Getting to "yes" in a world of "no"…

Archive for April, 2013

Rehypothecation and the death of working capital…

Here’s some stuff that turned my startup finance world upside down, perhaps it will do the same to yours.

One of my favourite mad economics topics is rehypothecation. If you’ve managed up till now to avoid the word, it’s because you’ve been living in a financial la-la land, a dreamworld where banks and brokers are honest & straightforward, and the world financial system is basically sound.

Of course, they simply aren’t, and it isn’t. But however bad you think everything is, rehypothecation makes it all worse… much, much worse.

The quick version goes like this: that when a bank or broker lends money secured against an asset, they can then borrow against the same asset they’ve lent against. And that the bank or brokers who lend them money can then repeat the process. The initial mortgaging is hypothecation: the subsequent chain of mortgages is called rehypothecation.

As explained on the excellent Zero Hedge site, there is a fundamental asymmetry between US rehypothecation rules and UK rehypothecation rules:-

Under the U.S. Federal Reserve Board’s Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client’s liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.

But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500).

And this is why the financial crisis actually started in London, in a little office in 1 Curzon Street, where AIG ran its UK operation – specifically there so that its boss Joe Cassano could sell credit default swaps (CDS’s) within the UK’s lax rehypothecation regime. Errrm…. $2.7 trillion of the b*gg*rs. And when that clever-arse scheme started to unwind, the whole financial world caught a cold. If not actually syphilis.

Of course, the UK government has dramatically responded by… leaving it all in place, exactly as it is. So, no danger of a repeat performance, then? Dream on!

All that’s actually happening is that US legislators are now making it harder for US companies to silently shift assets to London to rehypothecate them many times over. And this kind of activity makes up the core of what is known as the “shadow banking sector” (though the phrase has a different meaning in China).

Even though people know this is going on, they don’t often see what it has to do with them. And in particular, why should any given startup care about this kind of fairly abstruse systemic bad behaviour?

Well, I’ve always thought it was really central to understanding the way banks behave: and today I found this comment that crystallized all my thoughts into one single, chilling iceberg moment. The commenter writes:-

It always seemed strange that banks would accept accounts receivable as loan collateral, but not inventory. Now it makes sense – inventory is too real.

That which is real can be stolen, wither, rot, age, depreciate, fall out of favor, or die. Convert into a journal or book entry, and its value becomes more opinion than fact.

So, it would seem that the actual reason working capital has fallen so drastically out of UK banking fashion is that it’s fundamentally to do with real things. If it were more virtual, it could be endlessly rehypothecated. It’s not that there’s no money in working capital, it’s that there’s no capacity for rehypothecation. And that’s nothing that’s going to change in the UK in the obvious future… the City’s making far too much money out of it.

Hence you can see the UK financial regulation regime as one that has become irreversibly skewed away from the physical to the virtual – that for all the poxy pure software play startups that pop up in Shoreditch, the really virtual part of the economy is the one that attracts foreign assets to the Square Mile to be played endlessly with.

Who’d run a UK startup, eh?