Wednesday, September 12, 2012

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....


  1. Own gold...@45 minutes...sorry MB hosting at cfr.

    A Conversation with Ray Dalio (Video)

  2. I Love you man......
    1Kg Lunar Dragon

  3. Unlike Navin (Steve Martin) in the movie "The Jerk", you really can tell the difference between shit and shinola, can't you? Good posting, Dave. Keep telling it like it is, brother.

  4. The following is a rhetorical question:

    In a world where every kind of financial instrument has almost incalculable counterparty risk what is the value of physical gold?

  5. This "collateral transformation' thing sounds a little like CDO's with a new name.

    Who knows what is/will be in this new investment package, good bonds, supposedly good bonds, muni bonds from Illinois and California, etc.

    If it sounds too good to be true it probably is and a fool and his money is soon parted.

    I think I will stick to physical PM's for the short, mid and long term.

  6. Agree with JMR777. In a year or two (or months? weeks? Tomorrow?) they'll be tranching out "high quality, no risk, preferred" cocktails of Groupon, FB, Amazon, etal. Great post. Keep it up. Appreciated.

  7. Breaking news: The fed to spend 40bn a month purchasing MBS in order to lower borrowing rates. What's the definition if insanity again?

  8. This and Jim Sinclairs comments on it shocked me so much, I drove down to Scottrade this morning.

    Here's what they had to say:

    1. Most at risk for me is my Roth IRA at Scottrade and my 401k at Fidelty, so that's what I looked into. Scottrade says, my account is a "cash" account, not a margin account, and thus it is illegal for these shares to be lent out/sold short. Fidelity (on the phone) said the same thing.

    2. To get stock certificates printed they charge $500 per stock: 10 or 10,000 shares. Fidelity charges $100, if they have them. They might not, but other entities hold them on their behalf and they have their own fee structure's. One such entity is Computershare. I called up Computershare, and they didn't have me in the system, thus there was no way they were issuing me certificates. So I called Fidelity back, and got a representative directly associated with my 401k account. The rep. said it is rather difficult to have the certificates printed out under a 401k program, as the shares are deemed under the umbrella of the program - in my name technically, but functionally under Fidelity 401k Mgmt. And that if certificates are issues they go through the same process as a disbursement with all the restrictions, taxes and penalties that that entails. Not good.

    3. Also, the rep. at Scottrade said they don't do any proprietary trading there, so it wasn't the same risk as MF Global. However, I'm not sure that matters if they are still lending customer shares to trading entities. But, since my 401K and my IRA are cash accounts they are supposedly (again) not being lent or used as collateral. Actually, the collateral part I didn't ask about, so I guess that's an important future question to be asked. "Do you use 401K and IRA cash accounts to back any transactions?"

    4. So it seems the main risk is that Scottrade/Fidelity go bankrupt and because the shares that are held in my account are not in my name, but rather in the name of Scottrade/Fidelity, they can be used to cover their losses to other entities. Is this a credible risk? I dunno. Jim Sinclair asks us to look into the capital structure of our financial entity.

    "Do you know what your broker’s capital ratio is? Find out as that number is the order of magnitude at which your broker is gambling on with primarily your money. I dare you to ask."

    I have no idea what Fidelity or Scottrade look like capital wise. Any ideas on how to evaluate them?

    Thanks Dave,

    1. Thank you so much for finding out this information.
      $100 to print up share from Fidelity? I'm glad i sold what little I had and cashed out (not retirement account and it was only a few grand, but it is MY few grand, not Fidelity's money to fool with)

      Ai wish I could tell you what to do with the retirement money, cash it out and take the tax hit (half a loaf is better than none) roll it over to Everbank or SwissAmerican and get a gold backed IRA (unless Uncle Scam freezes all IRAs) roll it all into one bank IRA and hope for the best,etc.

      I really donKt know what is the best move for you, but fortunately (if you can call it fortunate) this financial train wreck is playing out in slow motion and you have some time to set up a game plan. Weigh all your options and best of luck to you.
      (Footnote-I'm not affiliated with Everbank or SwissAmerica, these were just two who offer gold backed IRA's, their names just popped into my head. Search carefully before getting a gold IRA, read everything, study everything, due dilligence and all that.)

  9. @JMR77 - I've already put a fair bit of my IRA into gold held at the Perth Mint via Sterling Trust. I assume this is similar to Everbank/SwissAmerican. Hopefully that's good for something. A PhD finance prof. friend of mine says that retirement accounts are insured up to $500K. So,
    the general bankruptcy risk I was talking about above should be eliminated.

    And he also sent my questions/comments to a promiment credit expert, who said that if we get to a scenario in which Fidelity/Scottrade are going bankrupt, legalese isn't going to matter, the law of the jungle will. So, yeah, physical gold buried in the ground * at that point *. But we are a long way from there, it would seem. Though, perhaps we are moving closer at an exponential rate, which might deceive my linear oriented senses. :)

    Finally, to clarify. The risks regarding MF Global/Sentinel are related to margin accounts, which allow your assets to be used/lent out. This, supposedly, can not legally happen with IRA/401K accounts, and if it did could, you're insured for $500K.