29 Dec 2011
How Close Are We to a Run on the Global Financial System?
Nine weeks after its bankruptcy, the general public still hasn’t quite realized the implications of the MF Global scandal.My own sense is, this is the first tremor of the earthquake that’s coming to the global financial system. And how the central banks and financial regulators treated the “Systemically Important Financial Institutions” that had exposure to MF Global—to the detriment of the ordinary, blameless customer who got royally ripped off in its bankruptcy—is both the template of how the next financial crisis will be handled, and an accelerator that will make the next crisis happen that much sooner.
So first off, what happened with MF Global?
Simple: It went bankrupt—because it made bad bets on European sovereign debt, by way of leveraging positions 100-to-1. Yeah, I know: Stupid. Anyway, they went bankrupt—which in and of itself is no big deal. It’s not as if it’s the first time in history that a brokerage firm has gone bust. But to me, the big deal in this case was the way the bankruptcy was handled.
Now there are several extremely serious aspects to the MF Global case: Specifically, how their customers were shut out of their brokerage accounts for over a week following the bankruptcy, which made it impossible for those customers to sell out of their positions, and thus caused them to lose serious money; and of course how MF Global was more adept than Mandrake the Magician at making money disappear—about $1 billion, in fact, which still hasn’t turned up. These are quite serious issues which merit prolonged discussion, investigation, prosecution, and ultimately jailtime.
But for now, I want to discuss one narrow aspect of the MF Global bankruptcy: How authorities (mis)handled the bankruptcy—either willfully or out of incompetence—which allowed customer’s money to be stolen so as to make JPMorgan whole.
From this one issue, it seems clear to me that we can infer what will happen when the next financial crisis hits in the nearterm future.
Brokerage firms hold clients’ money in what are known as segregated accounts. This is the money that brokerage firms hold for when a customer makes a trade. If a brokerage firm goes bankrupt, these monies are never touched—because they never belonged to the firm, and thus are not part of its assets.
Think of segregated accounts as if they were the content in a safety deposit box: The bank owns the vault—but it doesn’t own the content of the safety deposit boxes inside the vault. If the bank goes broke, the customers who stored their jewelry and pornographic diaries in the safe deposit boxes don’t lose a thing. The bank is just a steward of those assets—just as a brokerage firm is the steward of those customers’ segregated accounts.
But when MF Global went bankrupt, these segregated accounts—that is, the content of those safe deposit boxes—were taken away from their rightful owners—that is, MF Global’s customers—and then used to pay off other creditors: That is, JPMorgan.
(The mechanics of how this was done are interesting, but insanely complicated, and ultimately not relevant to this discussion. To grossly simplify, MF Global pledged customer assets to JPMorgan, in a process known as rehypothecation—customer assets which MF Global did not have a right to. Needless to say, JPMorgan covered its ass legally. Ethically? Morally? Black as night.)
This was seriously wrong—and this is the source of the scandal: Rather than being treated as a bankruptcy of a commodities brokerage firm under subchapter IV of the Chapter 7 bankruptcy law, MF Global was treated as an equities firm (subchapter III) for the purposes of its bankruptcy.
Why does this difference of a single subchapter matter? Because in a brokerage firm bankruptcy, the customers get their money first—because after all, it’s theirs—while in an equities firm bankruptcy, the customers are at the end of the line.
In the case of MF Global, what should have happened was for all the customers to get their money first. Then everyone else—including JPMorgan—would have picked over the remaining scraps. And the monies MF Global had already pledged to JPMorgan? They call it clawback for a reason.
The Chicago Mercantile Exchange, which handled the bankruptcy, should have done this—but instead, the Merc was more concerned with making JPMorgan whole than with protecting the money that rightfully belonged to MF Global’s 40,000 customers.
Thus these 40,000 MF Global customers had their money stolen—there’s no polite way to characterize what happened. And this theft was not carried out by MF Global—it was carried out by the authorities who were charged with handling the firm’s bankruptcy.
These 40,000 customers were not Big Money types—they were farmers who had accounts to hedge their crops, individuals owning gold (like Gerald Celente—here’s his account of what happened to him)—
—in short, ordinary investors. Ordinary people—and they got screwed by the regulators, for the sake of protecting JPMorgan and other big fry who had exposure to MF Global.
That, in a nutshell, is what happened.
Now, what does this mean?
It means that nobody’s money is safe. It means that regulators care more about protecting the so-called “Systemically Important Financial Institutions” than about protecting Ordinary Joe investors. It means that, when crunchtime comes, central banks and government regulators will allow SIFI’s to get better, and let the Ordinary Joes get fucked.
So far, so evil—but here comes the really troubling part: It is an open secret that there are more paper-assets than there are actual assets. The markets are essentially playing musical chairs—and praying that the music never stops. Because if it ever does—that is, if there is ever a panic, where everyone decides that they want their actual asset instead of just a slip of paper—the system would crash.
And unlike with fiat currency, where a central bank can print all the liquidity it wants, you can’t print up gold bullion. You can’t print up a silo of grain. You can’t print up a tankerful of oil.
Now, question: When is there ever a panic? When is there ever a run on a financial system?
Answer: When enough participants no longer trust the system. It is the classic definition of a tipping point. It’s not that all of the participants lose faith in the system or institution. It’s not even when most of the participants lose faith: Rather, it’s when a mere some of the participants decide they no longer trust the system that a run is triggered.
And though this is completely subjective on my part—backed by no statistics except scattered anecdotal evidence—but it seems to me that MF Global has shoved us a lot closer to this theoretical run on the system.
As I write this, a lot of investors whom I know personally—who are sophisticated, wealthy, and not at all the paranoid type—are quietly pulling their money out of all brokerage firms, all banks, all equity firms. They are quietly trading out of their paper assets and going into the actual, physical asset.
Note that they’re not trading into the asset—they’re simply exchanging their paper-asset for the real thing.
Why? MF Global.
“The MF Global scandal has made it clear that the integrity of the system has disappeared,” said a good friend of mine, Tuur Demeester, who runs Macrotrends, a Dutch-language newsletter out of Brugge. “The banks are insolvent, the governments are insolvent, and all that’s left is for the people to realize what’s going on—and that will start a panic.”
He hit it on the head: Some of the more sophisticated people—like Tuur, like some of my acquaintances, (like myself, frankly)—have realized that the MF Global scandal means that there is no safety for any paper investment: The integrity of the systems has been completely shattered. If in the face of one medium-sized brokerage firm going under, the regulators will openly allow ordinary people to be ripped off for the sake of protecting the so-called “Systemically Important Financial Institutions”—in this case JPMorgan—what will happen if there is a system-wide run? What if two or three MF Globals happen simultaneously?
Will they protect the citizens’ money? Or will they protect the “Systemically Important Financial Institutions”?
I think we know the answer.
And I think we all know the answer to the question of whether there will be crisis flashpoint in the near-term future: After all, as Demeester pointed out, all the banks and all the governments are broke.
Thus it’s only a matter of time before they come for your money.
At SPG, we’ve been putting together Scenarios for other black swan events which are becoming increasingly likely: What to do if the eurozone breaks up, what to do if you have to leave America, what to do if there is an Israeli-Iranian war, what to do if there is forced dollar devaluation, and so on.
Now, because of this open kleptocracy and cronyism being shown by the financial authorities in the wake of the MF Global bankruptcy, we’ve been obliged to put together a new Scenario, devoted exclusively to preparing for a run on the markets: What to do in order to protect your assets from regulatory malfeasance, if there is a system-wide MF Global-type breakdown and a subsequent run on the entire financial system.
And there will be such a run on the system: It’s only a matter of time. In fact, the handling of the MF Global affair has sped up the timeframe for this run on the system, because the forward-edge players—such as Demeester, myself, and my other acquaintances who understand the implications of the bankruptcy—realize that the regulators will side with the banksters, and not the ordinary investors: So we are preparing accordingly.
Once there is a full-on panic, anyone with money in the system will lose at least a big chunk of it, in one of two ways, or a combination thereof:
• One, the firms—commodities brokerage firms, equity firms, investment banks and commercial banks—will not allow people to withdraw the totality of their money, and/or they will put a withdrawal cap of some sort, enforced by the central banks and other regulatory bodies. (Like they did in Argentina.)
• Two, the central banks will “provide liquidity”—that is, print money—while simultaneously declaring a banking holiday to, quote, “calm the markets”. During that bank holiday, the currency will be devalued by double digits—which will mean that your cash holdings will essentially be taxed to save the banksters—again. (Like they did in Argentina.)
Thus apart from proving that the United States really is Argentina with nukes, the MF Global bankruptcy has proven something crucial: The central banks and government regulators have completely fallen into the trap of confusing the welfare of the “Systemically Important Financial Institutions” with the welfare of the system itself. They don’t seem to realize that the SIFI’s are actors within the system—not the system itself.
