December 13, 2011

How MF Global Almost Got Away With Everything

Posted in Banking, Big Banks, Europe, Finance, Foreign, investment advisor, investment banking, investments, sovereign debt, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , at 4:39 PM by Robert Barone

The MF Global (MFGLQ.PK) story is just another chapter in the continuing saga of the legal fleecing of America by a financial system joined at the hip in an “Unholy Washington-Wall Street Alliance.”

The rules of the game are such that the managements of large Wall Street entities are allowed to gamble with assets entrusted to them by an unsuspecting public. If the bets are successful, the spoils flow entirely to the management and the firm, with nothing going to the clients whose assets are at risk. On the other hand, if the bets fail, the clients take the entire loss! Unfair? Of course.

But, as you will see if you keep reading, MF Global’s client assets will not be “found,” and, worse, unless the NY attorney general becomes incredibly creative, no one is likely to go to jail because no laws appear to have been broken. MF Global is just another piece of evidence that the current financial system is addicted to and permits excessive leverage and is deeply flawed.

Until this is recognized and fixed, the financial system will continue to be besieged with crises spawned by Wall Street greed. There are likely other, yet to be discovered, atrocities lurking in the shadows.

Asymmetrical Borrowing Rules

It appears that MF Global, as well as every other major US investment banking firm, has taken “advantage of an asymmetry in brokerage borrowing rules that allow firms to legally use client money to buy assets in their own name,” Christopher Elias notes in a recent Thomson Reuters article.

Simply put, MF Global borrowed money, and, using that borrowed money, purchased the debt of the European periphery (Italy, Ireland, Greece, Spain, and Portugal) at very attractive yields. The borrowings and the debt purchased had the same maturity date, so the proceeds of the debt maturities were to pay back the borrowings. MF collected the difference between the low rate it paid on the borrowings and the high rate it received on the debt.

The euro debt it purchased was guaranteed by the European Financial Stability Facility (EFSF). To get the low rate, MF had to pledge collateral. So, it pledged the euro debt, and as additional collateral, it borrowed and pledged its clients’ assets, which assets it held as custodian. Looks like a no-brainer! So thought Jon Corzine and Co.

Margin in the US

In the US, a client with an account at a broker-dealer can place his assets in a “margin” account. The client is then allowed to borrow against those margined assets. There are rules for this called “margin requirements.” Generally, speaking, the value of the assets assigned to “margin” must be greater than the amount borrowed by a factor set by the Federal Reserve under Regulation T.

If the market value of the assets assigned to “margin” falls in value to the point where the margin requirement ratio is violated, a “margin call” is generated. The client either has to assign or pledge more assets to “margin,” or reduce the borrowing via a cash deposit. If the client fails to do either of those in the time allotted by regulation, usually three business days, the assets that were pledged to “margin” are liquidated (sold out) and the proceeds are used to offset the borrowings until the required margin ratio is satisfied.

Of relevance, clients who assign their equities to “margin” (the only other alternative is called “cash”) so that they can borrow against them also automatically grant their broker-dealer the right to “lend” their assets to another investor who wants to “short-sell” that particular asset because a short-seller must first “borrow” existing stock in order to “sell” it. The broker-dealer makes money by lending out equities in margin accounts to short-sellers. The everyday American investor is unaware of this, and earns nothing.


So, how did MF Global lose client assets? In the US, broker-dealers can use margined assets as a funding mechanism, i.e., by borrowing those assets themselves and using them as collateral to borrow. But in the UK, those same borrowed assets can be pledged several times over (called rehypothecation), resulting in very significant leverage. That is, the client assets stand behind several borrowings rather than just one.

Buried somewhere deep in the legalese of the account forms (you know the pages and pages of legal gobbledegook that nobody reads because one has to be an attorney to understand it), the clients gave MF Global the right to transfer those client assets to its UK subsidiary and to “borrow, pledge, repledge, hypothecate, and rehypothecate” those assets.

According to the Thomson Reuters article cited above, such language is common in most large US broker-dealer agreements. That language allows the large broker-dealers to circumvent US law and take advantage of UK law where rehypothecation (leverage) is allowed.

The Impact of Margin Calls

For MF Global, the unanticipated “tail” event occurred. (“Tail” events are only supposed to occur very infrequently. However, in an unstable financial system, they occur often.) When the value of the European periphery debt declined this past fall (even that guaranteed by the EFSF), margin calls occurred. MF Global would have been okay if it hadn’t used so much leverage.

The leverage magnified the margin calls to such an extent that all of the client assets weren’t enough to meet the margin calls. All of the collateral, including the euro debt (at bargain basement prices) and the client assets were sold to offset the borrowings. The clients’ assets are gone. They are not going to be “found.”


No laws appear to have been broken. No one is likely to go to jail. But, as you can see, the financial system is deeply flawed and is rigged in favor of Wall Street and against the ordinary investor. The causes of the financial crisis that appeared in the US in 2009 have not been resolved, only papered over (with money printing). In order to have a “fair” and healthy financial system, the excessive use of leverage, such that success leads to untold wealth for the managers and failure is directly borne by unsuspecting clients or taxpayers, must be changed.  Until this occurs, we will continue to experience such debacles. And the volatility caused by them will continue to keep the financial system unstable and limit economic growth.

