There’s a scary new word being added to investors’ vocabularies: rehypothecation.
The latest example is the collapse of MF Global, the brokerage founded by former Goldman Sachs executive and former New Jersey Gov. Jon Corzine.
MF Global lost $1.2 billion of investor money in a complex bankruptcy case only now unraveling.
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However, what has some investors worried most is that physical silver and gold for which they claim to hold receipts proving ownership allegedly was used by MF Global as collateral to back other deals. That is, the metal was rehypothecated. Put simply, the brokerage traded on the strength of other people’s money.
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The value of silver held by the brokerage has fallen by an estimated 28 percent as a result. "Warehouse receipts, like gold bars, are our property, 100 percent," John Roe, a partner in BTR Trading, a Chicago futures-trading firm, told Barron’s.
At issue, too, is whether the Chicago Merc, owned by CME Group, is liable for the transactions, which it cleared.
Rehypothecation is not illegal per se, but it is hardly examined, let alone regulated. The practice, which can be thought of simply as exorbitant leverage, is the driving force behind what is called the “shadow banking system,” the substructure under global finance that led in part to the collapse of U.S. brokerages Lehman Brothers and Bear Stearns and the resulting 2008-2009 credit crisis.
In a July 2010 paper, International Monetary Fund experts Manmohan Singh and James Aitken make the case that the shadow banking system, thanks to rehypothecation, “was at least 50 percent bigger than documented so far.”
They figure that shadow banking and rehypothecation peaked at more than $10 trillion in November 2007, just before the crisis began.
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