More important still, banks often churn, or "rehypothecate", that collateral. More specifically, when banks receive collateral from hedge funds, they often act as if they owned that collateral outright - and post that as collateral to support their own deals. Thus one piece of collateral can be churned several times to support several deals; hence that great financial candy floss cloud.Back to top
Now, until 2007 regulators tended to pay remarkably little attention to this, and even now the issue of rehypothecation is apt to be ignored by investors and policymakers, partly because most of this activity is very opaque. However, there are two reasons why it would make sense to track it much more closely. First, the price at which banks value collateral is a telling indication and early warning signal of how savvy financiers really feel about the risks in the system.
Second, as the IMF paper shows, this rehypothecation activity can be so frenetic it can significantly affect the overall volume of leverage in the system. The IMF paper calculates that, by 2007, the seven largest US brokers were getting about $4,500bn of funding from rehypothecation activity, most of which was not recorded in their accounts or the US government's flow of fund data.
Moreover, if you factor that activity into estimates of the size of the shadow banking world, this sector had swelled to about $10,000bn in size in the US - double previous estimates. And, this had a fascinating cross-border dimension. In the UK, as the IMF notes, "an unlimited amount of customers' assets can be rehypothecated and there are no customer protection rules". In the US accounts were segregated. Thus most funding has hitherto come from London.
Now, the "good" news, as it were, is that some of this candy floss cloud has now collapsed, because banks have become more risk-averse, and the collapse of Lehman Brothers alerted hedge funds to the risks of letting their collateral be rehypothecated in this way. Thus the IMF calculates that US bank funding from rehypothecation is now "only" $2,000bn-odd - or less than half its former size. That decline has clearly been painful for the banks. However, it does mean that some of the necessary, post-bubble adjustment is now taking place.