How to Keep the Next "Corzine Event" from Depleting Your Capital
Remnant Review (Dec. 10, 2011)
I have been publishing Remnant Review since May of 1974. I use it to get things off my mind and off my chest. I write longer pieces. They are detailed. They also tend to be more complex than Reality Check. I write it for people who are serious readers.
In this issue, I will discuss the power of leverage. Leverage makes a few people very rich. It is also at the heart of the American housing market. When it goes against you, it can inflict great damage. Ask the person who owned a $600,000 home in California in 2006 which is now worth $350,000. He paid 5% down and took a debt for $595,000 at 6.7%.
But the poster child for leverage is Jon Corzine. He saw MF Global go down in one week. He never saw it coming. He wrote this for investors a week before its demise:
Strengthened capital and liquidity position. As of September 30, 2011, the company has over $3.7 billion in available liquidity, including $1.3 billion in available committed revolving credit facilities and $2.5 billion in total capital."Reflecting the stressed markets in the quarter, we deliberately chose to reduce overall market exposure in most principal trading activities and focused on preserving capital and liquidity," said Jon S. Corzine, chairman and chief executive officer, MF Global. "We also used the dislocation in the markets to add quality people for strategic roles, as well as expand our client relationships across our businesses."
Mr. Corzine continued, "We were particularly pleased with the repositioning of our mortgage, credit and foreign exchange businesses; the performance of our commodities group; and the common alignment of our brand to strategy. These efforts reflect positively on our ability to execute and deliver competitive returns to shareholders in the quarters ahead."
As of September 30, 2011, MF Global maintained a net long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity (repo-to-maturity), including Belgium, Italy, Spain, Portugal and Ireland. The laddered portfolio has an average weighted maturity of October 2012 and an end date maturity of December 2012, well in advance of the expiration of the European Financial Stability Facility in June 2013. (see supplemental table for further details)
That web page is now missing. It is preserved here: //www.garynorth.com/members/8676.cfm.
The MF Global story continues to get media coverage, but as far as investors are concerned, this is crying over spilt milk. They lost everything they had in their accounts.
Here is the key fact: No one warned them that they could lose everything. The collapse happened in hours. Once the margin calls began, the company was dead. Like a loaded gun, pulling the trigger caused an explosive and deadly event.
The customers did not know the gun was loaded.
Those trusting investors used MF Global as a brokerage service. Many of them had accounts that were not leveraged. They owed nothing to another investor for their position. That's what they thought. They were wrong.
The company went bust. It cannot find $1.2 billion of customer funds. How does a brokerage firm lose track of $1.2 billion? How could this happen? The commodity clearing house firm that it used to maintain its futures contracts must balance the accounts at the end of every business day.
After the collapse, the clearing house did not intervene to make good all of MF Global's corporate losses that were imposed on the customers. Yet that is what it had always done in the past. An official bragged about this. See the video here: //www.garynorth.com/public/8837.cfm.
The non-leveraged investors will not get their money back.
Corzine was not arrested. No members of the company have been arrested. The customers' assets were used to pay off the commodity traders who had contracts with MF Global. The company's operations were such that the non-leveraged customers' assets were at risk. They did not know this.
I hope that you will read everything that follows. I hope that you will click each link, print out each document, and read all of them. You may not understand the technical details, but understand this: MF Global went down in just one week. Its managers also did not understand the details.
They are not the only fund managers who do not understand the details.
The customers with non-leveraged accounts had their money at risk for the brokerage firm's side bets. It turns out that this is common procedure. Here is an explanation from "Tyler Durden" on Zero Hedge. It has to do with "re-hypothecation." This is a legal practice that brokers use to make lots of money. The broker takes the customer's collateral and uses it to provide margin for the broker's own trades. Durden uses a Reuters story to show how it works. Investors do not know of this arrangement. The story is here. This is a long story. It is technical. Yet it reports on hidden liabilities of the world banking system that have been concealed from investors. This hidden system of liabilities is a time bomb under the West's financial system.
