First Brands: Canary In The Rehypothecation Coal Mine?

The First Brands Group, manufacturer of auto parts, including Raybestos brakes and FRAM, filed for bankruptcy on September 29th. This bankruptcy is troubling in two ways.

First, per the ZeroHedge chart below, the price of First Brands loans fell by 80% in a day. In other words, the loan market had no clue of financial problems or accounting irregularities. To that end, financial investigators are discovering a complex maze of undisclosed off-balance sheet financing. Initially, it was thought that First Brands had about $6 billion in liabilities, but after some investigative work, it is now over $10 billion and growing.

Second is the issue of what appears to be the fraudulent rehypothecation of collateral backing the loans. Rehypothecation refers to using the same collateral for multiple loans and lenders. Here is an example:

• First Brands borrows $1 million from Lender A, backed with accounts receivable invoices of $2 million. The lender presumes that the collateral is more than enough to pay off the loan if First Brands fails to repay it.
• First Brands then goes to lender B and uses the same invoices to secure another $1 million loan.
• First Brands defaults. Lender A and B not only realize that First Brands can’t pay their debts, but they also do not have the exclusive rights to the collateral supporting the debt. Thus, the collateral is insufficient to cover their losses.
• The rehypothecation allowed First Brands to take on much more debt than would have otherwise been possible.

This event could have a ripple effect throughout the vendor financing industry, making it harder for small and mid-sized companies that regularly use trade financing to sustain operations. Furthermore, Jefferies Financial, one of First Brand’s bankers, may encounter some challenges. Per ZeroHedge:

As a result, Bloomberg reports that for Jefferies – who is, or rather was, First Brands’ banker for more than a decade – the speculation around its role in the sudden demise of First Brands has became too loud to ignore, and the bank has come under scrutiny for its relationship with the insolvent company and its spectacular collapse.

The Week Ahead

The bond market will be closed on Monday for the Columbus Day holiday. Like last week, due to the shutdown, we are unsure of what government economic data will be reported. That said, the media is reporting that the government is recalling some BLS employees deemed essential to release the September CPI report.

Thus, later in the week, the September BLS employment report could be released. CPI, PPI, and Retail are on the calendar, but even if the government shutdown ends, it is likely these reports will take some time to compile.

Given the lack of economic data, earnings reports should take center stage. This week features earnings from the big banks, including JPMorgan (NYSE:JPM), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), and Goldman Sachs (NYSE:GS), on Tuesday. Johnson & Johnson (NYSE:JNJ), Kinder Morgan (F:2KD), and American Express (NYSE:AXP) will also report this week.

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