Returns, Rehypothecation, Banks and Hedge Funds

In a presentation written in May last year Manmohan Singh, a Senior Economist in the Financial Sector Analysis Division of the IMF gathered some interesting data about rehypothecation amongst what he termed “international banks”. Rehypothecation is the ability of a prime broker to use client assets posted as collateral to that prime broker for the prime broker’s own purposes. That the title of the presentation was “Collateral Pledging Post-Lehman: How Reducing Counterparty Risk Squeezed Liquidity” says where he was going with his work. The work gives some colour and data to the ever slower grinding of the wheels of market liquidity that occurred in the Credit Crunch, and I include consideration of it here because hedge funds were and are part of the Lehman’s imbroglio through the role of Lehman’s as prime broker to hundreds of major hedge funds. The changes to liquidity planning at banks has also inhibited their ability to engage in prop trading and arbitrage and that impacts the alpha available for hedge funds to exploit.

I would recommend the work for several things: for pointing out the difference between US and UK legal treatment of broker-dealers in the event of administration or bankruptcy; and for referring to a CGFS study on collateral (published by the IMF in 2001) which raise back then a query of how markets could adjust to a relative scarcity of low risk, liquid collateral. The CGFS study expressed concern that changes in collateral usage might alter market dynamics and the risk management demands on financial institutions, particularly in stress periods!
The key table is given below.

Fair value of securities received as collateral, which can be pledged (billions of dollars)

	Nov05	Nov06	Nov07	May08	Aug08	Nov08	Mar09
LEH	528	621	798	518
MS	798	942	948	953	877	294	283
GS	629	746	891	869	832	579	610
MER	538	634	855	865	676	327

Prime brokerage is not only carried out by American entities, rather, it is also significant for the European universal banks too. The data is not disclosed as frequently for the European banks because of the cycle of annual and semi-annual reporting rather than quarterly reporting necessary in the United States. Looking at first Deutsche Bank and then UBS:

The Group (Deutsche Bank), as the secured party, has the right to sell or repledge such collateral, subject to the Group returning equivalent securities upon completion of the transaction. As of December 31, 2008, and 2007, the Group had resold or repledged € 230 billion and € 449 billion, respectively. This was primarily to cover short sales, securities loaned and securities sold under repurchase agreements. (From the Deutsche Bank 2008 20-F, page 300)

Equivalent resold or repledged securities for UBS were CHF 430bn at the end of 2008 and CHF 1,118bn at the end of 2007 (UBS 2008 Form 20-F, Page 350)

The point here is that the ability to receive and then re-sell or re-pledge securities has been a massive part of bank funding for those involved in custodianship (BoNY, State Street, and JPM), and prime brokerage. The Manmohan Singh presentation went as far as to say that “The terminal event for Bear Stearns, Lehman was that they ran out of pledge-able, unencumbered collateral. If the fair value of securities received as collateral coming into a financial institution is decreasing, and at the same time they are being obliged to post more and more to their counterparties..it gets very uncomfortable.”

A consequence of the Lehman’s crisis is that the liquidity buffers (cash and high-grade, short-duration highly-liquid government bond collateral) of major banks are increasing as a matter of policy. For example the Goldman Sachs’ 10-Q for the 1Q 2009, page 135 stated:

Our most important liquidity policy is to pre-fund what we estimate will be our likely cash needs during a liquidity crisis and hold such excess liquidity in the form of unencumbered, highly liquid securities that may be sold or pledged to provide same-day liquidity. The U.S. dollar-denominated excess is comprised of only unencumbered U.S. Government securities, U.S. agency securities and highly liquid U.S. agency mortgage-backed securities, all of which are eligible as collateral in Federal Reserve open market operations, as well as overnight cash deposits. Our non-U.S. dollar-denominated excess is comprised of only unencumbered French, German, United Kingdom and Japanese government bonds and overnight cash deposits in highly liquid currencies.

The liquidity buffers of leading American financial institutions at the time of the presentation is given below:

Liquidity buffers, Q1 2009 (billions of dollars)

UBS	$200
BAC	$170
GS	$164
MS	$145

The total liquidity buffer (that is the very good quality collateral) across the banks with the biggest derivatives books is approaching $1.5 trillion. The significance for hedge fund returns last year and in prospect is that it is $1.5 trillion of risk capital and balance sheet capacity that may have otherwise been applied to proprietary trading, market-making and arbitrage activities. Has the absence of that capital applied to markets left low-hanging fruit for hedge funds to exploit? Recall that last year, across all strategies in aggregate, hedge funds produced their best returns in 10 years. Having built necessary liquidity buffers and repaid TARP money ASAP, will these banks be back to take this year’s fruit from the less-well equipped hedge funds?

PS The IMF’s Manmohan Singh gave some nice historical perspective for the significance of rehypothecation for broker dealers.

“The exclusive announcement in Sunday’s TIMES that the banking and brokerage firm of Greenleaf, Norris Co. had been placed in the hands of Seiah Chamberlain, as Receiver, on the latter’s affidavit that the firm had rehypothecated large amounts of securities deposited with them by other persons, as security for the repayment of loans obtained by them in their own name, and, that in this rehypothecation the securities had been mingled together, thus rendering it a very difficult task for the owners of the pledged securities to obtain their own property, created a sensation on the street yesterday.” The New York Times, March 5, 1878.