It’s 3:00 A.M. Do You Know Where Your Money Is?

It’s 3:00 A.M. on a cold winter night and you are fast asleep. As you are sleeping, something fascinating is taking place at most banks and financial companies. Your money is on the move, and in about 15 minutes it will circle the globe and be used to fund all sorts of transactions. So, what is happening to your money at 3:00 A.M.? Re-hypothecation.

Re-hypothecation is just a fancy banking term that allows a bank or financial entity to use your money as collateral to get low interest loans from the interbank lending system.[1] This use of your money is completely legal, and in most cases acts as a benefit to the world’s financial markets. It is a way for lender banks to inject money into the banking system.  The loans, in turn, help to fund the world’s bond markets as well as community development projects.

It works like this: a bank, overnight, collects all of its depositors’ cash and pools it into a fund which is then used as a good-faith down payment for a much bigger loan that the bank gets from a lender bank at a very low interest rate. The borrowed money is used to purchase something with a higher rate of return than the interest rate that will have to be paid on the borrowed money. If the bank gets the loan at 0.25%, for example, it can invest it in something that pays back at 5.25%. Over time the bank pays the loan back at 0.25%, and profits from the 5% difference. On a $1 million loan, the bank can make $50,000. Not bad for 15 minutes work.

Remember, banks can do this every night!  After the deal is complete your money is returned to your account, you can go on with your day, and the bank is $50,000 richer.

In the United States, regulations limit the amount of depositors’ money the banks can use for collateral in these overnight transactions.[2]  Also, there are strict rules for which depositors’ accounts can be used and how much can be borrowed against these funds.[3] But even the limits and restrictions do not make this process fool-proof. In the time that the bank is re-hypothecating your money, it is not yours; it belongs to the bank and if they lose it, it’s gone. This is what happened at MF Global, the now-famous investment company, but more on that in a minute.

In the past, banks always made very, very safe bets with your money. Towns and countries with good credit ratings, for example, had access to the new capital – that’s the loan from a lender bank – because banks could use this capital to buy a town’s bonds to fund roads, sewers and transportation systems. This re-hypothecated capital could also be used to pay down the borrower bank’s debt. This was a way of putting large sums of money to work with little risk, and it was good for everyone.

Now enter England, and in particular, London.  In London the banking regulators did away with the limits and account restrictions on how much of depositors’ money could be used as re-hypothecation collateral.[4]

If you are a depositor with a bank that has an office in London, your money can be transferred to the London branch and then it falls under English re-hypothecation rules. Companies with a London office, like MF Global, borrowed against their pool of depositors’ money, but due to the less restrictive English rules, there was no limit on how much money they could borrow from the interbank system.

Over time MF Global, as well as other investment companies, hit upon what they thought was a sure thing; purchasing sovereign debt with their re-hypothecated capital.  Sovereign debt is any country’s national debt.

Because so many countries have huge levels of debt from massive overspending, they need to sell billions of dollars in bonds each year to fund all this debt.  Firms like MF Global purchase this debt as a way to keep countries afloat.

MF Global’s plan was to buy as much Greek and European debt bonds as they could at a high rate of return, after having borrowed money from a lender bank at a low interest rate. Their theory was that the world would not let Greece default and would bail them out.  When this happened, MF Global reasoned, they would make a ton of money because the bailout would pay off all outstanding loans and bonds.

MF Global bought upwards of $6.3 billion in sovereign debt using $1.2 billion of account holders’ money as collateral.[5]

When Greece did not get bailed out in a timely manner, the lender banks that had loaned MF Global the money to buy Greek bonds began to demand repayment of the loans. MF Global was caught holding the bag; they simply ran out of money and had to file for Chapter 11 Bankruptcy.  $1.2 billion of customers’ money was gone, because at the time of the bankruptcy filing MF Global was using clients’ money to fund its own transactions and operations using re-hypothecated loans.[6]

The world is so far in debt now, and the need to refinance this mountain of debt is so large, that there is pressure on banks and investment companies to purchase this debt. If no one purchases this sovereign debt, countries could go bankrupt. The fear of going bankrupt is driving countries’ governments to offer their debt at higher and higher interest rates in hopes of continuing to fund their over spending.

MF Global succumbed to its own greed and lack of a strong regulatory environment, and began betting on risky investments in Greek debt. Worse was the fact that MF Global did not tell its clients that it had made these investments with client money.[7]

Remember that in the past, only safe investments were bought with re-hypothecated funds. But now, because of the overwhelmingly large global debt level, banks and investment companies are moving towards these risky investments using your money as collateral to try to capture higher rates of return.

The sovereign debt load of the world is now so large that it is no longer seen as “safe” debt.  In the U.S., for example, our debt to GDP ratio is over 100%, and we need to raise our debt limit (currently at $15.2 trillion) by $1.2 trillion in 2012 just to keep up with our government’s overspending![8]

What happened at MF Global is very similar, but on a smaller scale, to what happened to the world economy during the housing crisis. Greed and lack of over-site brought the world to the brink of economic collapse. Only the fact that governments had capital to bail out the banks saved the world economy from going over a cliff. This time the same thing is starting to happen, but it is the governments themselves, as well as the banks, that will be bankrupt. With governments out of money, who will be there to bail us out when trouble arises?

It is time to address the debt problem head-on in our country.  We are on a collision course with economic devastation if we do not.

In 2012 it is critical that we elect candidates at every level of government who take spending cuts seriously, and are willing to enact tough policies such as a balanced budget amendment and cuts in entitlement spending, forcing fiscal accountability.

Your financial security is at stake.  America’s future is your future.