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The European Shell Game

Posted by Larry Doyle on December 13, 2011 11:43 AM |

I recently received the following message from a regular reader. Given the fact that every other piece of financial news seems to address developments in Europe, I would like to share his message and my response.

Hi Larry –

Hope you are doing well. I have read several articles in the last few days on this topic – rehypothecation – and how this is what really brought down MF Global, and also in a way what brought down AIG.

I’m still not completely understanding this. My primary question right now that I’d love to hear your opinion on is this – Was this the primary reason why David Cameron refused on Friday for Great Britain to agree to the EU treaty?

The reason I ask that is because the only way that MF Global could utilize rehypothecation is because in the UK, it is legal and there is no limit whatsoever on the amount that can be rehypothecated there (as opposed to in the U.S. where there are strict rules).

So, according to these articles, MF Global moved their clients money to their London subsidiary, then followed the UK rules on rehypothecation, and now the client money is all gone and they didn’t do anything illegal because they did it in the UK, not in the U.S.

AIG did the same thing – what blew up AIG was AIG Financial Products, which was located in London. The reason AIGFP was located in London was again because of the abscence of regulations there, so that AIG could sell Credit Default Swaps outside of U.S. regulations.

So, again, is the reason David Cameron refused to go along with Friday’s EU treaty because that treaty would have basically put an end to the very lax regulations in the UK I just mentioned above which might either blow up a lot of big banks and/or prevent them from continuing their current operations there and therefore banks pressured him heavily into this? Something along those lines?

Do you feel that there is an enormous global risk right now of a possible unwinding of rehypothecated assets that could be worse than 2008, as some of these articles believe?


There are a couple of things at work here. One is the lack of eligible and available collateral to support the house of cards which defines the CDS market. The ‘rehypothecation’ process to which you refer was merely another means of employing leverage in an attempt to generate earnings. The need for quality collateral is the linchpin which allows for the leverage to be maintained.

Recall that when the Fed provided funding to the U.S. banking system back in 2008, our man Ben was allowing the banks to post anything and everything as collateral against the loans it provided. Given the credit quality of the European sovereign debt, there is a real shortage of quality collateral that can be pledged and is willingly accepted by counterparties.

What is the result? Credit flows come to a screeching halt and the banks do everything they can to repatriate capital so they do not go belly up.

In addition, you also make a great reference to the regulatory arbitrage which exists between countries and regions. Very savvy people within our financial markets are constantly looking for opportunities in which they can allocate capital and drive business in the most efficient and risk adjusted manner. The gross risk—not the net risk—has obviously grown to the point where the system is ready to implode without government intervention.

Add these two developments together—the rehypothecation and the regulatory arbitrage—and what we truly have going on in the markets is nothing short of a “shell game” in which the central bankers are compelled to add their own reserves in an attempt to buy time and inspire confidence to get others to play/participate.

While I do not know the specific prevailing reasons why UK Prime Minister David Cameron may not have agreed to play ball with Ms. Merkel, Mr. Sarkozy et al, I do have a strong inclination as to where this mess is headed.

Where is that?

Well, who blinked first?

Hank Paulson and Ben Bernanke. Having bailed out the U.S. banking system, I believe those in Europe, and especially in Germany, believe our Fed chair will ultimately be compelled to provide a backdoor bailout of the European banking system under the guise that he will be saving our domestic banking system in the process.

Fascinating stuff. Thanks for your question.

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets, our economy, and our political realm so that meaningful investor confidence and investor protection can be achieved.



  • fred


    Another theory making the rounds courtesy of Zero Hedge is that Courzine blew out MF Global purposely and for the benefit of shell companies on the other side of the trade.

    The problem I had with this theory was how the shell companies would know that the trades would lose. After thinking it through, I came to the conclusion that they would not have to know that the trades would lose, all they would have to know was when MF Global would be liquidating their positions, this knowledge would allow them to front run the unwinding.

    Interesting how no one ever figured out how H Clinton made all that money in cattle futures trading fo.

  • LD

    Hmmmmmmmmmm…..We have learned that Mr. Soros purchased a lot of the MF Global positions.

    How much do we trust him?

  • Bill

    Larry, read in the wsj that Soros bought his Euro debt position at less than market price. Some others may have also. Wondering what’s up with that? Is the market price not the market price in reality? Was this an unusually large trade, and for this reason went off at a discount to market? Sort of like when one of these MREITs sells stock to raise more capital, at a discount to the current market? Which knocks the market price down immediately.


    • LD


      Without knowing the exact details of the trade that occurred in which Soros purchased these positions, we cannot be sure of where the market stood at the time. Did Soros get a volume discount because he was able to take the size? Perhaps.

      Has the market rebounded from the time of purchase? Perhaps this has also occurred. I do know that 10yr Italian bonds did trade north of a 7% level and last I checked they were trading in or around the 6.5% level.

      Both of these scenarios could have occurred.

  • Bill

    On this rehypothecation issue, A borrows from B and pledges collateral. B then borrows from C and repledges A’s collateral. Now, assume A is current, but B defaults to C; C seizes or retains A’s collateral, so even though A is current, A loses his collateral. I suppose the remedy would be A is absolved of his liability to B in that event. A would be made whole unless his collateral exceeded his debt in which case he would become a creditor of B, probably unsecured.

    • LD


      If this practice is utilized extensively—which it was—then ultimately the system runs the risk of becoming a total house of cards. That, my good friend, defines a large part of the European banking system and by extension the global banking system as well.

      This reality explains why we continue to see a run on deposits within many of the European banks.

      • Bill

        LD, if the collateral is seized, as in my example, then the creditor should only be entitled to that part sufficient to cover its claim. It seems like it would in practice all net out. But I say that with no knowledge of the exact process. And then you could always have the Corzine scenario wherein the collateral is just stolen.

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