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


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


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.
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