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 reins - 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.”
* Nice word, eh?