Palm Beach, FL 1/10/12 (StreetBeat) --Simply put, rehypothecation is the application and re-application of grease in the financial system.Less simply, but more accurately, rehypothecation “means the use of financial collateral by a collateral taker as security for his own obligations to some third party (i.e. onward pledging).” At least that is how Manmohan Singh described it in his IMF paper Velocity of Pledged Collateral: Analysis and Implications; that was released in November 2011. So, in practical terms, if a financial entity such as a Hedge Fund posts collateral to its prime broker then it could be that this collateral is further used by the prime broker as collateral for its own purposes. And then it’s possible that that this new third party could use that same bit of collateral for its own purposes, and so on. That’s because when posted collateral can be rehypothecated by the collateral taker there is a title transfer involved with this transaction. (It showed be noted that in general an entity that allows posted collateral to be rehypothecated will pay less for the services rendered.) “Under a title transfer arrangement the collateral provider transfers ownership of collateral to the collateral taker. The latter acquires full title to the collateral received and, as the new owner of this property, is completely free to deal with it as he sees fit,” explains Singh in his paper. Therefore, at the time that the original collateral provider, remember our Hedge Fund, has discharged his financial obligation to the original collateral taker, remember our prime broker, then the collateral taker is required to return an equivalent piece of collateral to the original collateral provider, the Hedge Fund. As Singh further explains, “Note that the obligation is to return equivalent collateral (i.e. securities of the same type in fair market value terms, but not the original security). After rehypothecation has occurred it would be impossible for a collateral taker to return exactly the same property initially received as collateral.”
This last bit is important to the current chapter of the rehypothecation story, which I will get to below. There is a distinction between collateral that can be rehypothecated and collateral that cannot. There is something called “pledged collateral” and in these cases the “pledgee” or collateral taker, does not have explicit rights of re-use or rehypothecation of the collateral unless it is expressly written into the pledge agreement, unless of course there is a default of the original obligation. Under a pledge agreement the identical piece of collateral must be returned to the entity that posted the collateral in the first place; it should be held, untouched, in a segregated account.
As Singh says in regards to rehypothecation in the abstract of his paper that is cited above, it “helps lubricate the global financial system.” While it may not be clear what amount of grease is correct for the job, it is clear that too much can make for a slippery slope and too little can cause friction and stall out an engine.
I think it is fair to say that in the years preceding the Great Recession that there was an excess of grease in the financial system. The creation of collateralized securities, with acronyms that made full use of the alphabet, was rampant and risk was unfortunately mispriced. During this time collateral was rehypothecated again and again; creating increasingly longer chains of re-used collateral that, as it turns out, were full of weak links. But as the process of expansion was underway it was a key factor in the creation and growth of the Shadow Banking System; primarily the assets that were held off-balance sheet. This is the argument presented by Singh and James Aitken in their IMF paper called The (sizable) Role of Rehypothecation in the Shadow Banking System. As the authors explain the act of rehypothecation can be thought of as a churning, or a measure of the velocity, of collateral. And in regards to increasing the rate of churn an off-balance sheet vehicle was vital to the process for shadow banking. “On-balance sheet data do not ‘churn,’ where churning means the re-use of an asset. If an item is listed as an asset or liability at one bank, then it cannot be listed as an asset or liability of another bank by definition; this is not true for pledged collateral. Since on-balance sheet items are the snapshot of a firm’s assets and liabilities on a given day, these cannot be the assets or liabilities of another firm on that day. However, off-balance sheet item(s) like ‘pledged-collateral that is permitted to be re-used’, are shown in footnotes simultaneously by several entities, i.e., the pledged collateral is not owned by these firms, but due to rehypothecation rights, these firms are legally allowed to use the collateral in their own name.” So, after reviewing US and European bank data they figure that “the total available pledged collateral was over $10 trillion at end-2007”; inflating the realm of Shadow Banking by a churn factor of between 3 and 4 of the original value of the collateral before the rehypothecation chain began to accumulate links; accounting for a large portion of the global Shadow Banking System.
