You asked for more Welborn and you got it! 

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This week, we welcomed Dartmouth Senior Lecturer John Welborn back to Let’s Talk Markets. Last time we met, John joined co-hosts Dave Lauer and Pink in a colorful discussion on market structure reform.

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John brings the same illuminating candor to this week’s conversation about rehypothecation.

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Quick aside: If you’re trying to get away with something kind of shady, give it a needlessly obfuscating, multisyllabic, and difficult-to-pronounce name like, for example, rehypothecation.

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Now, back to rehypothecation. In order to know what rehypothecation means, you obviously have to know what hypothecation means.

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Hypothecation–Rhymes with “I’m On Vacation”

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In short, hypothecation is what happens when you put up stock that you own as collateral. As an investor, you have the ability to borrow money against the securities in your brokerage accounts. When you do this, your broker will issue cash based on the notional value of your collateralized securities.

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That part seems pretty rational. 

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But what about rehypothecation? This means your broker can recycle your collateral. They can use it as their own collateral to secure new loans. Or they can lend these shares out to other brokers seeking short sale locates. 

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And your broker can loan these shares out not just once, nor twice, nor thrice, but many, many times. 

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Rehypothecation is the ultimate act of conservation, an endless loop of recycled collateralization. John calls it “chain lending,” which doesn’t sound at all nefarious.  

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As John explains, an untold number of short sales may be facilitated by a single pot of collateral, which makes you wonder…

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What happens when you make a copy of a copy of a copy?

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The Math Doesn’t Math

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Well, here’s one thing that could happen. John raises the surreal case of Dole Foods, which was at the center of a $1.2 billion buyout in 2013. Shareholders were set to enjoy a profit of $2.74 per share. 

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Then the sale went through. 

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4,662 shareholders came forward to claim 49 million shares.

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The problem? Dole only had 36 million shares to go around.

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Naturally, this prompted legal action. In 2017, Delaware Court of Chancery Judge and Vice Chancellor J. Travis Laster ruled on the case, and further asserted “that the problems raised by short sales and trades during the three days before closing appear endemic to the depository system and hence likely infect every claims process.’’

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Textbook abusive naked short selling, right? 

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Not where Wall Street is concerned. 

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“You’d get in a room with the lawyers, and the answer was always ‘rehypothecation,’” says John.  “It’s not naked short selling and fails. It’s all rehypothecation.”

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It’s Actually Pronounced “Gaslighting”

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Fortunately, recent history is making it easier to see through big words like “rehypothecation.” Retail and options trading have gone mainstream. As a result,  a whole new generation of traders has become keenly aware that abusive naked short selling is real, that it definitely happens, and that it’s not ok. 

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Today, a whole new generation of traders is questioning the system. We innately understand that something just isn’t right here. 

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So what can we do about it? Tune in for the full episode of Let’s Talk Markets with John Welborn to find out. 

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