We critics of the current, corrupt state of affairs also sometimes confuse the SIFI’s with the system itself, whenever we say, “The whole system is corrupt!”
But the system is not corrupt—it’s the regulators and SIFI’s who are corrupt. If nothing else, the handling of the MF Global bankruptcy has proven that, once and for all. That’s why we’re pulling out our money now—while we still can.
Because once the general public catches on to what we already know . . . oh boy.
Source
24 Dec 2011
QE to infinity and beyond
At JSMineset.com, one commentator offers a pithy summary of this week’s long-term refinancing operation (LTRO) measures from the European Central Bank:
“Today the ECB provided a nearly half trillion euro loan to European banks.
More than 500 European banks took this 3 year loan at 1% interest.
The ECB plans to do another 3 year loan offer early next year (maybe February).
In exchange, banks are supposed to buy Sovereign Debt from European countries. Banks can pocket the huge differential in interest! What a Christmas present!
Jim, you said it first. Western governments are into QE to infinity!”
Given European banks deleveraging needs, however, sovereign bonds may not receive the bids that some had hoped. Reuters notes that bank analysts expect no more than €100 billion of these loans to be used to purchase more sovereign debt from the likes of Italy and Spain. Morgan Stanley estimates some €20-50 billion euros of Italian bonds could be bought. To put this in context, Italy must refinance about €150 billion of government debt from February-April alone. Likewise, French banks are expected to use the new loans to increase private sector lending and slow their deleveraging, rather than as a means of buying more sovereign debt.
So while this record liquidity injection may go a long way in terms of easing conditions in the European banking sector, the continent’s sovereign debt difficulties remain another matter. And while the next tranche of ECB bank loans scheduled for early next year will be just as heavily subscribed as this week’s was (who can say no to such cheap money?) as Reuters comments, the risk is that banks are becoming ever-more reliant on the central bank. This sentiment was echoed by Bank of England Governor Mervyn King, who remarked yesterday following a meeting of the European Systemic Risk Board in Berlin that “dependence on central banks has risen and signs are intensifying that stressed financial conditions are passing through to the real economy.”
In truth, markets are totally reliant on central banks. They have arguably been so for at least the last decade – following the decision from Alan Greenspan's Fed to target sub-2% interest rates as a response to the bursting of the Nasdaq bubble in 2000 and the US recession of 2001-2002. But in their endless “war” against deflationary threats and the dreaded spectre of “internal devaluation”, (a war in which savers necessarily become collateral damage) central banks face the need for constant escalation of policy responses.
This is in order to prevent accumulated malinvestments fostered by earlier rounds of easy money from collapsing. Each new round of monetary easing results in a greater total of misallocated capital, which makes going “cold turkey” that much more difficult for the economy. This means that if a deflationary collapse is to be delayed, the next intervention from the central bank must be even more aggressive than its previous intervention.
So what was regarded as loose monetary policy a decade ago becomes merely standard procedure today. This can be seen in the way in which zero-per cent interest rates have now become seemingly a semi-permanent part of central bank policy in developed nations, with the Fed promising to keep rates pinned to the floor until at least mid-2013.
Where does this end? Further purchases of dubious mortgages, nominal GDP targeting, purchases of stocks – perhaps even the targeting of specific levels on popular stock indexes. None can be ruled out as weapons that central banks might deploy in the coming years in order to support the existing (tottering) financial edifice.
Given the market’s sensitivity to central bank policies, it’s ironic that its missed perhaps the most significant central bank act of the last year: amid all the talk of how the ECB “isn’t doing enough” to “support” the eurozone (read: isn’t printing enough money), as ZeroHedge notes, the ECB has printed €500bn in the last six months – more than the Fed did in all of QE2.
Despite this largesse, gold and silver prices have been correcting since early September – which just goes to show that as far as the markets are concerned, perception matters just as much as reality. In this case, the perception that a “hawkish” ECB was prepared to countenance deflation and banking collapses in the eurozone, and that this was bearish for gold and silver prices.
In the words of ZeroHedge:
“Ironically, the broader "risk on" crew has not missed this, and while gold continues to be stuck in the old paradigm, it refuses to comprehend that explicit guarantees of trillions in debt (such as the LTRO repo operations), is an equivalent operation to printing money.
We fully expect the correlation arbs, which usually need someone to point out the glaringly obvious to them before they encode given relationships and correlation pairs into buy and sell signals, will very soon comprehend why the one most underpriced asset at this point, by orders of magnitude, is gold.”
And on that note, we at GoldMoney would like to wish you all a very Merry Christmas.
“Today the ECB provided a nearly half trillion euro loan to European banks.
More than 500 European banks took this 3 year loan at 1% interest.
The ECB plans to do another 3 year loan offer early next year (maybe February).
In exchange, banks are supposed to buy Sovereign Debt from European countries. Banks can pocket the huge differential in interest! What a Christmas present!
Jim, you said it first. Western governments are into QE to infinity!”
Given European banks deleveraging needs, however, sovereign bonds may not receive the bids that some had hoped. Reuters notes that bank analysts expect no more than €100 billion of these loans to be used to purchase more sovereign debt from the likes of Italy and Spain. Morgan Stanley estimates some €20-50 billion euros of Italian bonds could be bought. To put this in context, Italy must refinance about €150 billion of government debt from February-April alone. Likewise, French banks are expected to use the new loans to increase private sector lending and slow their deleveraging, rather than as a means of buying more sovereign debt.
So while this record liquidity injection may go a long way in terms of easing conditions in the European banking sector, the continent’s sovereign debt difficulties remain another matter. And while the next tranche of ECB bank loans scheduled for early next year will be just as heavily subscribed as this week’s was (who can say no to such cheap money?) as Reuters comments, the risk is that banks are becoming ever-more reliant on the central bank. This sentiment was echoed by Bank of England Governor Mervyn King, who remarked yesterday following a meeting of the European Systemic Risk Board in Berlin that “dependence on central banks has risen and signs are intensifying that stressed financial conditions are passing through to the real economy.”
In truth, markets are totally reliant on central banks. They have arguably been so for at least the last decade – following the decision from Alan Greenspan's Fed to target sub-2% interest rates as a response to the bursting of the Nasdaq bubble in 2000 and the US recession of 2001-2002. But in their endless “war” against deflationary threats and the dreaded spectre of “internal devaluation”, (a war in which savers necessarily become collateral damage) central banks face the need for constant escalation of policy responses.
This is in order to prevent accumulated malinvestments fostered by earlier rounds of easy money from collapsing. Each new round of monetary easing results in a greater total of misallocated capital, which makes going “cold turkey” that much more difficult for the economy. This means that if a deflationary collapse is to be delayed, the next intervention from the central bank must be even more aggressive than its previous intervention.
So what was regarded as loose monetary policy a decade ago becomes merely standard procedure today. This can be seen in the way in which zero-per cent interest rates have now become seemingly a semi-permanent part of central bank policy in developed nations, with the Fed promising to keep rates pinned to the floor until at least mid-2013.
Where does this end? Further purchases of dubious mortgages, nominal GDP targeting, purchases of stocks – perhaps even the targeting of specific levels on popular stock indexes. None can be ruled out as weapons that central banks might deploy in the coming years in order to support the existing (tottering) financial edifice.
Given the market’s sensitivity to central bank policies, it’s ironic that its missed perhaps the most significant central bank act of the last year: amid all the talk of how the ECB “isn’t doing enough” to “support” the eurozone (read: isn’t printing enough money), as ZeroHedge notes, the ECB has printed €500bn in the last six months – more than the Fed did in all of QE2.
Despite this largesse, gold and silver prices have been correcting since early September – which just goes to show that as far as the markets are concerned, perception matters just as much as reality. In this case, the perception that a “hawkish” ECB was prepared to countenance deflation and banking collapses in the eurozone, and that this was bearish for gold and silver prices.
In the words of ZeroHedge:
“Ironically, the broader "risk on" crew has not missed this, and while gold continues to be stuck in the old paradigm, it refuses to comprehend that explicit guarantees of trillions in debt (such as the LTRO repo operations), is an equivalent operation to printing money.
We fully expect the correlation arbs, which usually need someone to point out the glaringly obvious to them before they encode given relationships and correlation pairs into buy and sell signals, will very soon comprehend why the one most underpriced asset at this point, by orders of magnitude, is gold.”
And on that note, we at GoldMoney would like to wish you all a very Merry Christmas.
17 Dec 2011
Greeks fearing collapse of eurozone bailout pulled record sums from bank
A man walks through Athens' main food market. Greece abounds in stories of people lugging suitcases of cash out of the country to banks in Cyprus, London and Switzerland. Photograph: Yiorgos Karahalis/Reuters
An unprecedented exodus of capital from Greece – peaking in a record number of withdrawals from banks in recent months – has exacerbated the liquidity crisis now wracking the recession-hit country.
The latest figures released by the Bank of Greece reveal that in September and October alone investors pulled €12.3bn (£10.3bn) from domestic banks, spurred by fears of political uncertainty and economic collapse.
