Financial markets rise and fall based on the perceived value of the products being sold. But there are occasions when market value is affected by the condition of the marketplace itself, and whether the infrastructure that supports the market is structurally sound. This is the situation investors are now facing. There is rottenness apparent in even the largest and most trusted markets, like the US Treasury market, and investors are beginning to question how safe their funds are, or whether the protection being bought is worth anything. Private money is nervous, or it is fleeing the markets altogether. When so many different markets are afflicted by the same creeping structural weakness, it is no surprise that the average investor begins to ask whether Financial Armageddon may be upon us.
There are a number of recent cases where the “system” did not work the way investors expected, especially in the case of the collapse of MF Global, and the less-publicized ruling that banks would not have to pay out the protection they sold investors who bought credit default swaps covering a potential Greek government default. Before we turn to these specific and highly consequential events, we should look at the some of the precedents which reveal a history of rule-changing by banks and regulators that inevitably has worked against the interest of investors.
Rules Can be Changed for the Benefit of the Market Makers
A financial crisis as painful and as dramatic as that of 2008 can tell you a lot about whose interests regulators really are concerned about. When stress in the markets reached acute levels, the regulators changed the rules to benefit the market makers, not the investors. The sell-off in bank stocks in 2008 was becoming so steep that US regulators introduced a rule change that outlawed the short sale of bank shares. Investors were now limited only to buying bank stocks. The losses imposed on those investors who had presciently foreseen problems in the banking industry, and who had protected themselves by selling banks short, were staggering. These investors were penalized for being correct.
The rally in bank stocks following this rule change lasted a month or two, but the selling recommenced – not short selling (which was now illegal), but outright selling of positions by those still invested in the industry. As prices began to test the lows of 2008, regulators in March of 2009 changed the rules again, this time as a result of pressure from the banks and their paid servants in the US Congress. The practice of marking to market trading securities was suspended in the US; banks were now free to ignore what the market would pay for some of their shakier mortgage-backed securities, and were able to put their own price on these holdings. Securities that the market would have bought for 30 cents on the dollar were instantly re-priced on bank balance sheets at 90 to 100 cents on the dollar, creating immediate profit for the banks and allowing them to hide these securities away from public view. To this day, no one really knows how many such securities are owned by US banks, or what they are really worth.
There were of course many other special favors done for the US banks, many of which involved funneling trillions of taxpayer dollars in loans and guaranteed profits to the industry. Notice that the US has been lecturing Europe this past year to adopt the same game plan as a way of coping with its banking crisis. Europe has paid attention. Most of the major stock exchanges in Europe now outlaw short selling in bank shares, and there have been proposals put forward to allow banks to ignore market pricing for government securities. If there were such a thing as a US Treasury for Europe, it would already be lending a trillion or more euros into the banking market to stave off bank collapse. The essence of the crisis in Europe at the moment is to find a way to create a centralized Treasury for the EU, knowing that this will significantly limit the sovereignty of the individual member countries.
MF Global Bankruptcy Reveals Weakness in Registered Exchange Safety
Europe may not succeed in accomplishing this task in time to prevent global economic disaster, because the financial system is now so interconnected that any weakness in the structure impacts unsuspecting and faraway parties. This brings us back to the MF Global fiasco. This UK brokerage firm had extensive business practices in the US, chiefly as a commodity broker, but was never known as a major trader for its own account until the arrival a year ago of a true Master of the Universe – Jon S. Corzine. Corzine made his reputation as a trader at Goldman Sachs, rising to the top of the firm, where he oriented Goldman Sachs away from its traditional investment banking business, to a heavy reliance on trading revenue. Corzine was ousted from Goldman Sachs due to a series of questionable transactions, and went on to a political career as a US Senator and then Governor of New Jersey. His failure to get reelected as Governor last year led him to the position of CEO of MF Global.
