With each failure of a financial institution, a new term seems to find its way out of thousand page long regulations and onto the front pages. When Lehman Brothers collapsed, re-hypothecation was introduced to the front page. In the weeks following MF Global's collapse, re-hypothecation is back. It has been covered extensively, initially by Reuters, with additional reporting from Zero Hedge (link, link) and FTAlphaville (link, link).
What is re-hypothecation? Well, hypothecating something again, duh.
But really, hypothecation is the technical term for a borrower pledging collateral. Re-hypothecation occurs when a bank or broker re-uses assets pledged as collateral by customers as collateral for its own borrowing.
Example: You give a bank collateral. The bank takes that collateral and uses it again. Your collateral is no longer controlled by the bank you gave it to. It's controlled by the bank that the bank you gave it to gave it to. That's re-hypothecation. And it is legal under SEC Regulation T and included in standard customer account agreements with broker dealers.
Related story
The problem? If you bank goes under, the other bank has the first right to the collateral you pledged.
Segregated accounts are supposed to solve this problem by providing increased protection of customer assets through restriction of re-hypothecation. In an interesting twist, segregated accounts, particularly for large institutional customers, are more expensive for the customer, because the bank wants compensation for losing a source of collateral.
Why is this term everywhere? When confidence in the firm dropped, the counterparties funding the complex repo-to-maturity trades likely demanded increased collateral from MF Global and perhaps, mistakenly or otherwise, MF Global posted segregated customer funds as collateral. When MF Global went under, the other banks seized the collateral and poof, there went the customer funds. Further complicating matters, the missing customer funds were on the commodities side of MF Global, not the broker-dealer side that implemented the repo-to-maturity trades. Nonetheless, there are now reports from sources close to the investigation that customer assets from segregated accounts were indeed used by MF Global to meet margin calls.
The difference between illegal or improper rehypothecation lies in intent, as we've discussed before. To even come close to establishing intent, an almost line by line reconstruction of the trades and transfers executed in the final period of MF Global's existence will be needed.
