the FDIC or other government assurance programs take care of the customers by giving them pennies on the dollars that they have lost.

But how is the small investor’s money used to support rehypothecation schemes? When authorizing language is buried in the fine print of a CD, banking, brokerage or savings account agreement, the money can be taken from many small accounts, bundled into substantial enough packages, and used to capitalize loans under the impression that the brokerage owns and can produce the collateral.

Investors and bank customers need to check the fine print on their bank terms of agreements and investment portfolios.Find and look into any language that would allow a broker, bank or other third party to engage in any type of rehypothecation scheme. Demand full translation and revelation of any terms that even look like they may authorize rehypothecation, “repo”, or counter-party risk. 

The bad news is that brokers and financial advisers can get away with using ever changing and incoherent insider’s terminology to prevent the average investor from understanding what is going on. The worst news is that there is no real protection against this practice, except for the consumer to read every word of the fine print, then get rid of investments where they do not want to allow such use of their assets.