Overall, outflows have reached a record 25% since September 2009 – when household and corporate deposits stood at a peak of €237.5bn, the data showed.
Theodore Pelagidis, an economics professor at the University of Piraeus, said: "This is part of the death spiral of the recession as a result of austerity measures. People realise that contagion has come to banks and they are very afraid of losing their deposits. On average around €4bn-€5bn in capital flees the banking system every month."
The extraordinary figures back up anecdotal evidence that it is not just the super-rich behind the flight of funds.
Over the past year, as the eurozone debt crisis has intensified in the nation where it largely began, there have been countless cases of ordinary depositors hauling suitcases stuffed with cash to the safer destinations of Cyprus, London and Switzerland.
The weekly Proto Thema publication reckons that some 500,000 Greeks have moved money abroad, with a record 1.2m bank transfers being made over the last 18 months.
An estimated €40bn, amounting to 17% of the country's gross domestic product, is believed to have been withdrawn from the banking system over the past year.
Foreign banks with branches in Athens were facilitating the cash flight, the newspaper claimed, by encouraging Greek depositors to set up bank accounts abroad. The Swiss banking groups UBS and Credit Suisse had made it much easier for investors to open accounts in Geneva and Zurich by simplifying procedures.
"In this way, they are putting the nail in the coffin of liquidity in the Greek financial system," Proto Thema declared.
George Provopoulos, the governor of the Bank of Greece, recently said the exodus of capital had "stabilised" following the appointment of an interim coalition government, headed by the technocratic economistLucas Papademos.
Tasked with overseeing the latest European Union and the International Monetary Fund-sponsored €130bn bailout for Greece – a rescue package that will include a voluntary write-down on the value of Greek bonds – the new administration appears to have had a calming effect on a populace whose panic levels have risen amid persistent speculation of a Greek default and exit from the euro zone.
Tellingly, most of the outflows occurred in October, when a proposal by Athens' socialist former prime minister, George Papandreou, to hold a referendum over the debt deal shocked Europe and world markets, sparking feverish talk of an inevitable Greek departure from the EU.
"It's not only about capital flight," said one banker, referring to the massive withdrawals. "People have had to tap into their savings as household incomes have declined and they have had to pay bills.
"Instead of moving ahead with privatisations and shutting down useless public utilities, the [previous] government chose to exit the crisis by imposing Taliban tax rates and horizontal wage cuts, which has resulted in liquidity being limited and the Greek economy not operating as it should."
Source
Source
15 Dec 2011
Gold Is not Safe?
Investors aren't as keen to get their hands on gold any more. Photo: Peter MorrisThe thumping meted out to gold bulls overnight has certainly wiped some of the sheen from the precious metal's allure.
In the past four years, gold has been on a seemingly relentless march north, from levels close to $US600 until a few months ago when it appeared destined to smash through $US2000.
But gold traders have had second thoughts since September which has given the market a severe dose of the wobbles.
Overnight, gold dropped around $US92 an ounce, easily breaching the $US1600 barrier. And while it still is up 11 per cent for the year, the thinking among many traders is that it could go lower, possibly down to $US1400.
Exactly why this has happened is not easily explained. As fear grips money markets, and Europe continues to teeter on the brink of political self-destruction, gold ordinarily would be the natural haven of choice for investors too nervous for stocks and bonds.
But that enormous run up in recent years has lured investors into taking profits, for there are precious few assets in recent years that have been in the black. Many are looking to offset losses in other areas. There are plenty to choose from in that department. Bond markets and stocks have been hugely volatile for the best part of a year.
The other concern weighing on sentiment is the outlook for inflation. When the US Federal Reserve began printing money to kickstart the economy - and attempt to minimise debt by creating inflation - traders en masse jumped on board the gold bandwagon.
Recession fear trumps inflation
In more recent months, however, the concerns in Europe have overshadowed the fear of inflation. Now, the worry is that a recession in Europe will dampen global growth, taking the heat out of inflation.
While the European Central Bank has shunned the Fed strategy of printing cash to fund bond purchases of distressed nations like Italy, it is under plenty of pressure to do so as a way of extricating Europe from its immediate problems.
For as long as it retains its resolve to avoid the inflation cure, the euro will continue to struggle, the US dollar will shift higher and gold will weaken. But if it does succumb to the pressure and embark on that questionable strategy, the focus again will switch to gold.
Read more:
Here is a poll on what the Sheeple are picking as the safest place to park your cash.
Poll: With markets so volatile, where do you think is the safest place to park your money?
Shadow Banking Driving Gold Price to Xmas Present Levels
In the November monthly report, I mentioned how the MF Global collapse was a really big deal because it further shattered the one major commodity that holds financial markets together – trust. When investors lose trust in a 'system' meant to safeguard their wealth, uncertainty, illiquidity and volatility ensue.
I was only half right. This is a really, really big deal. And not just because MF Global stole client money. The investigations into its downfall have revealed a system of finance so rotten and corrupt that you won't even believe it possible. Making things much, much worse, is that this system is legal.
So sit back and prepare to be shocked. The whole idea around the SMSI service is to encourage you to think differently about your wealth. Well, if you don't do so after today, I'm not sure you ever will.
What is going on in financial markets is truly momentous. By the end of this issue, you'll understand why gold and silver are getting hammered right now – and why this will prove to be one of the great buying opportunities of this historic bull market in precious metals.
You'll also see why, despite showing an apparent reluctance to do so in today's FOMC (Federal Open Market Committee) announcement, the US Federal Reserve will have to resort to another round of money printing, most likely sometime in January.
There is a lot going on in global financial markets at the moment – Europe and China are the obvious areas of focus. But the macroeconomic climate in these regions is a just a sideshow. To understand what is really going on you need to look under the hood.
And it starts with MF Global. For a brief background story, please read the November monthly. I incorrectly thought MF Global was a simple story of theft. That is, use of client money (that should have resided in segregated counts) to fund the company's speculative investments.
It turns out it is much more than that. It could well transpire that much of the $1.2 billion in missing client funds was legalised theft.
How could that happen? Let me introduce you to the arcane world of shadow banking. I'll try and keep it as simple as possible.
First, let's start with normal banking. When you deposit funds in a bank account, the bank takes that money and lends it to someone else, usually only setting aside a small portion as a reserve. These reserves are enough to satisfy a small number of people wanting their cash back at any particular time. But, if everyone loses confidence in the bank and wants their cash back at the same time, the bank will collapse. It simply doesn't have enough liquid assets (cash) to satisfy the demand from customers.
That's how the traditional banking system works.
The shadow banking system works in much the same way except it is much larger, unregulated and far more risky.
When you're dealing in amounts in the hundreds of millions, you don't usually deposit your funds in a traditional bank. The traditional banking system in the US only insures amounts up to around US$250,000. It's deposit insurance for the little guy.
So big depositors (and big borrowers) play in the shadow banking system. The interest rate is usually a little better and insurance takes the form of 'collateral', which is the simple ownership of a security, like a US treasury bond, while funds are on deposit. Instead of a guarantee that your deposit is safe, you get a treasury bond.
Shadow banking is for the financial behemoths, like sovereign wealth funds, hedge funds, large corporations, investment banks and their brokerages, governments etc. It's very complex and only a small percentage of financial market participants would know what it's about.
But I think it's very important you get the gist of how the system works (and is currently imploding) so you can understand what the market is doing and where it is going.
As a broker dealer, MF Global was part of the shadow banking system. It took money in from clients. But instead of just acting as a transactor of trades and custodian of client funds, it used those monies for itself. But the thing is, it might not have been illegal.
You might find this hard to believe, but US and UK securities law allows client funds (that are being held as security against the client's position) to be used by the holder of those funds to place new bets.
Say you have $1,000 worth of futures with MF Global, but have only put up $700 of your own money. MF Global has lent you $300. Under US rules, MF Global is allowed to use the $700 worth of securities that you think you own and post that as collateral for its own trading activity.
In the UK, there are no limits. The broker can take the whole amount and use it as collateral for its own trades. It's trading on someone else's money – and taking the profits for yourself. It's no surprise then that MF Global was operating out of London, where there were no limits on the use of client funds (as were Lehman Brothers and AIG before their bankruptcies).
The process I have just described is called hypothecation and re-hypothecation. You may have heard of it recently. It refers to the fact that when someone puts up collateral for a loan in the shadow banking system, the creditor 'hypothetically' owns that collateral. And it can then re-lend, or 're-hypothecate' the collateral onto someone else, for its own benefit
Fractional Reserve Banking on Steroids
This principle of hypothecation and re-hypothecation extends across the whole shadow banking system. Depositors' funds are taken, re-lent, and the next party in the chain does the same thing. This goes on and on until the chain of actual ownership of anything resembling a real asset is so long and tenuous a puff of wind would break it.
