The Downside of Rehypothecation

Sadly, as witnessed in 2007-2009, mismanagement and the outright pursuit of profit no matter what the cost can cause financial devastation on a global scale. The result of leveraging and the rehypothecation of mortgages by many global banks and financial institutions left many businesses in bankruptcy and some banks close to failure.

As advised above, rehypothecation is where a financial institution utilises the collateral taken for loans and repackages them, sometimes into a debt instrument which will raise funds in the secondary market. Many of these instruments are referred to as collateralised debt obligations, or CDO’s.

These instruments are awarded a credit rating from credit rating agencies such as Standard and Poors, Moodys and Fitch, so they may be traded within the guidelines capital adequacy rules as promulgated by the Bank for International Settlements, Basle, Switzerland. Allegedly, these rating agencies advised the banks how to structure these debt instruments, so they could be traded under an AAA rating, meaning they have virtually no risk.

In the case of mortgages for example the CDO’s are referred to as collateralised mortgage obligations, CMO’s, or mortgage backed securities, (MBS). The CMO’s are a mixture of commercial mortgages and private home mortgages, and a MBS represents the amount of interest in a pool of mortgages.

However, in the aftermath of the 2007 2009 financial meltdown, (also referred to as the subprime mortgage crisis) some investment houses refer to CDO’s as “bespoke tranche opportunities”, BTO’s, which is essentially a CDO backed by a credit-default swap.

The financial crisis started in the United States and like a domino effect spread to the rest of the world. The federal reserve in 2001-2003 lowered their interest rates from 6.5% to 1% creating a home mortgage boom, including a government no income tax policy on interest paid on mortgages. At the same time checks and balances intended to ensure lenders did not give risky loans were removed.

As more and more homes were bought, home owners became highly leveraged. There were suddenly millions of risky mortgages in the market, and some bankers found an innovative way of getting these loans of their balance sheet by issuing CMO’s and MBS and leveraging their initial investment by up to 40 times.

In the summer of 2007, the global financial markets were showing warning signs that the cost of many years of cheap credit were coming to an end. Northern Rock a British Bank was soon going to ask the Bank of England for emergency funding, (it was eventually nationalised), BNP Paribas were warning clients that they may not be able to withdraw funds and Bear Stearns had two hedge funds that collapsed.

The risky loans were coming home to roost, there was a massive crash in the property market, and as more and more mortgage payments stopped, homes were repossessed. IndyMac Bank failed, one of the largest banks ever to fail in the USA, and Fannie Mae and Freddie Mac were taken over by the US Government, along with hundreds of billions of mortgage guarantees.

The result was such a liquidity shortage of such magnitude that banks would not trade with each other, the interbank market collapsed, and there were virtually no credit facilities available. The Wall Street bank Lehman Brothers collapsed, Bear Stearns a Wall Street giant was bought by JP Morgan Chase for cents on the dollar. The upshot was a global financial crisis that governments struggled to halt and restore confidence.

The above is a vey basic overview but shows if rehypothecation is abused, it can cause carnage throughout the globe.

For more information on:

• The Secondary Market
• Collateralised Mortgage Obligations
• Mortgage Backed Securities
• Credit Default Swaps
• Rating Agencies
• Bank for International Settlements

Please go to Definitions and Explanations