Wednesday, December 7, 2011

Are alarm bells sounding in the financial community about CIBC and Royal Bank?

Back in August, the website Zero Hedge sparked a debate about the soundness of Canadian banks.

The issues raised about Tangible Common Equity (TCE) were quickly dismissed by Canadian authorities, but the issue has been raised again with a slight twist.

In a post tonight, Zero Hedge strikes again zeroing in on something called Re-hypothecation which lies at the heart of the whole MF Global scandal.

In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital).

Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.

In the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated.

By 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system.

Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation.

In its quarterly report, MF Global disclosed that by June 2011 it had repledged (re-hypothecated) $70 million, including securities received under resale agreements.

The off-balance sheet treatment means that the amount of leverage (gearing) and systemic risk created in the system by re-hypothecation is staggering.

Re-hypothecation transactions are off-balance sheet and are therefore unrestricted by balance sheet controls. Whereas on balance sheet transactions necessitate only appearing as an asset/liability on one bank’s balance sheet and not another, off-balance sheet transactions can, and frequently do, appear on multiple banks’ financial statements.

What this creates is chains of counterparty risk, where multiple re-hypothecation borrowers use the same collateral over and over again.

Essentially, it is a chain of debt obligations that is only as strong as its weakest link.

With collateral being re-hypothecated to a factor of four (according to IMF estimates), the actual capital backing banks re-hypothecation transactions may be as little as 25%. This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing.

So what does all this have to do with CIBC and Royal Bank?

With weak collateral rules and a level of leverage that would make Archimedes tremble, firms have been piling into re-hypothecation activity with startling abandon. A review of filings reveals a staggering level of activity in what may be the world’s largest ever credit bubble.

Engaging in hyper-hypothecation have been
  • Goldman Sachs ($28.17 billion re-hypothecated in 2011),
  • Canadian Imperial Bank of Commerce (re-pledged $72 billion in client assets),
  • Royal Bank of Canada (re-pledged $53.8 billion of $126.7 billion available for re-pledging),
  • Oppenheimer Holdings ($15.3 million),
  • Credit Suisse (CHF 332 billion),
  • Knight Capital Group ($1.17 billion),
  • Interactive Brokers ($14.5 billion),
  • Wells Fargo ($19.6 billion),
  • JP Morgan($546.2 billion),
  • and Morgan Stanley ($410 billion).
That's right, CIBC and Royal Bank have over $125 Billion of collateral backing up its derivatives book which is actually client collateral!!!

When the crunch came for MF Global, their clients collateral was seized and is now gone. It is being suggested that MF Global's bankruptcy has already set off a chain of events which not even all the world's central banks can halt.

Back in August, Canadian banks defended themselves against the concerns of TCE. And anyone looking through the balance sheet of Canadian banks could turn up no alert signals.

Was it because hundreds of billions of dollars worth of debt exposure was off the books?

Reuters is reporting on the MF Global Re-hypothecation scan here. It explains the whole issue very well. From the article:
A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients.

After reading all this, do you feel safe with your money at CIBC or Royal Bank?

Look for lots of interest in Canada to be generated by this latest Zero Hedge post.


Click 'comments' below to contribute to this post.
Please read disclaimer at bottom of blog.


  1. Wonder to what extent other Canadian banks have been involved. Wonder how they derived these numbers.

  2. I knew our banks had some "off balance sheet"crap.
    I wonder what other stinky derivatives will be exposed as the tide goes out in Europe.
    Oh yeah...why are banks allowed off balance sheet accounting,would Revenue Canada accept that from me?

  3. Ya gotta like Garth Turner's response when this was brought to his attention... pretty typical of him. He just keeps pumping those paper assets.
    "Misinformed commentary from a discredited source on this subject. — Garth"

  4. @anon 12:52pm

    That's because, you know, Turner knows what he's talking about. Look below from some of his previous predictions...

    “November 20, 2000: After Nortel has fallen 50% in a month and trading $40: “So, here’s a strategy: If you own Nortel, or a mutual fund holding it, don’t bail out now. We are near, but not at, the low point. If you do not own Nortel, then this is the time to start accumulating it, or a good science and technology fund with exposure to the company. If you’re a gambler, then roll the dice and leverage. If you’re a wimp, don’t read or watch any news for the next six weeks.” (NT changed hands at $2.60 today).

    December 4, 2000: Mr. Turner is wildly bullish on equities and is dismissive of an email from a financial advisor who is suggesting bonds: “Will the Nasdaq again reach 5,000 and the TSE 300 attain 11,000? Will it be warmer again in April? How about clipping this column and taping it to the fridge? Let’s see who was truly dangerous, when the flowers are back.” (Nasdaq closed today at just above 2340). [Nasdaq never went above 2900 in the past 12 years!]

    February 19, 2001: Nortel has just announced that it is losing money and laying off 10,000 employees and is trading around $30: “Now the bright side of this is that since every market correction is also an opportunity; since we all know the Internet and technology will still be the backbone of the future; since the economy will resume its growth in a while; and since the markets will reflect that, this is an excellent time to be buying, and the wrong time to be selling.””

  5. Don't be sheep and believe any nonsense that these writers spew. Has the author even bothered to check the drivers of the rehypothecation of collateral? Don't think so. Most of banks' rehypothecated or third party collateral being repledged is generated from securities lending on behalf of their clients as part of their custodial business. This earns additional revenue for both bank and client. The collateral recieved is then used for indemnity purposes. The other big source is from repo activities. Reverse repos generate collateral recieved , which is generally offset by repo activity in which the collateral from the reverse repos are lent for cash, netting both sides out.

    1. Thank you for the good point, and I've learned from your post. But for me, and probably for other too, we think this is too complex to be "honest banking" and wish our banks would isolate us from the international mess that is about to implode.