It's all about using other people's money to make a profit. It's like fractional reserve banking (where your local bank lends your money to someone else) on steroids. And because the system is so opaque and unregulated, no one knows where the risks are pooling.
This re-hypothecation of client money means the shadow banking system is far more leveraged that what official figures suggest. By how much no one knows. The IMF guessed that by the end of 2007 it could have been as high as 4 times. Even if it's only twice as large now, it's still massive. Officially, there's around US$15 trillion in the shadow banking system.
In the case of MF Global, it made a bad bet with re-hypothecated client money. That's why clients won't get their money back. It wasn't stolen in the way you normally think of a theft.
Essentially, the asset you thought you had was 'sold' and put into something else. When that 'something else' didn't pay off, your asset disappeared up, or down, the chain of other people using other people's money.
This is why the issue is so huge. It is systematic theft and when everyone realises this, confidence in the system will disintegrate.
It's already happening. The problems in the European banking system have obvious macroeconomic foundations. But the deleveraging of the shadow banking system is making these problems much worse. That's because the shadow banks are (or more accurately were) major funders of the European banks. When they pull their funding, the Euro banks will have to go to the ECB for cash... and/or sell assets.
A subscriber sent an email in today asking why the ECB's recent offer of unlimited cash to the euro banks wasn't having a negative effect on the euro and a positive effect on gold. I think it's partly to do with the fact this liquidity injection by the ECB isn't new liquidity. It's merely replacing the disappearing liquidity from the shadow banks. But the gold story is more complex and murkier than that.
What has gold got to do with it?
Indeed, just what has gold got to do with it? A lot. Much more than you would think actually. To introduce gold to our story, let's start with this recent article from the Financial Times:
It appears that the faulty plumbing connections in the euro-area banking system are now creating something I have never seen before: a crisis of confidence in a monetary system that leads to a frantic selloff in gold.
The partnership between the Federal Reserve and European Central Bank to provide hundreds of billions of relatively low-cost dollars for euro-area banks should have relieved the pressure to come up with greenbacks. Yet gold market people say European commercial banks are being driven to lend gold for dollars at negative interest rates just to raise some extra cash for a few weeks. There's not a lot of transparency about where the banks are getting the gold they are lending out, but it could be lent to them by either their national central banks or by gold exchange-traded funds.
Read that last sentence carefully. Banks don't own any gold. So they can't be selling it. But they could be selling someone else's gold. Or, using our new found lingo, they could be re-hypothecating gold held by various ETFs (exchange traded funds), which just so happen to have large banks as their trustees and/or custodians.
Gold has corrected sharply in the past week and I would put that down to two things:
1. Selling in the paper/futures markets as leveraged players dump their positions. The MF Global situation should also be waking players up to the fact the futures markets are rigged and they are closing down their positions, exacerbating the selling.
2. New supply of physical gold coming from the banks, via the ETFs, as per the article above.
Relative to the amount of 'money' in the world, the gold market is tiny. So the rise in the gold price over the past decade might seem impressive. But in absolute dollar terms, it's minimal compared to the credit created by central banks and the traditional and shadow banking systems that they oversee.
Now you could argue that gold is falling because these fragile credit markets are themselves deflating (at least the shadow banking system is), which on the surface makes sense. But when you consider that the gold market is itself a type of fractional reserve system, whereby the ounce you think you own is actually owned by a number of other parties, then you can see how gold moves with the credit system itself.
The irony of this is profound. You own gold because it is meant to protect you from all the failings of the fractional reserve banking and shadow banking system we are all caught up in. You own gold because it is no one else's liability. It is outside the 'system'.
While it might not be apparent now, the MF Global collapse will be the trigger that breaks gold away from the fractional reserve banking system. It will send a very strong signal to those who own gold in any form other than physical (i.e. you hold it yourself or store it outside the banking system) that their insurance policy is worthless. When this realisation dawns and big money demands delivery of physical metal to vaults outside of the banking system, the gold fireworks will begin in earnest.
In another irony, it will be the deleveraging of the fractional gold market that leads to its price explosion. That's because there is not enough gold (at current prices) to satisfy the demand for REAL gold. Not paper gold or re-hypothecated gold.
So do not be spooked out of your gold position at this point. If you are underweight, or want to get more exposure, this is a great time to do so. I have long advised against owning ETFs and I reiterate that advice strongly now. If you own an ETF, sell it and buy physical. There is a high likelihood that at some point the gold position you thought you had will not be yours at all. It will have been lent out to someone else who went bankrupt...and your gold will have disappeared down the chain of related counterparty failures.
As for the rest of the 'system', the Fed will have no option but to print more money. Early in the new year is my best guess. As the ramifications of the MF Global failure continue to reverberate, more money will flee the shadow banking system. At the very least, participants will make sure their funds are not re-hypothecated by signing agreements to that effect. This will continue to have a deflationary effect. Hence the Fed stepping in. The battle between inflation and deflation continues.
I was only half right. This is a really, really big deal. And not just because MF Global stole client money. The investigations into its downfall have revealed a system of finance so rotten and corrupt that you won't even believe it possible. Making things much, much worse, is that this system is legal.
So sit back and prepare to be shocked. The whole idea around the SMSI service is to encourage you to think differently about your wealth. Well, if you don't do so after today, I'm not sure you ever will.
What is going on in financial markets is truly momentous. By the end of this issue, you'll understand why gold and silver are getting hammered right now – and why this will prove to be one of the great buying opportunities of this historic bull market in precious metals.
You'll also see why, despite showing an apparent reluctance to do so in today's FOMC (Federal Open Market Committee) announcement, the US Federal Reserve will have to resort to another round of money printing, most likely sometime in January.
There is a lot going on in global financial markets at the moment – Europe and China are the obvious areas of focus. But the macroeconomic climate in these regions is a just a sideshow. To understand what is really going on you need to look under the hood.
And it starts with MF Global. For a brief background story, please read the November monthly. I incorrectly thought MF Global was a simple story of theft. That is, use of client money (that should have resided in segregated counts) to fund the company's speculative investments.
It turns out it is much more than that. It could well transpire that much of the $1.2 billion in missing client funds was legalised theft.
How could that happen? Let me introduce you to the arcane world of shadow banking. I'll try and keep it as simple as possible.
First, let's start with normal banking. When you deposit funds in a bank account, the bank takes that money and lends it to someone else, usually only setting aside a small portion as a reserve. These reserves are enough to satisfy a small number of people wanting their cash back at any particular time. But, if everyone loses confidence in the bank and wants their cash back at the same time, the bank will collapse. It simply doesn't have enough liquid assets (cash) to satisfy the demand from customers.
That's how the traditional banking system works.
The shadow banking system works in much the same way except it is much larger, unregulated and far more risky.
When you're dealing in amounts in the hundreds of millions, you don't usually deposit your funds in a traditional bank. The traditional banking system in the US only insures amounts up to around US$250,000. It's deposit insurance for the little guy.
So big depositors (and big borrowers) play in the shadow banking system. The interest rate is usually a little better and insurance takes the form of 'collateral', which is the simple ownership of a security, like a US treasury bond, while funds are on deposit. Instead of a guarantee that your deposit is safe, you get a treasury bond.
Shadow banking is for the financial behemoths, like sovereign wealth funds, hedge funds, large corporations, investment banks and their brokerages, governments etc. It's very complex and only a small percentage of financial market participants would know what it's about.
But I think it's very important you get the gist of how the system works (and is currently imploding) so you can understand what the market is doing and where it is going.
As a broker dealer, MF Global was part of the shadow banking system. It took money in from clients. But instead of just acting as a transactor of trades and custodian of client funds, it used those monies for itself. But the thing is, it might not have been illegal.
You might find this hard to believe, but US and UK securities law allows client funds (that are being held as security against the client's position) to be used by the holder of those funds to place new bets.
Say you have $1,000 worth of futures with MF Global, but have only put up $700 of your own money. MF Global has lent you $300. Under US rules, MF Global is allowed to use the $700 worth of securities that you think you own and post that as collateral for its own trading activity.
In the UK, there are no limits. The broker can take the whole amount and use it as collateral for its own trades. It's trading on someone else's money – and taking the profits for yourself. It's no surprise then that MF Global was operating out of London, where there were no limits on the use of client funds (as were Lehman Brothers and AIG before their bankruptcies).
The process I have just described is called hypothecation and re-hypothecation. You may have heard of it recently. It refers to the fact that when someone puts up collateral for a loan in the shadow banking system, the creditor 'hypothetically' owns that collateral. And it can then re-lend, or 're-hypothecate' the collateral onto someone else, for its own benefit
Fractional Reserve Banking on Steroids
This principle of hypothecation and re-hypothecation extends across the whole shadow banking system. Depositors' funds are taken, re-lent, and the next party in the chain does the same thing. This goes on and on until the chain of actual ownership of anything resembling a real asset is so long and tenuous a puff of wind would break it.