Durden begins his quotations.
[h]ypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is "hypothetically" controlled by the creditor, who has a right to seize possession if the borrower defaults.In the U.S., this legal right takes the form of a lien and in the UK generally in the form of a legal charge. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default.
In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital).
Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker's own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.
The Reuters story continues.
Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500).
This asymmetry of rules makes exploiting the more lax UK regime incredibly attractive to international brokerage firms such as MF Global or Lehman Brothers which can use European subsidiaries to create pools of funding for their U.S. operations, without the bother of complying with U.S. restrictions. In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as "churn"), the original collateral being used may have been as little as $1 trillion -- a quarter of the financial footprint created through re-hypothecation.
Then he draws a conclusion.
So let's see: a Prime Broker taking posted collateral, then using the same collateral as an instrument for hypothecation with a net haircut, then repeating the process again, and again... Ring a bell? If you said "fractional reserve lending" - ding ding ding. In essence what re-hypothecation, and subsequent levels thereof, especially once in the shadow banking realm, allows Prime Brokers is to become de facto banks only completely unregulated and using synthetic assets as collateral. Curiously enough it was earlier today that we also penned "ECB Confirms Shadow Banking System In Europe In Tatters" in which we explained that since ECB has to expand the eligible collateral it will accept, there is no real collateral left, meaning the re-hypothecation process in Europe has experienced terminal failure. Yet the kicker is that the "safety haircut" only occurs in the US. Not in the UK.
Got that? There is no real collateral left, meaning the re-hypothecation process in Europe has experienced terminal failure.
One fine day, it will hit here. The tsunami that will start in Europe will cross the Atlantic at the speed of light.
Let's all get together and say, "margin calls."
Yesterday, Durden updated his report.
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.
Paper gold is digital gold. In other words, it isn't gold. It's a promise to be related to gold. But no one ever takes delivery. So, the owners write multiple contracts against it. Paper gold is fractionally reserved gold.
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.
I remind you once again of Max Blumert's three rules: "Buy the best. Pay cash. Take delivery."
Jim Sinclair is an expert on the financial markets. He is also a certified gold bug. Here is his assessment of the implications of what happened to MF Global.
How can you have your money anywhere and expect and feel certain that this money will be returned to you when you see the inner workings of finance and Wall Street through the eyes of the collapse of MF (Global)? Totally shocking.We are in the midst of a crisis which is so complex that the public generally doesn't understand it. This event is so complex that I'm not sure professionals reporting on it or possibly even a good deal of the management of companies operating in it totally understand it. The derivative is ahead of the client.
So in the Lehman case the banks just took out Main Street. When MF Global went down, that broke the mechanism. The sharks will eat the sharks now because in the case of the clearing house, what you are taking out are the traders and investors who had confidence that a clearing house meant their money was safe and segregated from misuse by the management of the clearing house. You lose confidence in that, how do you settle trades?
Today it's not a question of will your investment come out correctly. Today it's a question of whether the money you put into the investment will ever come back again, regardless of what the quotation is. The only money I can count on is the gold I own. Everything else depends on the system.
The system is at risk, as we have seen.
Ann Barnhardt made her living as a commodity futures trader specializing in cattle. She did it for 20 years. After the Chicago Merc refused to pay off the clients of MF Global, she shut down her firm and sent her clients their money. She says that the markets are now broken.
She did a detailed report to the public as soon as she shut down, It is posted on her site, http://barnhardt.biz. (Problem: she does not isolate her posts. They are all in one huge file. Search for regret.)
She consented to a long interview by Financial Sense, Jim Puplava's site. Here, she got down to the nitty-gritty.
