The Hyper-Hypothecation Credit Default Swap Time Bomb

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"Hey Bill, lend me $1,000 would you?"

"John, under normal circumstances that would be fine, but you've been out of work for months. How are you going to pay me back?"

"No worries. Sam owes me $1,000. As soon as he pays me, I'll pay you."

"But Sam is an incorrigible drunk!"

"I know but Charley promised to pay Sam $1,000 as soon as he sobers up."

"Who's Charley?"

Multiply the numbers by a billion and change the names to Lehman, Merrill, Goldman, and AIG and you get a picture of what happened when Wall Street's Credit Default Swap (CDS) house of cards tumbled down into Fannie Mae's collapsed subprime mortgage cesspool. When financial markets froze up, policy makers saw bailing out the lot as the lesser of two evils, notwithstanding the moral hazard this created by signaling to the financial masters of the universe that they could get away with disregarding counterparty risk.

Yet cascading counterparty risk - the failure of a trading partner to make good on a contract - is the number one cause of market freeze ups. This is a problem which Dodd-Frank was supposed to address by standardizing CDS contracts and forcing them to trade through a centralized clearinghouse. Like generals preparing to fight the last war, though, this attempt to solve an old problem does nothing to prevent the next one.

And the next one seems to be brewing, at least according to a frightening scenario described in Zero Hedge that looks at the practice of hyper-hypothecation across Europe's shadow banking system. It might also provide the answer to the mystery of what happened to the missing $1.2 billion in client funds that the disgraced Goldman Sachs ex-CEO, former Senator Jon Corzine, "lost track of" when his firm MF Global spiraled into bankruptcy.

It seems that MF Global and many other firms have clauses buried in their contracts that allow them to take the assets clients provide as collateral for margin loans, pool those assets, and pledge them to other brokers as collateral for heavily leveraged proprietary trading deals. This is called re-hypothecation. When those other brokers do the same thing with other brokers that do the same thing, this is called hyper-hypothecation. All of this credit creation takes place off-balance sheet and outside the reach of standard balance sheet controls.

What is the motivation for all this? According to the rocket scientists who do the math behind the machinations, risk gets dispersed rather than concentrated, freeing the masters of the universe to make outsize bets without having to raise capital to back them up. After all, what are the odds that all of these trades are going to go sour at the same time, or that entire collections of underlying collateral turn out to be grossly mispriced?

Before you know it, virtually unlimited leverage gets piled atop a thin wedge of actual assets owned by somebody somewhere down the chain. If any link in that chain breaks - say, when an out-of-control rock star CEO makes a series of bad bets on European sovereign debt and can't come up with enough cash to cover margin calls - the next broker up the chain swoops in and takes the collateral. Which is the best guess as to what happened to MF's missing client funds. Fingers point at J.P. Morgan's London operation, but the jury is still out.

All of this is perfectly legal, and a big caveat emptor to you, sad client. The fact that MF's repossessing counterparties have not come forward to clear up the mystery gives one pause that a much larger problem may be lurking underneath.

That larger problem? Imagine if trillions in hyper-hypothecated leveraged bets were built atop a pile of assets that happened to be a collection of PIIGS government bonds, once treated as if they were good as gold. Imagine what would happen to the entire European financial system if those PIIGS bonds simultaneously go kablooey, say, if the Euro were to unwind and all those bonds had to be repriced in resuscitated national currencies.

Most rocket scientist models justify this kind of gambling because they fail to account for cascading counterparty risk. They pretty much assume that a contract is a contract. Besides, visibility back down the chain is limited (who's Charley?), and if the whole system freezes up, what the heck, a government bailout will surely follow. Until then, let the bonuses flow!

When I asked my hedge fund expert if he thought there was a regulatory solution to the problem, such as an outright ban on re-hypothecation, he quickly came back with the right answer. Only a fool would sign a contract that allows his broker to re-hypothecate collateral! In retrospect, this pretty much describes MF Global's client base. Many other clients at many other firms around the world are probably not even aware that they have handed this doomsday device to their brokers. The solution, then, is to read the fine print in your broker dealer contract. If your broker refuses to eliminate the re-hypothecation clause and swear off gambling with your collateral, go find another broker.

Meanwhile, efforts seem to be quietly underway to unwind all this excess leverage as savvy traders wake up to the potential destruction that awaits if all these hyper-hypothecation chains were to collapse simultaneously. This involves trading out of positions and recognizing losses along the way, so no one seems to be in a great hurry. But as the latest Wall Street movie Margin Call so aptly portrays, once a rush for the door starts things can get ugly very fast.

Bill Frezza is a fellow at the Competitive Enterprise Institute, and a Boston-based venture capitalist. You can find all of his columns, TV, and radio interviews here.  If you would like to have his weekly columns delivered to you by e-mail, click here or follow him on Twitter @BillFrezza.

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