It's all about using other people's money to make a profit. It's like fractional reserve banking (where your local bank lends your money to someone else) on steroids. And because the system is so opaque and unregulated, no one knows where the risks are pooling.
This re-hypothecation of client money means the shadow banking system is far more leveraged that what official figures suggest. By how much no one knows. The IMF guessed that by the end of 2007 it could have been as high as 4 times. Even if it's only twice as large now, it's still massive. Officially, there's around US$15 trillion in the shadow banking system.
In the case of MF Global, it made a bad bet with re-hypothecated client money. That's why clients won't get their money back. It wasn't stolen in the way you normally think of a theft.
Essentially, the asset you thought you had was 'sold' and put into something else. When that 'something else' didn't pay off, your asset disappeared up, or down, the chain of other people using other people's money.
This is why the issue is so huge. It is systematic theft and when everyone realises this, confidence in the system will disintegrate.
It's already happening. The problems in the European banking system have obvious macroeconomic foundations. But the deleveraging of the shadow banking system is making these problems much worse. That's because the shadow banks are (or more accurately were) major funders of the European banks. When they pull their funding, the Euro banks will have to go to the ECB for cash... and/or sell assets.
A subscriber sent an email in today asking why the ECB's recent offer of unlimited cash to the euro banks wasn't having a negative effect on the euro and a positive effect on gold. I think it's partly to do with the fact this liquidity injection by the ECB isn't new liquidity. It's merely replacing the disappearing liquidity from the shadow banks. But the gold story is more complex and murkier than that.
What has gold got to do with it?
Indeed, just what has gold got to do with it? A lot. Much more than you would think actually. To introduce gold to our story, let's start with this recent article from the Financial Times:
It appears that the faulty plumbing connections in the euro-area banking system are now creating something I have never seen before: a crisis of confidence in a monetary system that leads to a frantic selloff in gold.
The partnership between the Federal Reserve and European Central Bank to provide hundreds of billions of relatively low-cost dollars for euro-area banks should have relieved the pressure to come up with greenbacks. Yet gold market people say European commercial banks are being driven to lend gold for dollars at negative interest rates just to raise some extra cash for a few weeks. There's not a lot of transparency about where the banks are getting the gold they are lending out, but it could be lent to them by either their national central banks or by gold exchange-traded funds.
Read that last sentence carefully. Banks don't own any gold. So they can't be selling it. But they could be selling someone else's gold. Or, using our new found lingo, they could be re-hypothecating gold held by various ETFs (exchange traded funds), which just so happen to have large banks as their trustees and/or custodians.
Gold has corrected sharply in the past week and I would put that down to two things:
1. Selling in the paper/futures markets as leveraged players dump their positions. The MF Global situation should also be waking players up to the fact the futures markets are rigged and they are closing down their positions, exacerbating the selling.
2. New supply of physical gold coming from the banks, via the ETFs, as per the article above.
Relative to the amount of 'money' in the world, the gold market is tiny. So the rise in the gold price over the past decade might seem impressive. But in absolute dollar terms, it's minimal compared to the credit created by central banks and the traditional and shadow banking systems that they oversee.
Now you could argue that gold is falling because these fragile credit markets are themselves deflating (at least the shadow banking system is), which on the surface makes sense. But when you consider that the gold market is itself a type of fractional reserve system, whereby the ounce you think you own is actually owned by a number of other parties, then you can see how gold moves with the credit system itself.
The irony of this is profound. You own gold because it is meant to protect you from all the failings of the fractional reserve banking and shadow banking system we are all caught up in. You own gold because it is no one else's liability. It is outside the 'system'.
While it might not be apparent now, the MF Global collapse will be the trigger that breaks gold away from the fractional reserve banking system. It will send a very strong signal to those who own gold in any form other than physical (i.e. you hold it yourself or store it outside the banking system) that their insurance policy is worthless. When this realisation dawns and big money demands delivery of physical metal to vaults outside of the banking system, the gold fireworks will begin in earnest.
In another irony, it will be the deleveraging of the fractional gold market that leads to its price explosion. That's because there is not enough gold (at current prices) to satisfy the demand for REAL gold. Not paper gold or re-hypothecated gold.
So do not be spooked out of your gold position at this point. If you are underweight, or want to get more exposure, this is a great time to do so. I have long advised against owning ETFs and I reiterate that advice strongly now. If you own an ETF, sell it and buy physical. There is a high likelihood that at some point the gold position you thought you had will not be yours at all. It will have been lent out to someone else who went bankrupt...and your gold will have disappeared down the chain of related counterparty failures.
As for the rest of the 'system', the Fed will have no option but to print more money. Early in the new year is my best guess. As the ramifications of the MF Global failure continue to reverberate, more money will flee the shadow banking system. At the very least, participants will make sure their funds are not re-hypothecated by signing agreements to that effect. This will continue to have a deflationary effect. Hence the Fed stepping in. The battle between inflation and deflation continues.
14 Dec 2011
Europe Using US as Model to Fix Debt Crisis
European policymakers are taking a page out of their American counterparts' playbook to address their burgeoning sovereign debt crisis, banking analyst Dick Bove said.
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The European Central Bank already has begun its own version of quantitative easing, the program used by the Federal Reserve to recapitalize banks during the financial crisis that exploded in 2008, said Bove, vice president of equity research at Rochdale Securities.
At the same time, Bove said the ECB is well on its way to a "partial nationalization" of European banks, in which it will take equity stakes in the institutions as it seeks to stabilize the financial system.
The end result could be a boon for banks in the US and elsewhere that will benefit from the pain their European competitors will have to endure, Bove believes.
"The suffering in Europe may impact the rest of the world. However, there will be significant opportunities for non-Euro banks if this train of events occurs," Bove said in a research note. "The Euro zone banks will now become quasi utilities. Thus, the non-Euro zone banks will begin to fund the private sector companies that the Euro zone banks cannot handle."
Comparisons between the current state of European banking, which is bracing against the losses the system will take from likely national debt defaults, and the situation in 2008 when U.S. banks took massive writedowns from subprime mortgage losses, are easy to make.
Both suffered as much or more from illiquidity as insolvency, and solutions to both situations focus heavily on government backstop measures to ensure that capital remains flowing.
A move starting Dec. 21 that will allow European banks to borrow at low rates and in turn buy up sovereign debt looks, to Bove, "suspiciously likequantitative easing ."
In the U.S. Fed's QE measures, it slashed interest rates to near zero and bought up mortgage securities and government debt to recapitalize the banks and get money flowing through the system.
The European version also includes low rates and incentives for banks to buy sovereign debt.
A notable difference: The ECB will not buy the debt itself, allowing it to avoid navigating the political minefield in which the Fed found itself.
"The reason that the ECB is not opening the flood gates to buy sovereign bonds in unlimited amounts is due to what happened in the United States," Bove said. "In this country, once the Federal Reserve made it known it would use quantitative easing to buy Treasury debt, the Congress abandoned any attempt to deal with U.S. deficit. The ECB has learned this lesson and is not letting European governments slide back into their old habits. It wants some discipline."
In exchange for the loans, European banks will have to sell equity and comply with stringent capital requirements.
"European banks must sell equity and buy sovereign debt. They will be forced by these parameters to abandon private sector offerings and private sector clients," Bove said. "The clients that will be the first to go will be those outside each bank’s country."
Similarly, Bove sees two possible solutions coming to address the complications brought about because the widely disparate European nations must abide by the rules of the same currency.
He predicts a possible "pseudo-euro" of lower quality issued to heavily indebted countries, which then can default on their obligations and devalue their currencies in order to cheapen their debt.
In the second case, he sees "partial nationalization" as governments purchase stakes in the European banks, in much the same way the US government took positions in Wall Street's largest financial players.
"This program may actually start today with a Commerzbank sale of stock to the German government," Bove said. "The problem with this approach is that the private sector is starved for funds and this causes a significant recession of greater than normal longevity."
For Bove, all of the scenarios point towards opportunities for US banks, which have gotten clobbered this year over concerns that the European crisis will spread across the Atlantic and infect the American financial system. He said the situation will be much like the 1990s when US banks took clients from failing Japanese institutions.
"This is not a phenomenon that will begin; it began months ago," he said. "The fear of contagion is a myth. The ability to gain market share is reality."