Up until last month on Friday, October 31st, the customer segregation of funds rule was utterly sacrosanct. Even when Refco imploded and imploded quite dramatically in 2005, no customer funds were gone. It was on the prop trading side of the company but the customer funds were there, were accounted for, and it is the onus of the Mercantile Exchange to audit these FCMs [Futures Commission Merchant]. MF Global was under the auspices and under the supervision, of the auditing supervision, of the CME. And I believe that MF was audited not just annually, but quarterly. Also, there is the question of how in the world can the Merc miss the margin being posted. The Merc is supposed to be moving equity and doing margin wire transfers twice a day every day. How could those customer funds be "missing". They aren't missing. They were stolen. They were stolen by Jon Corzine and his cadre of associates at MF Global. So yes, again, to your listeners who may not fully appreciate the gravity of this, this has never, ever happened before. Nothing even close to this has ever even happened before and it is the function of the Mercantile Exchange itself--the reason why the exchanges exist is that they stand in the middle of every transaction and they act as the de facto counterparty to every single transaction so that, for example, my clients never had to worry about the credit worthiness of the other individual, whoever it might be, who is on the other side of any trade that they did.Now, for every buyer there is a seller and it is a one-for-one, zero-sum game; but to ensure the credit worthiness and the integrity of the market, the function of the Mercantile Exchange itself is to stand in the middle of every transaction and be the guarantor. So a year ago when Terry Duffy held a press conference [watch it here] and said never in the history of the Mercantile Exchange has a customer ever, ever lost funds resulting from the collapse of a firm, he was telling the truth a year ago. Everything changed on Halloween of this year though. And that's why I had to shut the doors of my brokerage because I could not in good conscience continue forward knowing that the Mercantile Exchange was no longer going to fulfill their fiduciary duty.
Puplava then asked the right question:
What would you advise? I am a long term believer in the bull market in commodities, but how do you play commodities when the futures market is no longer secure? And what does this do to the proper functioning of the markets? In other words, now that you've closed your firm because you don't believe in the integrity of the system and we just listed a series of reasons why--not honoring contracts, appropriating funds, not allowing trades to go off. Not one investigation, in fact, this goes even further than that. We had Bill Black on the program recently, who helped make prosecutions in the S&L scandal. And at that time, 2,000 individuals went to jail. There has not been one criminal charge brought by the justice department since the 2008 crisis. So given that this is where we are, what do you advise and what will you do personally?
She gave him the answer no one wants to hear. It is the answer that persuaded her to shut down her firm.
Well get the hell out. Get out of all paper and it's not just the commodities markets. This is going to cascade through everything. It is going to get into the equities. It is going to get into 401ks and IRAs, it is going to get into pension plans and so on and so forth. Total systemic collapse. Get out! I don't know how I can be anymore plain about this. I say this over and over and over again and then I get scads of emails saying, well I can't get out of my 401k. Yes, you can. Yes, you can. Take the penalty and get the hell out of there. What would you rather do? Would you rather pay the 10% penalty or would you rather have it all go up in smoke? Because that's what we're staring down the barrel of. Number two, we seem to have this backwards. In terms of what I do, cattle and grain specifically, the futures markets are the derivatives. The futures markets are derived from the actual cash commodity market. Now, I am blessed because my area of expertise is actually in the physical cash market, actual cattle on the hoof. So I have a consulting firm and I'll continue to teach cattlemen how to trade actual physical cattle. But, yeah, to all the people out there listening--you are going to have to get away from paper and get back into physical commodities, the real deal. Anything that is on paper anything that involves a promise or a commitment is no longer valid because as we said there isn't a rule of law anymore. People can steal from you. Your money can be confiscated. And think how easy now it is to confiscate people's wealth. Most of our wealth in this society exists as zeroes and ones on a computer server. It takes no effort whatsoever to steal zeros and ones on a computer server. So what I have been telling people is you need to get into physical commodities. And the rule of thumb is if you can stand in front of it with an assault rifle and physically protect it, then it's real--it's a real commodity. That includes food, that includes water, that includes long guns and ammunition. That includes fuel. That includes precious metals--gold and silver coinage. Most especially silver coinage because silver is the metal of barter and transaction and currency. Gold is the storage metal because it's so valuable per ounce. And also, silver is extremely undervalued relative to gold because that market has been synthetically suppressed for the last several years by again, these nefarious actors. So yeah, reallocate into physical commodities.