Corzine was anxious to duplicate his success at Goldman Sachs, and immediately began redirecting MF Global traders to step up their risk taking activity. He personally initiated and authorized substantial bets on government bonds issued by European countries under the most financial stress: Greece, Ireland, Spain, Portugal, Italy, etc. At Goldman Sachs, Corzine was used to holding on to losing positions for months, and sometimes over a year, until his expected outcome and profit materialized. Goldman Sachs had very deep pockets; MF Global did not. When the MF Global positions turned sour, Corzine discovered that MF Global had such a thin cushion of capital that it did not have the luxury of waiting months for the positions to right themselves. The market sensed the same thing, and began withholding credit from MF Global, credit being the lifeblood of any brokerage firm. The situation quickly became untenable, and MF Global was on the ropes, being shopped around to potential buyers.
By the end of October, it appeared a larger firm was willing to buy MF Global’s basic businesses, but over the last weekend of the month, this firm pulled out of negotiations, announcing to the world (and to clueless regulators), that MF Global had a serious hole in its cash accounts. The Federal Reserve quickly stepped in and discovered over $600 million of client monies were missing. MF Global was promptly shut down. Jon Corzine was forced to resign from the board and from all his executive positions at the firm on November 4, 2011. He immediately hired a criminal defense attorney for himself.
At this point, the first level of embarrassment was directed at the Federal Reserve. MF Global held the coveted status of Primary Dealer to the US government. The Federal Reserve and US Treasury grant such status only to those brokerage firms of impeccable financial reputation and health, because the Primary Dealers are required to bid on and support all US Treasury auctions. They are the interface between the US government and the global bond market. The Federal Reserve has the right to audit the Primary Dealers. How then, did the Fed miss something so basic as a half billion dollar hole in the cash accounts of a Primary Dealer?
Not only were these funds missing, there was good evidence that MF Global had committed an illegal act by commingling customer funds with its own funds, essentially using customer money for its private purposes. This is Brokerage Business 101; any executive of a brokerage firm knows they can go to jail for violating the trust customers have placed in the firm that their invested monies will be used only for investments as they so direct. No wonder Jon Corzine now has a criminal attorney representing him in the ongoing investigations as to where the money went. This has naturally led investors to wonder how safe the US Treasury market really is.
A second level of embarrassment is being shared by the large New York investment banks which helped MF Global go to the bond market for funds when Corzine took over the firm. So masterful was Corzine considered in the financial markets, that investors had to pay a premium to own these bonds, since it was almost a sure thing that Corzine was going to turn this firm around and create another financial powerhouse to rival Goldman Sachs. It didn’t work out that way; in fact the most recent bond issue had not even reached its first required interest payment before the firm went bankrupt. Already this weekend two US pension plans have sued Goldman Sachs, JP Morgan Chase, Citigroup, Bank of America and other underwriting banks for failure to do proper due diligence when marketing these bonds.
The third level of embarrassment is the most serious and involves the Chicago Mercantile Exchange, where MF Global kept over $1 billion in assets in support of their customer’s commodity trading. The CME is the primary regulator for its broker members like MF Global. This is a long-standing practice on the registered exchanges, whereby the exchange “self-regulates” rather than subject itself to regulation by a government agency. Commodity exchanges do answer to the Commodity Futures Trading Commission on policy matters regarding which products they can offer their members, but when it comes to knowing whether MF Global was keeping customer accounts segregated from its own funds, it was up to the CME.
The CME says it did audit MF Global but was deliberately misled by the firm. MF Global had $5.5 billion in customer accounts, but at the time of its bankruptcy on October 31, $663 million was “missing”, presumably used by the firm for its own purposes. CME further states that as of its most recent audit of the firm, all customer monies were accounted for, but immediately after the audit MF Global quietly maneuvered over $600 million out of the customer accounts without the CME being able to detect the deception.
What happened at this point, however, has outraged other members of the CME. The exchange, in dealing with the shortfall, froze all MF Global individual customer accounts at the exchange. Nor would it allow these customers to at least trade against their accounts in order to protect themselves from further market moves. These actions essentially violated the basic premise of dealing on a registered exchange. Because all accounts are collateralized against both existing and potential adverse market rate changes, the exchange provides a nearly fool-proof guaranty that a customer bankruptcy will not impact the other members or any individuals who trade through these other members. The only circumstance that would violate this promise is if market price movements moved so adversely as to overwhelm the amount of collateral that was posted by the member for potential adverse market rate changes. Theoretically, this could happen in an extreme but highly rare market event, and should it happen, the exchange rules require that it “pass the hat” among all its broker members to make up the collateral difference for the bankrupt member. Even in this extreme circumstance, individuals who deal on the exchange would not be affected.