Source
Source
10 Dec 2011
The Gold "Rehypothecation" Unwind Begins: HSBC Sues MF Global Over Disputed Ownership Of Physical Gold
That paper gold, in the form of electronic ones and zeros, typically used by various gold ETFs, or anything really that is a stock certificate owned by the ubiquitous Cede & Co (read about the DTCC here), is in a worst case scenario immediately null and void as it is, as noted, nothing but ones and zeros on some hard disk that can be formatted with a keystroke, has long been known, and has been the reason why the so called gold bugs have always advocated keeping ultimate wealth safeguards away from any form of counterparty risk. Which in our day and age of infinite monetary interconnections, means virtually every financial entity. After all, just ask Gerald Celente what happened to his so-called gold held at MF Global, or as it is better known now: "General Unsecured Claim", which may or may not receive a pennies on the dollar equitable treatment post liquidation. What, however, was less known is that physical gold in the hands of the very same insolvent financial syndicate of daisy-chained underfunded organizations, where the premature (or overdue) end of one now means the end of all, is also just as unsafe, if not more. Which is why we read with great distress a just broken story by Bloomberg according to which HSBC, that other great gold "depository" after JP Morgan (and the custodian of none other than GLD) is suing MG Global "to establish whether he or another person is the rightful owner of gold worth about $850,000 and silver bars underlying contracts between the brokerage and a client." The notional amount is irrelevant: it could have been $0.01 or $1 trillion: what is very much relevant however, is whether or not MF Global was rehypothecating (there is that word again), or lending, or repoing, or whatever you want to call it, that one physical asset that it should not have been transferring ownership rights to under any circumstances. Essentially, this is at the heart of the whole commingling situation: was MF Global using rehypothecated client gold to satisfy liabilities? The thought alone should send shivers up the spine of all those gold "bugs" who have been warning about precisely this for years. Because the implications could be staggering.
Probably the core primary consequence of this discovery, which obviously has a factual basis, or else it would not lead to an actual lawsuit between two "reputable" firms (aka ponzi participants), is whether gold in the GLD warehouse, supervised by HSBC, is truly theirs, or has it all been hypothecated from some other broker who never really had the asset or the liquidity, and so on in what effectively can be an infinite chain of repledging one asset to countless counterparties. Because if there is on cockroach...
Suffice to say, expect either a prompt settlement in this lawsuit, or a fervent denial by all parties involved that any gold was misplaced. Because here is the punchline: each physical gold or silver bar has a unique deisgnator that should never be replicated, yet this is precisely what happened to lead to the lawsuit! In a non-banana world, there should never be any debate over who owns a given physical asset, as replicated ownership (note - not liens) effectively means someone stole the gold (or there was counterfeiting involved) and was never caught... until MF Global finally expired of course.
So in other words, is this the eureka moment when everyone realizes that any gold, be it paper or physical, is either a irrelevant electronic binary claim held in some semiconductor, or at best an asset in some vault, that the brokerage next door suddenly also has claims over?
The end result is that the biggest loser is Joe Sixpack who bought the gold, and decided to keep it in a bank warehouse for "safekeeping" only to realize said gold will never be seen or heard of again.
From Bloomberg:
Five gold bars and 15 silver bars underlie eight Comex contracts between the brokerage and client Jason Fane of Ithaca, New York, London-based HSBC said in a court filing yesterday. Both parties have asserted claims to the bars, creating difficulties for HSBC, which is storing them, the bank said, asking a judge to decide who the rightful owner is.
“HSBC has received conflicting instructions regarding ownership and disposition of the property,” it said. “Accordingly, HSBC is exposed to multiple liabilities with respect to the disposition of the properties.”
According to Fane’s letter, the five Comex gold contracts are for an average of 99 ounces of gold each.
Giddens, who is liquidating the brokerage, has transferred about 38,000 commodity accounts to other firms. Three transfers of collateral made and pending will give commodity customers more than $4 billion of their assets, according to court filings.
The punchline:
The judge handling the bankruptcy said today he would deal in January with issues about distributing physical goods, such as gold and silver bars, after lawyers for some customers said they couldn’t get their share of the payouts because bars can’t be broken into pieces.
...indeed there is a reason why people say gold can not be diluted.
As for our advice: move any gold out of the LBMA or CME warehouse system immediately. And only treat any GLD investment as a day trading vehicle that can and will be lost the second there is a global liquidity or solvency freeze, because that particular asset will be wiped out as easily as "C:\format C:"
The brokerage case is Securities Investor Protection Corp. v. MF Global Inc., 11-02790, U.S. District Court, Southern District of New York (Manhattan). The parent’s bankruptcy case is MF Global Holdings Ltd., 11-bk-15059, U.S. Bankruptcy Court, Southern District of New York (Manhattan).
Update: as reader D points out, none of this should come as a surprise: after all the UK financial regulator, the FSA, already warned about each step of this unwind back in March 2010.
3.1 In this chapter we consider restricting two practices we believe pose an unacceptable risk to protecting client money and assets, and financial stability.
a) Restricting the placement of client money deposits within a group
Scope
3.2 Please note that our policy proposals in this section apply to UK authorised firms that place client money in client bank accounts held with a group bank, credit institution or qualifying money market fund. These requirements will not apply to incoming EEA firms conducting investment business, as under MiFID regulating client assets is a home state responsibility. We will consider extending these proposals to general insurance intermediaries when we begin reviewing CASS 5 – Insurance Mediation Activity in the first quarter of 2011.
Intra-group client money deposits
3.3 CASS contains guidance requiring firms to conduct an appropriate level of due diligence on institutions with which client money is held and to ensure deposits are appropriately diversified. We currently allow firms to hold client money with a deposit taker within the same group as the firm subject to appropriate due diligence and diversification.
3.4 There is no standard market practice for depositing client money within a group structure. For example, a number of investment firms take an explicit decision to hold client money deposits outside of the group, while other firms deposit significant amounts intra-group. Existing handbook provisions seek policy outcomes that ensure an appropriate level of diversification is achieved to protect clients’ money.
3.5 CASS contains provisions regarding a firm’s selection of a bank, credit institution or qualifying money market fund. A firm must exercise all due skill, care and diligence in selecting, appointing and periodically reviewing the institution where the client money is deposited and arrangements for holding this money. Handbook guidance also provides a list of matters a firm should consider in the process.
3.6 The money deposited at a group bank is held on trust by the firm for the firm’s clients, but it is treated as an ordinary banking deposit at the bank. Put another way, all client money at the end of a chain will eventually be held as a deposit. There is always a risk that a bank with which the deposit is held will enter insolvency proceedings and at this point it becomes possible that not all money deposited in client bank accounts as client money will be available for return to the underlying clients. Accordingly, the regime does not envisage a 100% return to clients in the event that client money is lost due to a bank’s insolvency, with CASS providing that clients will generally share rateably in the loss.
3.7 The issue under consideration is not that the funds are held as a deposit, but that when held within a group, there is an increased contagion risk that both the investment firm and the group bank or affiliate will fail simultaneously (or one will fail shortly after the other).
3.8 The resulting risk is that a firm will place an inappropriate amount of client money intra-group, usually as a source of liquidity, which has a lower cost of capital than external sources. Furthermore, as a group’s financial position deteriorates, there is a risk that firms within the group will deposit more client money intra-group to fund operations. This may give clients an inappropriate level of exposure to the bank’s credit risk. It also may lead to clients unfairly bearing the risk of the group as a whole, rather than just the individual firm. The existing sourcebook provisions which address this mismatch of firms’ and their clients’ incentives can be strengthened so the risk to clients is mitigated in the event of a firm’s default.
3.9 Imposing a hard limit on the proportion of client money which can be held intra-group is attractive and will mitigate concentration risk. However, limiting the level of client monies held within a group may increase overall credit risk where outside options are less highly rated. We have considered consulting on the basis of a 20% limit in order to fully identify stakeholders’ concerns, particularly if there is a knock-on effect on liquidity.
3.10 We have worked with firms during 2009 to reduce the concentration of client money held intra-group. During pre-consultation firms estimated that the proposals would result in an increase of approximately 10–25 basis points for additional costs, together with removing stable funding and increasing compliance and operational overheads.
3.11 Accordingly, we propose limiting the amount of client money held by a firm which can be deposited in intra-group client bank accounts to 20%. We understand firms may require some flexibility in holding money intra-group (for example, where a firm’s client specifically requests their money is held with that specific institution) and propose to address this on a case by case basis. We also propose changing existing guidance into a rule to provide a clear basis for our expectations.
3.12 We take this opportunity to highlight that our proposal to re-introduce a client money and asset return to the FSA (see below) which includes content regarding intra-group client money deposits.
b) Prohibiting the use of general liens in custodian agreements
Scope
3.13 Our proposals apply to all UK authorised investment firms and overseas branches of these UK firms. These requirements will not apply to incoming EEA fiirms conducting investment business as under MiFID regulating client assets is a home state responsibility.
3.14 Some firms in the UK appear to have inappropriately allowed custodians and subcustodians to include general liens covering, for example, group indebtedness to the custodian or sub-custodian in contractual agreements, or they have failed to pay due regard to this issue. As we have observed from LBIE’s insolvency, liens have contributed to significant delays or obstacles in an IP’s ability to recover assets from depots not under their direct control.
3.15 CASS 6.3.3G requires a firm to consider the terms of its agreements with third parties with which it will deposit a client’s safe custody assets. As part of this guidance, the firm should consider restrictions over the third party’s right to claim a lien, right of retention or sale over any safe custody asset in the account, as well as identifying client assets separately from assets belonging to the firm.
