Hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral, but it is “hypothetically” controlled by the creditor in that he has the right to seize possession if the borrower defaults.
Why would anyone hypothecate a loan rather than borrow the money? Because if you pawn an asset, you have to leave it with the pawn shop. If you hypothecate an asset, you get to keep the asset. Evidently Big Banks have learned a few things from pawn shops. Big bank A will hypothecate their assets to Big bank B for a loan, and everyone continues doing business like nothing ever happened.
Except if something happens, Bank B gets to claim the cash assets without going through bankruptcy court. You might think “No they can’t!” But, they can and the FED and FDIC know it.
ZeroHedge had a story last October detailing how Bank of America (BAC) moved $53 billion worth of derivatives from its Merrill Lynch unit to the retail bank unit. The holding company had been downgraded by Moody’s (MCO) and Merrill's derivative customers wanted more collateral. By moving them out of the Merrill Lynch unit and into the retail bank the derivative customers had $1.04 trillion in deposits as a backstop. Bloomberg reported the Federal Reserve signaled that it favored moving the derivatives while the FDIC objected because they would have to pay off depositors in case of a bank failure. The bank’s stance was that regulatory approval was not needed.
Section 23A of the Federal Reserve Act limits moving derivatives contracts between business units of a bank holding company to prevent Holding Company business units other than the regulated bank from benefiting from the federally guaranteed FDIC insurance and to protect the bank from excessive risk originating at non-bank units. Bank of America was given an exemption to Section 23A in September of 2010.
Re-hypothecation is fractional reserve banking, except on steroids. Bank B loaned money to Bank A against Bank A’s assets. Let’s suppose that Bank B wants to borrow some money, so it goes to Bank C and uses Bank A’s assets that are hypothecated in its loan to Bank A as collateral for a loan from Bank C. And you see how Bank A’s assets could be guaranteeing a loan downstream to Bank C,D,E or F.
What happens if Bank A defaults to Bank B? Does Bank B line up in bankruptcy court and detail how much it is owed, with all the other creditors? NO. Are Bank B’s claims secondary to bondholders? NO In 2005 the U.S. Congress passed and President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA).
An amendment was inserted in the BAPCPA that exempted derivative counterparties. The U.S. Financial Inquiry Commission investigated the credit crisis of 2008. Their report observes “derivative counterparties were given the advantage over other creditors of being able to immediately terminate their contracts and seize collateral at the time of bankruptcy.”
One unintended consequence of the derivative exemption in the BAPCPA is the attitude of creditors. When someone owes you money under normal circumstances, you don’t want to force them into bankruptcy. You would be thrown in with all other creditors and have to wait on the bankruptcy trustee to report to the bankruptcy court. Then a judge would allocate the remaining capital according to seniority of the debt.
If you have a hypothecation on bankrupt assets (or other derivative like a re-po) why do you care? In fact, you can get your hands on their assets immediately if they declare bankruptcy.
The minute Bank B loses confidence in Bank A; Bank B will apply pressure to push Bank A into bankruptcy so they can collect the assets before a bankruptcy trustee is even assigned. Bankruptcy lawyers may argue that Bank A’s customer’s cash does not belong to Bank B, but possession is 9/10’s of the law. Lawyers can string this out for months or years while the bank uses the assets to make a profit.
The European Union adapted similar exemptions for derivatives as BAPCPA’s.
As we watch the drama in Greece, remember every creditor does not have the same interest. Some have sovereign debt from Greece. These creditors want to help Greece become solvent and collect what they can. Some have derivatives that guarantee the value of the Greek bonds. These investors/traders will take nothing less than 100% of face value on Greek debt. If Greece defaults they will be able to collect on their Credit Default Swaps (CDS).
Some parties have hypothecated loans to eurozone banks that will allow them to seize bank assets in front of other creditors if they cannot be repaid within terms. If turbulence creates uncertainty, these traders can demand payment. They have no risk if firms are pushed into bankruptcy. A Greek default would create a fire-sale mentality as banks try to liquidate eurozone bonds and other assets to avoid bankruptcy. One way or another, the hypothecated lender gets paid.
Greece must negotiate "haircuts" or write-downs with bondholders of their existing debt or face default. The derivative owners with CDS against their debt and hypothecated lenders to eurozone banks could win the most if talks fail.
I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.