The CME did not follow through on this rule. Admittedly the shortfall in the MF Global account was not due to an adverse market rate move, but rather to a fraud or deception on behalf of that member. Even so, all other broker members should have received a loss allocation to make up the difference. In fact, the CME had the necessary funds in its own reserve account; it could have made up the difference immediately, and passed the hat later in the day or the next day to replenish its reserve fund.
What happened instead is that the CME grabbed hold of individual investor monies to make up the shortfall – specifically, from those investors who were trading on the CME through MF Global – by seizing their collateral and freezing their positions. This is, as far as anyone can tell, an unprecedented move for a registered exchange when dealing with a broker bankruptcy. It trumpets loudly to individual investors, who are after all the mainstay of the financial markets, that their funds are not safe at the brokers with whom they deal, nor are they safe from the CME itself.
Over 150,000 individual accounts at MF Global have been frozen by the CME as of this past Monday. These individual investors are also asking another question: what happened to the insurance that the brokerage industry said was available to protect individuals from precisely this sort of loss? This insurance is provided by the Securities Investor Protection Corp., which acts like a private version of the FDIC, the federal agency which guarantees the safety of depositors’ accounts at commercial banks. The SIPC was designed to convince individuals it is safe to move their money out of banks, where government insurance protect them, and to brokerages, where private insurance will protect them instead. It now turns out the SIPC may not have enough resources to reimburse all the investors for the amounts insured.
There are major political ramifications for what has happened with MF Global and the CME. Since the 2008 credit crisis, it has been a matter of faith among regulators that what are called “over-the-counter markets”, run by banks and the subject of billions of dollars of losses in 2008 and 2009, should be reorganized into registered exchanges like the CME. The futures exchanges have been clamoring for this for a long time; a former head of the CFTC – Brooksley Born – made this very argument in front of the Congress in 1998 when the Glass-Steagall Act was being overturned. Given the unprecedented losses investors have now suffered as a result of the MF Global collapse, and given the very fundamental failure of the CME to operate in the way it promised, this argument now looks very hollow. Exactly what the regulators should do next, however, is not clear, especially since the exchange will argue that MF Global was a “one-off” event.
But was it really? Knowing how damaging to its franchise its actions would be, why did the CME go ahead and seize individual investor assets? There is much speculation about this, some of it centering on the problem the CME would have faced if it went ahead with its own rules and allocated the losses to its other broker members. Some members may not have been able to raise the money required in a loss allocation, leading to a systemic failure event. Another theory says the CME may have feared that “passing the hat” now might have worked, but at some potential later bankruptcy of another member, the exchange itself might have been jeopardized by following the rules this way. This suggests, however, that the CME is aware of some severe and non-public problems with major market participants, such as banks and other large brokers, and is willing to damage its reputation now to give itself maneuverability should these problems surface at a later time.
For now, the damage has been done. Investors can either choose to continue to deal in futures and options through a broker, knowing now the full extent of the risks involved, or they can exit these markets. One commodities broker has already shut their business down rather than submit their clients to such levels of risk. In a letter to her clients, which is now being spread rather widely around the internet, CEO Ann Barnhardt of her eponymous brokerage company has explained the reasons for shutting down her business. Her main argument is as follows:
The reason for my decision to pull the plug was excruciatingly simple: I could no longer tell my clients that their monies and positions were safe in the futures and options markets – because they are not. And this goes not just for my clients, but for every futures and options account in the United States. The entire system has been utterly destroyed by the MF Global collapse. Given this sad reality, I could not in good conscience take one more step as a commodity broker, soliciting trades that I knew were unsafe or holding funds that I knew to be in jeopardy.