3.16 We believe the sourcebook can be enhanced with hard rules rather than guidance in this regard. This would enable us to effectively monitor compliance and take enforcement action where appropriate.
3.17 Accordingly, we are consulting on the basis of changing the existing guidance into a rule. We propose creating a rule that prohibits using general liens over client assets which are held under custodian agreements, except to cover the situation when a firm (or if the client has a direct relationship with the custodian, the client) does not pay custodian fees and charges to the third party holding the custody assets.
Probably the core primary consequence of this discovery, which obviously has a factual basis, or else it would not lead to an actual lawsuit between two "reputable" firms (aka ponzi participants), is whether gold in the GLD warehouse, supervised by HSBC, is truly theirs, or has it all been hypothecated from some other broker who never really had the asset or the liquidity, and so on in what effectively can be an infinite chain of repledging one asset to countless counterparties. Because if there is on cockroach...
Suffice to say, expect either a prompt settlement in this lawsuit, or a fervent denial by all parties involved that any gold was misplaced. Because here is the punchline: each physical gold or silver bar has a unique deisgnator that should never be replicated, yet this is precisely what happened to lead to the lawsuit! In a non-banana world, there should never be any debate over who owns a given physical asset, as replicated ownership (note - not liens) effectively means someone stole the gold (or there was counterfeiting involved) and was never caught... until MF Global finally expired of course.
So in other words, is this the eureka moment when everyone realizes that any gold, be it paper or physical, is either a irrelevant electronic binary claim held in some semiconductor, or at best an asset in some vault, that the brokerage next door suddenly also has claims over?
The end result is that the biggest loser is Joe Sixpack who bought the gold, and decided to keep it in a bank warehouse for "safekeeping" only to realize said gold will never be seen or heard of again.
From Bloomberg:
Five gold bars and 15 silver bars underlie eight Comex contracts between the brokerage and client Jason Fane of Ithaca, New York, London-based HSBC said in a court filing yesterday. Both parties have asserted claims to the bars, creating difficulties for HSBC, which is storing them, the bank said, asking a judge to decide who the rightful owner is.
“HSBC has received conflicting instructions regarding ownership and disposition of the property,” it said. “Accordingly, HSBC is exposed to multiple liabilities with respect to the disposition of the properties.”
According to Fane’s letter, the five Comex gold contracts are for an average of 99 ounces of gold each.
Giddens, who is liquidating the brokerage, has transferred about 38,000 commodity accounts to other firms. Three transfers of collateral made and pending will give commodity customers more than $4 billion of their assets, according to court filings.
The punchline:
The judge handling the bankruptcy said today he would deal in January with issues about distributing physical goods, such as gold and silver bars, after lawyers for some customers said they couldn’t get their share of the payouts because bars can’t be broken into pieces.
...indeed there is a reason why people say gold can not be diluted.
As for our advice: move any gold out of the LBMA or CME warehouse system immediately. And only treat any GLD investment as a day trading vehicle that can and will be lost the second there is a global liquidity or solvency freeze, because that particular asset will be wiped out as easily as "C:\format C:"
The brokerage case is Securities Investor Protection Corp. v. MF Global Inc., 11-02790, U.S. District Court, Southern District of New York (Manhattan). The parent’s bankruptcy case is MF Global Holdings Ltd., 11-bk-15059, U.S. Bankruptcy Court, Southern District of New York (Manhattan).
Update: as reader D points out, none of this should come as a surprise: after all the UK financial regulator, the FSA, already warned about each step of this unwind back in March 2010.
3.1 In this chapter we consider restricting two practices we believe pose an unacceptable risk to protecting client money and assets, and financial stability.
a) Restricting the placement of client money deposits within a group
Scope
3.2 Please note that our policy proposals in this section apply to UK authorised firms that place client money in client bank accounts held with a group bank, credit institution or qualifying money market fund. These requirements will not apply to incoming EEA firms conducting investment business, as under MiFID regulating client assets is a home state responsibility. We will consider extending these proposals to general insurance intermediaries when we begin reviewing CASS 5 – Insurance Mediation Activity in the first quarter of 2011.
Intra-group client money deposits
3.3 CASS contains guidance requiring firms to conduct an appropriate level of due diligence on institutions with which client money is held and to ensure deposits are appropriately diversified. We currently allow firms to hold client money with a deposit taker within the same group as the firm subject to appropriate due diligence and diversification.
3.4 There is no standard market practice for depositing client money within a group structure. For example, a number of investment firms take an explicit decision to hold client money deposits outside of the group, while other firms deposit significant amounts intra-group. Existing handbook provisions seek policy outcomes that ensure an appropriate level of diversification is achieved to protect clients’ money.
3.5 CASS contains provisions regarding a firm’s selection of a bank, credit institution or qualifying money market fund. A firm must exercise all due skill, care and diligence in selecting, appointing and periodically reviewing the institution where the client money is deposited and arrangements for holding this money. Handbook guidance also provides a list of matters a firm should consider in the process.
3.6 The money deposited at a group bank is held on trust by the firm for the firm’s clients, but it is treated as an ordinary banking deposit at the bank. Put another way, all client money at the end of a chain will eventually be held as a deposit. There is always a risk that a bank with which the deposit is held will enter insolvency proceedings and at this point it becomes possible that not all money deposited in client bank accounts as client money will be available for return to the underlying clients. Accordingly, the regime does not envisage a 100% return to clients in the event that client money is lost due to a bank’s insolvency, with CASS providing that clients will generally share rateably in the loss.
3.7 The issue under consideration is not that the funds are held as a deposit, but that when held within a group, there is an increased contagion risk that both the investment firm and the group bank or affiliate will fail simultaneously (or one will fail shortly after the other).
3.8 The resulting risk is that a firm will place an inappropriate amount of client money intra-group, usually as a source of liquidity, which has a lower cost of capital than external sources. Furthermore, as a group’s financial position deteriorates, there is a risk that firms within the group will deposit more client money intra-group to fund operations. This may give clients an inappropriate level of exposure to the bank’s credit risk. It also may lead to clients unfairly bearing the risk of the group as a whole, rather than just the individual firm. The existing sourcebook provisions which address this mismatch of firms’ and their clients’ incentives can be strengthened so the risk to clients is mitigated in the event of a firm’s default.
3.9 Imposing a hard limit on the proportion of client money which can be held intra-group is attractive and will mitigate concentration risk. However, limiting the level of client monies held within a group may increase overall credit risk where outside options are less highly rated. We have considered consulting on the basis of a 20% limit in order to fully identify stakeholders’ concerns, particularly if there is a knock-on effect on liquidity.
3.10 We have worked with firms during 2009 to reduce the concentration of client money held intra-group. During pre-consultation firms estimated that the proposals would result in an increase of approximately 10–25 basis points for additional costs, together with removing stable funding and increasing compliance and operational overheads.
3.11 Accordingly, we propose limiting the amount of client money held by a firm which can be deposited in intra-group client bank accounts to 20%. We understand firms may require some flexibility in holding money intra-group (for example, where a firm’s client specifically requests their money is held with that specific institution) and propose to address this on a case by case basis. We also propose changing existing guidance into a rule to provide a clear basis for our expectations.
3.12 We take this opportunity to highlight that our proposal to re-introduce a client money and asset return to the FSA (see below) which includes content regarding intra-group client money deposits.
b) Prohibiting the use of general liens in custodian agreements
Scope
3.13 Our proposals apply to all UK authorised investment firms and overseas branches of these UK firms. These requirements will not apply to incoming EEA fiirms conducting investment business as under MiFID regulating client assets is a home state responsibility.
3.14 Some firms in the UK appear to have inappropriately allowed custodians and subcustodians to include general liens covering, for example, group indebtedness to the custodian or sub-custodian in contractual agreements, or they have failed to pay due regard to this issue. As we have observed from LBIE’s insolvency, liens have contributed to significant delays or obstacles in an IP’s ability to recover assets from depots not under their direct control.
3.15 CASS 6.3.3G requires a firm to consider the terms of its agreements with third parties with which it will deposit a client’s safe custody assets. As part of this guidance, the firm should consider restrictions over the third party’s right to claim a lien, right of retention or sale over any safe custody asset in the account, as well as identifying client assets separately from assets belonging to the firm.
3.16 We believe the sourcebook can be enhanced with hard rules rather than guidance in this regard. This would enable us to effectively monitor compliance and take enforcement action where appropriate.
3.17 Accordingly, we are consulting on the basis of changing the existing guidance into a rule. We propose creating a rule that prohibits using general liens over client assets which are held under custodian agreements, except to cover the situation when a firm (or if the client has a direct relationship with the custodian, the client) does not pay custodian fees and charges to the third party holding the custody assets.
9 Dec 2011
China Monetary Easing- What does it mean?
