Wednesday, January 18, 2012


Last week I wrote in a post that Wall Street was "doing it again." Specifically, in the post I discussed how broker-dealers in the 1960s had "borrowed" assets from client accounts and used them as collateral to secure loans from banks (i.e. repo borrowing). They then used the money to make investments elsewhere, which they (or the firm) pocketed when the gambles paid off. Problems developed, however, because numerous broker-dealer deals failed, which led to over $100 million in losses for their clients.

As you can imagine, investors were furious. Congress acted and we ended up with new regulations through Rule 15c 3-3. To be sure, broker-dealers in the United States still retained the authority to borrow against client accounts. But they would not be able to operate as loosely as they did in the late 1960s (securities accounts were segregated, new net capital rules were implemented, reserve requirements were imposed, etc.). This is precisely why this article by Money Morning's Keith Fitz-Gerald is an eye opener.

In "How Banks Are Using Your Money to Create the Next Crash" Fitz-Gerald makes it clear that market players are not only using client accounts to borrow money and make trades elsewhere, but they're now borrowing and gambling at record levels.

How is this happening, you ask? Check it out.

Let's say you have a portfolio valued at $5,000. Most of what you have is invested in stocks, securities and other market instruments. Suddenly, you find yourself in need of cash (for whatever reason) and dip into your investment fund. You borrow $2,000 against your $5,000 portfolio. Legally you have to pay the $2,000 back or suffer serious early withdrawal tax penalties. But you're fine with this because you're actually paying yourself back.

Good so far? Great. This is where it starts to get good.

According to SEC Rule 15c3-3, the broker-dealers who run your portfolio can take what you owe to yourself - in this case $2,000 - and use that amount as a source of credit for their own use. Loosely speaking, your broker-dealer can use your promise to repay yourself as if it were a promise to pay the firm. The idea is that since you're going to return the $2,000 to your fund, you're actually paying your broker-dealer because they're the ones who manage the account.

It makes perfect sense, doesn't it? I mean, since you owe your account money, it's actually a credit for the broker-dealers who manage your funds, right?

But wait. It gets better ... for the broker-dealers that is.

According to the rules broker-dealers can add 40% of what you owe to "their" credit accounts. So, for example, if you borrow $2,000 from your account your $2,000 debt magically turns into a $2,800 credit (or borrowing limit) for the broker-dealers. Once your broker-dealer borrows $2,800 and then deposits it in a bank the $2,800 (less reserve requirements) can then be invested or lent out elsewhere. This money can then be deposited, and then used again (again, less reserve requirements), then deposited and lent again, then ... well, you get the point.

This daisy chain of debt is one of the primary reasons that the size and volume traded in our financial markets has exploded (computers, deregulation, etc. have also contributed to its growth).

In effect, your debt contract enables broker-dealers to borrow and gamble in other areas that they might never had done, were it not for your account. And while it's been going on since the 1960s, it really exploded with computers, deregulation, and the creation of new security products (repo borrowing surged past $1 trillion before the 2008 market collapse).

The explosion in financial trading has been phenomenal. Consider the following.

While our national economy produced approximately $14 trillion in goods and services in 2011, the total value (i.e. "notional value") that our financial market players have gambled on various market instruments, or now claim some kind of control over, has grown to well over $300 trillion (commercial banks contribute about $120 trillion to this amount).

To put this in perspective, this is akin to your debt-laden neighbor making $60,000 a year and your bank allowing him borrow $1.2 million to invest gamble as they want.Try asking your bank if they'll let you borrow 20 times the value of your assets & income.

But wait. It gets even better. On a global level, if we throw in what market players in the G-10 nations are doing, the total value (i.e. notional value) that our market players now control or claim some kind of authority over now hovers around $600 trillion, or 40 times what America produces in a year. Nice.

At the end of the day, this financial daisy chain is built on your hard work. It derives it's entire value from your financial accounts (and your debt). But here's the kicker. Whatever paper trail of wealth that's created won't be shared with you (have you ever seen a note in your monthly portfolio statement that reads "Here's an extra $20,000, which represents a small part that I earned from using your account to make bets elsewhere"? Neither have I).

According to Larry Fitz-Gerald, not only is this wealth extracting daisy chain legal, but "it's common practice specified in the fine print of most brokerage agreements." And it's called rehypothecation.

I think I'll leave it that for now.

- Mark

ADDENDUM: All of this is only the beginning. The legal use of your account (i.e. rehypothecation) has created a murky world where activities derived from your account (i.e. pledged collateral rights tied to rehypothecated instruments) can be used by several entities at once (p. 9). This is one of the reasons that the size of our shadow banking system (which is largely unregulated) now reaches into the multiples of trillions (p. 9), while the size of our real economy pales in comparison to our symbolic economy by a ratio of at least 20: 1. 

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