I know what I call this outlook: hard-core hard money.
I have cited experts who have made their living trading. They are afraid of what took place on October 31: the bankruptcy of MF Global and the failure of the clearing house to clear the accounts. They see this as the final gasp of an over-leveraged financial market.
Most investors ignore all this. Stock markets are up. There is no real fear. The experts have shrugged it off. So, what are we to conclude? That the system can violate the rules and still prosper? I don't think it can.
The leverage is enormous. Brokerage firms can use their customers' non-leveraged capital to trade for the brokerage firm in highly leveraged markets. There is no protection for the customers. Their interests will be sacrificed for the sake of paying off the full-time traders on the other side of the futures contracts. It's a game rigged for the leveraged Big Boys, not the conservative clients.
No one saw the collapse of MF Global coming. It hit like a thunderbolt.
You may think that your ETF is safe. It won't happen to you.
You may think your IRA is safe. It's so conservative.
Fact: Nothing is safe. There are only degrees of uncertainty.
I am not big on IRAs. I do not recommend 401(k) programs. I think the banking system is at risk.
The problem is this: if the banks ever implode in a wave of defaults, this civilization ends in 30 days. Without credit from banks, deliveries into cities end.
The smart fellows at the top have gambled with our lives and our futures. Barnhardt is unsparing.
The only lesson that these criminal degenerates learned from the 2008 situation was that they could do anything they want and that pimp daddy government would bail them out. You have to understand, people like Jon Corzine, these are evil, evil people. He went into MF Global looking to rape that company personally for his own good. And that's what the motivation of a lot of these people are. You have to get your heads around this. You have to get your heads around the fact that there are truly evil people in the world who do not give a crap about anyone or anything except themselves, their own personal wealth and their own personal power. And they would sell their grandmother to the Nazis for a nickel without hesitation if they thought they could get away with it. It's the same with people like Jon Corzine, and then we have talked about the fact that Jon Corzine is tied into the Obama regime. And we now know that the government is absolutely stuffed to the gills almost exclusively with this same type of moral degenerate culture. These people that are in the government--not just the Congress and Executive Branch but also in the bureaucracy--they are in it for themselves. They are in it for the money. And two weeks ago when we had the 60 minutes exposé on the insider trading, those of us who have been in the business have known intuitively that that was going on for a very, very long time. We knew that there was front running going on by politicians. A great example of this is someone like Harry Reid. When he entered Congress, Harry Reid had a low six-figure net worth. He now has an eight-figure net worth. And he's never done anything except be a United States Senator. The salary I think of which is something like $170,000 a year. How does that happen? How does a man with $170,000 a year salaried position go from having a six-figure net worth to an eight-figure net worth? That doesn't make any sense unless he is doing nefarious, illegal, insider trading type deals.It is obvious what's been going on. You have to start acknowledging these people for what they are, and that is moral degenerates who are basically sociopaths and psychopaths. Meaning they don't feel any sympathy or empathy for other human beings. The only thing they care about is themselves. They will do anything. They will steal. They will lie. They will cheat. They will lie to your face. They will look in the camera with this tremendous earnestness and lie with fork tongues through their teeth in order to advance their wealth and power. And if we, as a people, don't get real about this, if we keep having these Pollyanna visions that these people are all on our side and they are really looking out for us. And they are doing the best they can. We will be cork screwed into the ground and this nation will be reduced to a smoldering rubble. You've got to wake up.