Not surprisingly, the Reserve Bank of Australia cut interest rates for the second time in two months yesterday. The official rate is now down to 4.25 per cent. And if I'm right about the major China slowdown coming in 2012 (more on that below) you can expect to see further interest rate cuts next year.
That's great news if you're up to your neck in debt, but not so good if you're a saver. This interest rate shift – already underway – will have major implications for the Aussie economy and market next year. I'm going to devote a good portion of your next monthly edition, due out on 21 December, to what these implications are and more importantly, how it will affect our portfolio strategy.
In short though, here are some of the immediate issues to consider:
Official rates will probably fall further than they ordinarily would because of the banks' reluctance to pass on the cuts in full. Banks will try to maintain their world beating (and unsustainable) returns on equity by lowering interest on savings accounts straight away while holding off on cutting rates for borrowers. No real surprises there...
But this presents another problem for the banks. Lower interest rates on savings accounts will see previously strong deposit growth slow and probably reverse in 2012. This will only exacerbate the banks' funding costs, already pressured by the situation in Europe.
I'll go into this in much more detail in the monthly report but the point to think about here is that interest rate reductions will not pack the same punch as previous rate cutting cycles. This has implications for the banks and the housing market in particular.
China monetary easing – what does it mean?
The China bulls and 'soft landing' proponents got all excited when the People's Bank of China (PBoC) lowered its banks' required reserve ratio by 50 basis points last week, to 21 per cent. This was seen as a sign of the central bank using just one of the many 'tools' it has at its disposal.
The market loved it.
But let's put the move into perspective. First of all, what does it mean?
A reserve requirement ratio (RRR) of 21 per cent is the minimum amount of reserves China's banks must hold as a percentage of customer deposits. If you look at the chart below, you'll notice how China's RRR has increased sharply since about 2003.
This is because the RRR is used as a tool to try to offset the inflationary effects of maintaining a pegged currency. If you remember back to the October monthly report about why China would have a hard landing in 2012, one of the central themes was the yuan's peg to the US dollar. The peg is the mechanism that leads to lots of printing of yuan to offset the flow of dollars coming into China from the trade surplus with the US.
The dollars go into the foreign exchange (FX) account as an asset. On the other side of the ledger the PBoC creates yuan that sit as reserves in China's commercial banking system.
It's a bit complicated, I know. But what is important to understand is that the RRR is a function of China's rising FX reserves. The currently high RRR is not a sign of 'tight' monetary policy. It's purely a reflection of the ridiculous size of China's FX reserves.
And as I pointed out in the October monthly report, China's 2009–11 credit boom was hardly the result of tight monetary policy. So lowering the RRR might help at the margin but it won't increase the demand for credit and certainly won't reinflate China's property bubble.
That's great news if you're up to your neck in debt, but not so good if you're a saver. This interest rate shift – already underway – will have major implications for the Aussie economy and market next year. I'm going to devote a good portion of your next monthly edition, due out on 21 December, to what these implications are and more importantly, how it will affect our portfolio strategy.
In short though, here are some of the immediate issues to consider:
Official rates will probably fall further than they ordinarily would because of the banks' reluctance to pass on the cuts in full. Banks will try to maintain their world beating (and unsustainable) returns on equity by lowering interest on savings accounts straight away while holding off on cutting rates for borrowers. No real surprises there...
But this presents another problem for the banks. Lower interest rates on savings accounts will see previously strong deposit growth slow and probably reverse in 2012. This will only exacerbate the banks' funding costs, already pressured by the situation in Europe.
I'll go into this in much more detail in the monthly report but the point to think about here is that interest rate reductions will not pack the same punch as previous rate cutting cycles. This has implications for the banks and the housing market in particular.
China monetary easing – what does it mean?
The China bulls and 'soft landing' proponents got all excited when the People's Bank of China (PBoC) lowered its banks' required reserve ratio by 50 basis points last week, to 21 per cent. This was seen as a sign of the central bank using just one of the many 'tools' it has at its disposal.
The market loved it.
But let's put the move into perspective. First of all, what does it mean?
A reserve requirement ratio (RRR) of 21 per cent is the minimum amount of reserves China's banks must hold as a percentage of customer deposits. If you look at the chart below, you'll notice how China's RRR has increased sharply since about 2003.
This is because the RRR is used as a tool to try to offset the inflationary effects of maintaining a pegged currency. If you remember back to the October monthly report about why China would have a hard landing in 2012, one of the central themes was the yuan's peg to the US dollar. The peg is the mechanism that leads to lots of printing of yuan to offset the flow of dollars coming into China from the trade surplus with the US.
The dollars go into the foreign exchange (FX) account as an asset. On the other side of the ledger the PBoC creates yuan that sit as reserves in China's commercial banking system.
It's a bit complicated, I know. But what is important to understand is that the RRR is a function of China's rising FX reserves. The currently high RRR is not a sign of 'tight' monetary policy. It's purely a reflection of the ridiculous size of China's FX reserves.
And as I pointed out in the October monthly report, China's 2009–11 credit boom was hardly the result of tight monetary policy. So lowering the RRR might help at the margin but it won't increase the demand for credit and certainly won't reinflate China's property bubble.
China's Reserve Requirement Ratio
Source: BIS
Speaking of the property bubble, the rapid change in prices (to the downside) and sentiment over the past few months must be of concern to China's central planners. With inflation still elevated (predicted to be around 4.5 per cent in the 12 months to November) last week's cut to the RRR took the market by surprise.
The fact the PBoC acted while inflation is still a problem goes to show how worried the authorities are. The bottom line: This is a worrying sign and confirmation that China's slowdown is worse than expected.
But the market certainly didn't view things that way. This is where psychology comes into play. Despite loads of historical evidence to the contrary, investors have strong faith in authorities to manage the slowdown. You would've seen the same response when the Fed first cut interest rates – by a larger than usual 50 basis points – back in September 2007 in response to the bursting US housing bubble. And where did that... and the subsequent lowering of interest rates to zero... get them?
A rescue plan for the Eurozone – no, really.
This weekend – apparently – you'll be reading about the definitive rescue plan for the Eurozone. To be honest, I'm not sure what the actual plan is anymore and I don't know whether anyone else does either.
These euro engineers are really starting to lose the plot. Just a few days ago Merkozy (Merkel and Sarkozy in case you're not up to date with the latest European soap opera) told the holders of sovereign bonds that they would not suffer losses on any future bailouts. Who do these people think they are?
The promise is all about protecting banks and creditors and getting bond yields down to manageable levels in Spain and Italy. But it's insane. You can't tinker with the market mechanism (by declaring all reward and no risk) and not expect unintended consequences.
It's actually beginning to get a little scary. These career bureaucrats and politicians are sacrificing democracy and national sovereignty for the sake of the Euro project.
It will end badly.
As anyone who has been to Europe, or studied European history would know, the place is made up of many different countries, with different national identities, aspirations, animosities, cultures and beliefs. The only similarity is the currency. Trying to homogenise Europe for the sake of that artificially created construct will prove impossible.
But when ego and self-interest get in the way of common sense, guessing what happens next is hazardous.
This weekend's summit is all about delivering an outcome that will prolong the impossible. Markets have rallied in the 'hope' that something is in the works. My feeling is that Merkozy still doesn't really know what that something is. They'll go for the confidence inspiring headline – the bazooka play – but I think when 'the plan' is analysed it will come up short...again.
What isn't in doubt though is the Fed's desire to protect US banks. Last week's central bank intervention – where the Fed lowered the borrowing cost for European banks to borrow US dollars – was conducted because a very large French bank (allegedly Credit Agricole) was close to folding.
This would have caused a run on the European banking system, which in turn would have triggered all the insurance written on European banks via credit default swaps. US banks have written a huge amount of that insurance so Europe would bring down US banks too.
Hence the Fed's involvement. What that tells you is that systemic contagion will be avoided at all costs. As this global debt crisis deepens in the years to come (and it will) central banks will be forced to become even more involved in the markets.
It is still questionable whether equities in general will benefit materially from this intervention. But there should be little doubt that gold and silver will be the big winners.
Right now, precious metals is the only asset class I have a high conviction on over the next few years. There is simply too much debt, political incompetence, greed, corruption and intervention influencing the market for gold and silver not to continue rising in price.
So take this opportunity to continue to BUY/HOLD/ACCUMULATE the precious metals while we are in this consolidation phase. We are about four months into this consolidation period (see chart below) and my guess is it won't last much longer than six months, if that.
Silver's price structure is different (see chart below). It's currently trading just under its 50-day moving average (blue line). It silver breaks through this area I would expect some pretty rapid gains to follow.
But keep in mind silver is a heavily manipulated metal. Some of the biggest banks in the world have huge short positions in the silver futures market, which means they won't want to see it rise too quickly. So buy with a long-term view and learn to deal with the volatility.
Gold – Still in a consolidation phase
Source: Stockcharts
Silver – Ready to break higher?
Source: Stockcharts
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