Lesson 9 of 25 · 6 min
A prime broker's failure, 2008: client assets and rehypothecation
Assets you thought were yours became a claim in an estate, because the agreement allowed them to be lent on.
Lehman Brothers filed for bankruptcy protection in September 2008, and its London entity entered administration the same week. For the firm's prime brokerage clients the consequence was not a trading loss. It was a question of property: which assets were theirs, and which were assets of an insolvent estate in which they held a claim.
The distinction turns on rehypothecation, the practice by which a broker takes client securities that sit as collateral and uses them for its own financing. Track 1 lesson 16 covers the clause itself. What mattered in 2008 was the limit: some agreements capped the amount at a multiple of what the client owed, while others, particularly those written under English law, permitted the broker to use the full amount with title passing to it.
Where title had passed, the client did not own a share; it owned an unsecured claim for the return of an equivalent one. Clients' positions were frozen at the moment of the filing, so hedges could not be adjusted and short positions could not be closed. Recoveries came through the administration over a period of years, and that period is itself a cost that no risk report had priced.
The episode changed practice measurably: clients spread balances across multiple prime brokers, negotiated caps on rehypothecation, and asked where assets were actually held rather than which name was on the statement. The mechanism to carry away is that custody is a legal fact, and it is decided by a clause, not by a screen.
Key terms
- Rehypothecation
- A broker's reuse of client collateral for its own borrowing. Permitted by agreement, invisible on a statement, and decisive if the broker fails.
- Segregation
- Holding client assets apart from the firm's own, so they are returnable rather than distributable. Only the un-rehypothecated part is genuinely segregated.
- Unsecured claim
- A right to be paid from whatever an insolvent estate collects, ranking behind secured creditors and settled in years rather than days.
Worked example
What a cap is actually worth
Illustrative figures scaled down so the arithmetic is followable; they are not the reported amounts. Client long positions of $6,400,000 financed with a $2,300,000 margin loan, under an agreement capping rehypothecation at 140 percent of the loan, with an illustrative estate recovery of 38 cents.
- Client net equity at the broker
- $4,100,000
- Amount the broker may reuse
- $3,220,000
- Assets genuinely segregated
- $3,180,000
- Claim value on the reused assets
- $1,223,600
- Recovery after setting off the loan
- $2,103,600
- Share of net equity recovered
- 51.3%
$6,400,000 − $2,300,000.
$2,300,000 × 1.40.
$6,400,000 − $3,220,000.
$3,220,000 × 0.38.
$3,180,000 + $1,223,600 − $2,300,000.
$2,103,600 ÷ $4,100,000.
The cap worked exactly as written and still exposed $3,220,000 of a $4,100,000 stake. With no cap, the exposed amount is the whole position.
Check yourself
A client holds $2,500,000 of positions against an $800,000 margin loan, with rehypothecation capped at 140 percent of the loan. The broker fails and the estate eventually pays 30 cents. What is recovered?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.