The system is rigged. It is also over-leveraged. The rigging has subsidized the leverage. But there will come a day when the leverage overwhelms the rigging. That happened to MF Global in the final week of October.
What happens if Italy defaults? Leverage will come into play, fast.
If you rely on digital wealth for your future, you are assuming what the insiders also assume: leverage does not go into reverse. It can, we all admit. But we think it won't. That's what Corzine thought, too.
There is money to be made in digital accounts. But, ultimately, we must get out of digital accounts. We must acknowledge that the dominoes are stacked against us.
When they fall, they may fall very fast.
The central banks will inflate. That is the law of central banking. But if they do, they risk hyperinflation. They will try to avoid this. But they will inflate to overcome a series of daisy-chained Lehman events. They will inflate to save big banks. They may let European governments default. But they will save the big banks if they can.
My conclusion: at my age, I want safety. This means this: I want time to reallocate my money when a crisis hits. I do not want to be in a leveraged fund. I want FDIC protection, which buys me time. I prefer low returns and extra time to higher risk and overnight failures.
You must decide. The crash may not come soon. Or it may come very soon. Europe is a walking time bomb. The leaders don't know what to do. There are too many summits. There is no sense of the threat that leverage poses. The bureaucrats will not see it coming. They never do.
So, what do I recommend now? This: you must think very carefully about the threat of leverage to your digital capital. The worst case is a complete failure of the banks. It's possible, but I think the Federal Reserve can delay this in a crisis. It will intervene. In that breathing space, which may last only a few weeks, but probably months, you should buy what you are saving up to buy. You just buy less of it than you had planned.
Or buy it now.
Think about this: What do I intend to buy with my accumulated digital money?. You accumulate money because you cannot know the future well. But when the future gets clear -- a market crash, followed by mass inflation -- you sell money to buy things.
I want my money in a non-leveraged institution. But they do not exist. So, I want my money where I can buy time. That means an FDIC-insured bank.
The threat is this: an MF Global margin-call event that takes down your brokerage house. Your money will then be used to pay the commodity speculators on the other side of the trades that you knew nothing about.
The financial system is a daisy chain of promises that, in a major crisis, cannot be met.
Gerald Celente has been predicting financial Armageddon for years. Yet he invested his capital on the assumption that the financial system was just fine. He thought paper gold was gold. He took the word of an ex-Goldman Sachs CEO who had failed in politics. He believed a defeated politician who said there was nothing to fear. He trusted digits. He did not follow Max Blumert's rules: Buy the best. Pay cash. Take delivery.
Digits are leveraged. Leverage is a two-way street. Invest accordingly. We cannot escape from digits. They keep us alive. But the bulk of your capital should not be in digital form.
If you hold yen, it is safer to hold them in Everbank, because of the FDIC protection. The bank is not going to use futures. This reduces your risk. An ETF is more risky.
If you want gold in storage, use GoldMoney or Bullion Vault, not an ETF.
ETFs may work fine until the day they don't work at all. They are all or nothing. In this environment -- a European crisis -- I think you should go for physicals.
MF Global went under because of its leveraged holdings of European government debt. The size of the big banks and brokerage firms is enormous. They are highly leveraged. Your local bank isn't.
If your digits are local, you can convert them into physicals: foreclosed real estate and currency in a crisis. Think "physical."
There may not be another Corzine-like event. But the condition of the largest investment banks points to a future systemic crisis. The leverage is enormous. It is the basis of the biggest banks' huge profits. This is an accident waiting to happen. The public does not understand this. How could it? Corzine did not understand it.
It's all or nothing. People do not perceive this. The system is set up to be a chain reaction. Meanwhile, European bankers do not know how to solve the PIIGS's problem.
It's not just the PIIGS's problem. It's our problem.
Maybe the system will hold. I hope it does. I will not bet my future on the assumption that it will.
For a general guide to avoiding risks above your tolerance level, click here. These are good for discussion on the Remnant Review forum.