Robert Barone  and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment  Advisor. Statistics and other information have been compiled from various sources. Universal   Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.  Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.   A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

March 30, 2010

Health Care Bureaucracy May Be Like FDIC

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 8:18 PM by Robert Barone

The folks in Washington D.C. say one thing – the bureaucrats in the field do another.  This is happening today on Main Street to America’s community financial institutions.  Because I suspect the health care bureaucracy will be similar, this writing will point out the abuses by the FDIC and relate them to what might happen in health care.

There are now 702 institutions on the FDIC’s Medusa list.  This number is likely to rise in the second quarter despite the closure of 41 banks year to date through March 26, 2010.  Almost all of these are community based or regional institutions, and they are victims of current economic conditions.  The balance sheets of these institutions were never meant to be “marked to market” or “marked to fire sale prices”.  As the economy heals, so would these balance sheets.  In the interim, nearly all of these institutions have enough liquidity to survive even if their “capital” base is low.  Yet, the FDIC’s approach has been that the managements and boards of directors of these institutions are lacking or even incompetent despite the fact that 3 years ago the FDIC itself rated most of these managements and boards in the top two rating categories.  It almost appears that the FDIC is on a mission, directed by the “Too Big To Fail” (TBTF) institutions, to eliminate a large chunk of community institutions so that the TBTF can get even larger.

The institutions on the Medusa list cannot raise capital precisely because they are on the Medusa list.  The FDIC is supposed to “resolve” a failing institution in a “least cost” way.  The least cost way would be to provide some seed money (like TARP which went mainly to TBTF) or change some regulatory accounting rules to allow write-downs to amortize over a longer time period, like 10 years.  In either case, once the public perceives that the Medusa banks can survive, private capital would become available.  But, under current FDIC policy, why should private capital come into a Medusa institution when all the investors have to do is wait for the FDIC to “resolve” the institution?  The deals the FDIC makes when it closes an institution are once in a lifetime deals for investors, and something they would never see in a free market transaction.  How could it cost the FDIC more if private capital comes to the aid of the institution without an FDIC “intervention”?  Even if it is later closed, the FDIC would be better off by the amount of the private capital raised.  Clearly, the FDIC closure policy is illogical in and of itself.

Let’s dig a little deeper.  Each of the Medusa institutions is under a “Cease and Desist” order which requires a blizzard of paperwork and reports which takes up most of management’s time and effort, often reporting on a weekly basis, to fulfill a whole lot of irrelevant requirements.  This takes time away from the important things management should be doing, e.g., dealing with the asset problems and trying to find additional capital.  At examinations, examiners are often arbitrary, especially when it comes to capital, often requiring uncalled for asset write-downs, which directly depletes capital.  It actually appears as if the examiners are under orders from their superiors to do so.

Having given away taxpayer money to save TBTF Wall Street institutions (the very ones that caused the financial crisis), the FDIC seems to have reacted to taxpayer outrage.  So, in an effort to appear “tough”, they aren’t about to help any other institution, even if it’s what the public wants or is the “least cost” resolution method.

More important, the way government bureaucracy is set up leads to wrongheaded decisions.  Today, the FDIC case managers are overwhelmed with the number of cases to manage.  The Medusa institutions send paperwork to the case managers who have so many cases to manage that they don’t have time to read the reports they themselves have required.  Most of these Medusa institutions regularly get messages from the case managers asking for reports that often have already been sent multiple times.  In the end, the easiest way for the case managers to cope is to reduce the number of cases.  This is shorthand for “closing” the institution, because keeping it open would only increase the case manager’s workload.  From their point of view, it isn’t their money and the money pot is unlimited.  So, case managers instruct field examiners to do what they have to do to justify an FDIC “intervention”, even if they have to be arbitrary in their judgments.  (Often, when the “intervention” occurs, it is Gestapo like.  For example, the FDIC sent 65 field agents to close a one branch, nine employee bank in Carson City, NV in February!)

This is what happens when a bureaucracy is given unlimited power.  The managements, boards of directors and shareholders have no recourse, and any lawsuits filed are met by an army of government lawyers with unlimited resources.

Think of what this means for the health care system.  First, for any particular illness, the bureaucrats will establish rules and guidelines which they will apply whether it makes sense or not.  That is, the bureaucrat, not the doctor and/or patient makes the medical decision.  Second, because cost will always be an issue in health care, the case managers will always be overwhelmed.  They will not have time to collect and read all of the relevant information.  Even if they do, if the rules and guidelines do not permit a treatment, it is safest for the bureaucrat to say “no”, even if he/she thinks a different treatment is appropriate.  No criticism can be leveled against a bureaucrat who follows all the rules.  Finally, like at the FDIC, the best way to control your workload is to get rid of case files.  Saying “no” may lead to a patient’s death – saying “yes” may prolong the life and keep the case file on the bureaucrat’s desk.

Like the TBTF Wall Street banks, if you are lucky enough to be a celebrity or a big political contributor, no doubt you will receive “special treatment” in the new health care world.  But, if you, like most, live on Main Street, no matter what is said in Washington, D.C., if you become ill, you can expect the same treatment that the 702 Medusa institutions are now receiving at the hands of the FDIC.

Robert Barone, Ph.D.

March 29, 2010

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778