MF Global On Steroids

There is no way over, under, around or through the fact that no progress will be made as long as the world is divided up between the rulers and the ruled and the ruled accept their lot...There has never been any shortage of those who want to rule. The problem has always been with the vast majority who are content to be ruled. Today’s global outcry for the manufacturing of more and more “money” out of thin air is an eloquent testimony. It shows that most people have no understanding of freedom, markets or money. Lacking such understanding - and having no desire to gain it - most people have accepted government as their masters.  - Bill Buckler, The Privateer

Before I get to the subject of the title, I wanted to just say that it's spiritually rewarding for me to make an assertion about something and then to be rewarded by being right once all the facts come out.  Last week Henry Blodget, unconvicted violator of securities laws, tried to pump up Facebook stock by saying that the Company's decision to buyout and retire employee stock at $19/share that was held back from the IPO was a stock buyback and signaled to the market that the stock was cheap.  I immediately called b.s. on that and suggested that it was nothing more than a disguised form of required W2 compensation tax-withholding: LINK

Turns out I was right and Blodget once again revealed his true nature as corrupt pump-n-dump stock analyst.  You can read about the details here:  LINK  In brief, FB's little manipulative maneuver there represents a required 45% State and Federal tax withholding on employee compensation that took the form of restricted stock units rather than a standard paycheck.  Henry, veritas liberabit vos, the truth will set you free...

With regard to my title, Bloomberg published an article Sunday night which described the new Wall Street gimmick called "collateral transformation:"  LINK  A big problem in the financial markets in Europe and in the U.S. is the scarcity of high quality "collateral" that can be used as margin "equity" against derivatives positions.  For the average retail brokerage customer, collateral is in the form of cash or a percentage of the value of stocks held in an account.  There are very strict regulations in place and actually enforced with retail broker accounts.

It's a whole different ballgame when it comes to multi-billion dollar bank repo transactions and multi, multi-billion dollar OTC derivatives transactions.  With repos, which give large banks short term liquidity funding, banks originally had to post Treasuries as collateral. Same with OTC derivatives. Over time, because of the growing demand and scarcity of Treasuries and Euro-sovereign bonds due to the growth in OTC derivatives and expansion of repo programs,  the Fed and ECB began to allow "lower quality" forms of collateral like mortgage-backed securities.  In fact, the ECB now allows an even wider basket of collateral.  And of course, now the Central Banks and clearing houses allow the use of gold as collateral.

But the market continues to be hampered by a lack of collateral.  And if banks and big investors can't post collateral for margin calls, the whole global Ponzi house of cards will collapse.  In order to address this, Wall Street had to figure out a way to repackage crap assets so they could be utilized as collateral that could be posted against extremely risky OTC derivatives positions. Ergo, "collateral transformation."  Just let that term roll around your tongue and the right side of your brain for a few moments.  It's such a grandiose and exalting term.  Like, the geniuses on Wall Street are going to metamorphize good collateral out of bad.

The way it works is that "collateral transformation" desks at the big bank will take crappy assets from big investors who are required to post more collateral against losing derivatives positions and exchange them for Treasuries.  The crap assets will be assessed some kind of discounted value, so if you need $100 million in Treasuries to post as collateral, you might have to come up with $120 million of "assessed" value in the crap assets.  Does this sound at all familiar?  Hint: AIG, Bear Stearns, Lehman, etc.   

In reality, "collateral transformation" is just fancy name for hypothecation.  In other words the big Wall Street banks will find Treasury bonds that can be posted as collateral and charge the counterparty a nice fee for this.  Theoretically the Treasuries can't come from customer accounts, but we saw with MF Global just how rigid this law turned out to be.  This is adding another layer of hypothecation in the financial market Ponzi scheme, only the collateral being posted to "back" the hypothecated Treasuries will crater in value in a bad market and there will be massive losses.  The fact is, Wall Street has taken the MF Global/JP Morgan model for collateral posting and injected it with steroids.  You can thank the Obama Government for enabling and allowing this.

One last point, if you read through the Bloomberg report, you'll note that Calpers (the California public pension management firm) has $224 billion under management, of which $30 billion is in the form of OTC derivatives.  I'm not really sure why Calpers has OTC derivatives in its pension portfolios, but OTC derivatives are completely inappropriate and unsuitable for pension funds.  I would be terrified if I were a Calpers pension fund stakeholder.  That aside, Calpers proudly announced that it will side-step the costs of "collateral transformation" by using Treasuries from its own in-house portfolios.  Again, this is a horrifying idea.   To play this out:  let's say you have your money in a Calpers Treasury fund;  Calpers needs to post more collateral against a losing OTC derivatives position in one of its super-duper high risk/high return funds;  Calpers will take Treasuries from your fund (hypothecate them) and use them as collateral for the other fund;  if the OTC derivative blow up, the counter-party to the trade keeps the Treasuries and your Treasury fund loses the Treasuries.

Now, this is an example in isolation, and ultimately if it were only on instance, the super-duper fund would have to compensate the Treasury fund for the loss.  But OTC derivatives blow-ups don't happen in isolation.  There is a very high degree of systemic correlation and the blow up in the Calpers trade will likely be accompanied by a daisy-chain of similar trades blowing up system-wide.  And then we have what happened in 2008 x 10...

Collateral transformation....remember portfolio insurance in the mid 1980's?  Remember the "flawless" derivatives hedging utilized by Long Term Capital in 1998?   The housing bubble/OTC derivatives bust in 2008?  These financial market disasters continue unabated and get worse successively.  "Collateral transformation" - I wonder when the "I can turn lead into gold" myth will be revived....