Allegedly, as much as $1.2 billion in customer funds have been “misplaced” which would appear to be clearly against the law. Customer funds are supposedly sacred in the brokerage/bank/etc. business. Should one of these custodians of investor funds go belly up because a proprietary trade (where the firm is supposedly risking its own capital) went wrong, then the customers should not be on the hook.

The Red Coats are Coming!

MF Global has a subsidiary company based in the UK where financial regulation is considerably more lax. Remember Joe Cassano and AIG? That was a London based operation that caused an American company to go under.

One of the causes of the MF blow up is related to re-hypothecation. Most brokers and asset managers in the US are allowed to hypothecate and/or re-hypothecate assets held in customer margin accounts. This works similarly to a mortgage. You own your home, but the bank that holds your mortgage has a claim on that asset if you fail to pay. In other words, despite the fact that you are the owner of the asset, the bank has a “hypothetical” claim against that asset through the lien on your house -- thus the term hypothecation.

If you are purchasing stocks or futures, as is the case with MF, on margin, then the broker has a claim against your assets if you fail to meet a margin call. Now in order to meet day to day cash flow needs, brokers and asset managers can use your assets as collateral in exchange for cash. Usually this is done on an overnight basis in the form of a repurchase agreement, or repo. In the U.S., the hypothecation level of brokerage firms is limited to 140% of margin debt.

So let’s say, for example, that you own $1000 worth of treasury securities and you would like to buy some futures contracts but do not want to sell your treasuries. You can pledge those securities as collateral for which the brokerage firm will lend you cash to buy futures contracts. Let’s assume that your futures contract will cost you $300 and your brokerage firm does not have the cash on hand to provide you that $300. The brokerage firm can then pledge, or hypothecate, up to $420 ($300 * 140%) of your treasury pledge to another entity that will lend the broker the cash to lend to you. In the U.S., whatever gain or loss the brokerage firm incurs on its transaction should not impact your account.

The paragraph below is from the TD Ameritrade Customer Agreement, where "you" means TD Ameritrade and "I" means you the account holder:

TD Ameritrade Section 9.g, Customer Agreement: Pledge of Securities and Other Property. You may pledge, repledge, hypothecate, or re-hypothecate, without notice to me, all securities and other property that you hold, carry, or maintain or for any of my margin or short Accounts. You may do so without retaining in your possession or under your control for delivering the same amount of similar securities or other property. The value of the securities and other property that you may pledge, repledge, hypothecate, or re-hypothecate may be greater than the amount I owe you, and any losses, gains, or compensation that result from these activities will not accrue to my Account.

So TD Ameritrade can hypothecate as much as $420 of your treasury holdings, lend you $300 in cash which it will charge you interest on, and invest the additional $120 in something else, usually treasuries, which they also receive interest on. Problems begin to develop when whoever TD Ameritrade pledges your collateral to decides that they want to re-hypothecate or repledge those securities to someone else. This can happen multiple times turning $420 in assets into some multiple of that through the re-hypothecation process. In other words, your $420 in assets can be levered up many times.

This in itself is a dangerous process and is at the core of the shadow banking system. But in the UK it’s even worse, since brokers are allowed to hypothecate or re-hypothecate 100% of your assets, causing even more leverage to work its way into the system. Since MF’s subsidiary is based in the UK, it used the full extent of its hypothecation abilities, and used the additional funds beyond what its customers needed to buy Italian and peripheral debt, no doubt using margin of its own.

Going back to our example, in the UK, MF pledges the full amount of your $1000 in treasuries as collateral to a third party, lends you the $300 to make your futures purchase, and invests the remaining $700 in Italian debt. It is then highly likely that whomever MF Global pledged your treasuries to, repledged those treasuries as collateral to make its own bets. And so the cycle expands and leverage grows as multiple players now have legal claims to 1 set of assets.

Below is an excerpt from the MF Global customer agreement:

Section 7, MF Global Customer Agreement. Consent To Loan Or Pledge. You hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate, loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.

As you can see the wording here’s a little different than the TD Ameritrade agreement. MF global is practically telling you that they plan on levering up and they may not have the collateral to cover that leverage. And their customers agreed to that.

“I never intended to break any rules,” Corzine stated during his testimony.

I’m sure you didn’t Mr. Corzine. Your intention was to exploit a loophole for profit by putting customer account assets under your UK subsidiary, using a lack of foreign regulation to lever up those customer assets. Now multiple entities have a claim on those assets, and your customers are likely to lose big.

It is likely that there may have been some additional shenanigans surrounding MF Global’s demise, but this is at the heart of the matter.

The bottom line is that it’s time for investors to reexamine their customer agreements with their brokerage firms. The section on hypothecation, which is not going away, should read more like the TD Ameritrade agreement than the MF Global agreement. (Understand this is not an endorsement of TD Ameritrade. The agreement from Vanguard reads similarly. Rather, the comparison is presented simply to make you aware of what you need to look for and where to look for it.)

Changing hypothecation rules is probably something that regulators should consider worldwide, but that’s not going to happen overnight. Remember anybody you pay, like your broker, whether it is a fixed fee or through commissions, works for you and is obligated to make sure that you understand and are comfortable with the conditions of your agreement. No need to panic, just be aware.