But I get a lot of urgent sounding mail none the less regarding MF Global and the rehypothecation scare going around.
I found this article by Janet Tavakoli to be quite informative.
Rehypothecation Is An Old Story
Allowable Rehypothecation: Problematic, But A Different Problem Than MF Global's
There has been a lot of misinformation about rehypothecation, and old term that seems to have been newly rediscovered by bloggers. To be clear, allowable rehypothecation is not the dark question that has been raised about MF Global. Filching funds as I described above is illegal. Writing rubber checks is illegal.
My favorite rehypothecation story involves Henry Jarecki, then head of Mocatta Metals and current head of Gresham Partners LLC. I'm sure he'll tell the story better and give you more details than I. But here is the basic story, and it is a parable of this problematic but legal practice.
Around 1979, Mocatta Metals owned 30 million ounces of silver that Jarecki leased to industrial users. He was long silver outside the exchanges, and he hedged by being short silver on the exchanges using futures contracts. But all the price action was on the exchanges where prices were soaring. Jarecki used cash to meet margin calls. People started getting nervous and rumors circulated, because most people were unaware he owned a huge silver position.
Meanwhile, the Hunts had borrowed $50 million from Mocatta to buy more silver and had deposited 10.7 million ounces with Mocatta as collateral for the loan. Jarecki rehypothecated the Hunts' silver, meaning he used it as collateral for his own borrowing. This wasn't prudent, but it was definitely legal. After the Hunts posted the silver as collateral with Mocatta, the price of silver tripled. The Hunts were nervous after hearing the rumors about the cash margin calls for Mocatta's futures hedges, and they showed up in Henry Jarecki's office in a very bad mood.
The Hunts knew the value of their collateral at then market prices far exceeded the cash value of their loan, and they wanted the loan size increased so they could buy more silver. Jarecki agreed to a bigger loan, but the increase wasn't big enough increase to satisfy the Hunts, who became suspicious that Jarecki was in financial trouble. The Hunts then said they wanted to prepay the loan and take back their silver. Jarecki responded that the loan terms didn't allow for early repayment. Now the Hunts were afraid and angry.
If Jarecki had to buy the Hunts silver in the open market or if he had to cancel his futures trades with no offset to meet the Hunts' demands, it would have created a liquidity crisis for Mocatta. Instead, Jarecki solved everyone's problems. He arranged an exchange of futures for physicals (an EFP to cancel out his and the Hunts' futures positions in exchange for a special agreement on the silver) and sold the Hunts 23 million ounces of silver for cash at what was then the top of the silver market.
Honest People Don't Look for Malicious Loopholes
At all times the Hunts had cash in exchange for their assets, there was a full accounting, and Mocatta metals was good for its obligations. In fact, Mocatta metals immediately satisfied the Hunts' demands. Even better, it sold the Hunts more silver, which the Hunts wanted. Honest people don't exploit customers by citing malicious loopholes, they come up with creative solutions to more than satisfy customers.
Mocatta used creativity to prevent a liquidity crunch. Even in its best form, rehypothecation can create a liquidity crisis and panic due to the basis risk. Mocatta averted that and everyone was satisfied. It's poetic justice that Mocatta was also lucky in its timing in the silver market.
But as I said at the outset, allowable rehypothecation is not what has everyone up in arms about the missing money at MF Global.