Then came the demise of Lehman Brothers and all of the trouble that followed. One of the important, but underappreciated, aspects of the post-Lehman financial system is the sharp decline in the availability of suitable collateral and a corresponding fall in of velocity of rehypothecation of all collateral.
Much of the existing collateral lost value and became subject to larger haircuts, meaning that it took more collateral to finance the same positions. Counterparty risk became a much bigger part of the investment equation, leading to less interaction amongst financial system players and or a demand for more security from both sides of the trades when they were executed. Good collateral, such as Treasuries or German debt, became more valuable by comparison and have become more closely held than was the case pre-Lehman. Additionally there has been a record issuance of covered bonds, which are secured by “dedicated” collateral that cannot be re-used and which therefore takes even more suitable collateral off the market.
As a result of these factors Singh estimates that the rehypothecation chains have fallen to a churn rate of 2.4 times by the end of 2010, meaning that there has been a reduction in collateral totaling $4 to $5 trillion; a fall from the end of 2007 peak of $10 trillion down to about $5.8 trillion.
“This decline in leverage and re-use of collateral may be viewed positively from a financial stability perspective,” wrote Singh in his paper on velocity of pledged collateral. “From a monetary policy perspective, however, the lubrication in the global financial markets is now lower as the velocity of money-type instruments has declined.” The way Singh sees it the “velocity of collateral” is analogous to the concept of the “velocity of money”. When there is too much velocity or grease, as was the case in the years leading up to Lehman, the markets are apt to slip and slide on the excesses. But when there is too little velocity the system could grind to a halt. “Collateral is the grease that oils the lending system,” said Richard Comotto of the International Capital Market Association to the Financial Times in an article on Singh’s research. “If the grease starts to freeze or run out, the loan cogs won’t run as well.”
Singh says that the “velocity of collateral” is analogous to the concept of the “velocity of money”. The way he sees it, “a shortage of acceptable collateral would have a negative cascading impact on lending similar to the impact on the money supply of a reduction in the monetary base. Thus the first round impact on the real economy would be from the reduction in the ‘primary source’ collateral pools in the asset management complex (hedge funds, pensions and insurers etc), due to averseness from counterparty risk etc. The second round impact is from shorter ‘chains’—from constraining the collateral moves, and higher cost of capital resulting from decrease in global financial lubrication.” He thinks the traditional monetary indicators used by central banks should be augmented by including collateral and rehypothecation chains.
To do this would require an acknowledgement by the central banks that the rehypothecation of collateral, especially by the Shadow Banking System, has infringed upon the territory once dominated by the central banks; in essence the creation and or destruction of money outside of the central bank domain known as the monetary base. In September 2008 I wrote in this space a paper called A Broken Transmission. I argued that effectiveness of Fed policy was thwarted by this new wrinkle in money creation. The rate hike cycle that began in 2004 did nothing to stop or even slow the growth rate of shadow banking, nor could the easing cycle keep pace with the deleveraging of this system that occurred post-Lehman. The research of Singh and Aitken highlights this story by measuring the increase and eventual collapse of the rehypothecation chains, or churn rate, which in essence increased the supply of “money” on the way up, and evaporated it on the way down. In the 2008 essay I quoted a paper written by BIS economist Stephen Cecchetti in which he described why it was vital for a central bank to have the sole control of the supply of money in order for them to properly conduct monetary policy. “For policy to even exist, some government authority, such as a central bank, must be the monopoly supplier of a nominally denominated asset that is imperfectly substitutable with all other assets. I will call this asset ‘outside money’. In the current environment, it is the monetary base.” A policy action, such as a Fed change in the funds target rate, can only have an effect if the Fed is in firm control of the nominal supply of outside money; “otherwise,” wrote Cecchetti, “a change in the nominal quantity of outside money cannot have any impact on the real interest rate, and will have no real effects.”
And, I would argue, reinforced by the research on rehypothecation that I have extensively quoted above, that this is where we find ourselves now in regards to the ability of the Fed to effectively conduct monetary policy in a world when they are no longer the sole source of ‘outside money.”
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