The Rot Spreads to the Over-the-Counter Market
A somewhat similar situation has occurred in the over-the-counter market for Credit Default Swaps (CDS). These products are largely the province of the major global banks, with JP Morgan Chase, Goldman Sachs, Citigroup, and Bank of America issuing over half of all the CDS protection now outstanding in the market. The buyers of these products are other banks, pension plans, insurance companies, universities, endowment funds, mutual funds, and other large institutional players who are willing to pay a fee for protection against the default of one or more of the issuers of bonds they may own. Lately, that has meant that these institutional investors have been purchasing protection against default risk in Greek, Spanish, Portuguese, Italian, and other European debt. The amounts are stupendous; nearly a trillion dollars of such insurance has been issued, well beyond the amount of such debt outstanding in the market.
There was considerable euphoria in the markets over the most recent EU package designed to deal with the Greek debt problem. The EU promised to deliver another badly-needed cash infusion to the Greek government – badly needed just to make the next interest payment on their debt – in exchange for Greece imposing yet more domestic economic austerity on its people, and for the banks holding the debt agreeing to take a loss on the existing debt they own. This latter part is important, because it is the first time the EU has focused on debt relief for Greece, by forcing the banks to absorb some of the cost of dealing with the problem.
The banks, of course, have resisted this fiercely, first because it sets a dangerous precedent for dealing with other government debt, and second because the banks do not have the capital to absorb significant losses on their Greek debt holdings. To deal with this second problem, the EU did a survey of European banks to find out what the loss would be if the banks were forced to take a 50% haircut on Greek debt. They came up with a number somewhat larger than €100 billion. There was a lot of argument among analysts that this was too small, but the EU was prepared to pay this amount to the European banks to “ease their pain.”
Then another complication arose. Most of these banks had purchased protection against default for some portion of their Greek portfolio, through Credit Default Swaps. The main providers of this protection were the large US banks that dominate the CDS market. These banks did not want to pay out huge sums of money to the European banks in a Greek default; moreover, these banks control the industry arbiter on whether an event constitutes a default that would force a pay-out under a CDS contract. This industry body – the International Swap and Derivatives Association – ruled rather conveniently for the big US banks that the Greek default as proposed by the EU was “voluntary”, and as such a pay-out under the CDS product was not required.
The product that was sold to the European banks was not called the Credit Involuntary Default Swap. Any reasonable reading of the ISDA contract underlying the product would conclude that a 50% haircut on Greek debt constituted a default whether it was voluntary or not. Besides, most banks felt there was nothing involuntary about the regulators forcing banks to accept a huge loss on their Greek debt.
The consequence of all this has been that the CDS market has been thrown into complete turmoil. The product is not in fact operating the way investors assumed from years of previous practice and from the wording in the legal contracts for such swaps. The situation is rather similar to what has happened on the CME; in this case it is institutional investors, not individual investors, who are discovering that the protections they thought they had do not exist. The market makers – the sellers of the product – have unilaterally announced that they are keeping all those billions of dollars of fees they received when selling this protection, but they will not necessarily deliver what they promised when a default occurs.
Why the big players in the market would destroy such a lucrative business in so short-sighted a way is open to question. They may well fear going bankrupt themselves, not necessarily because they must pay out on a Greek default, but because they would have to pay out next on a much bigger Italian default. Alternatively, these banks may simply feel entitled to do whatever they want to do. After all, these banks were able for years to declare profits on their housing securities when housing prices were going up, which led naturally to very large bonuses for the banks involved. The minute the market turned sour, these banks very conveniently were allowed to suspend mark to market, and avoid taking losses.
Given the fact that the CDS product now appears to be deeply compromised, institutional investors are voting with their feet. They no longer have the hedges against default that they thought existed on their European debt, so their only option is to sell the debt itself. This is exactly what has been happening in the past few weeks, and this explains why there have been such steep increases in interest rates for the debt of Italy, France, and now Germany. You might call this the law of unintended consequence; certainly when the EU regulators commenced their latest rescue package for Greece, they never dreamed it would result in a noticeable sell-off for all European government debt.
Some Commonalities Now Are Evident
Any reasonably intelligent and informed protestor at the Occupy Wall Street demonstrations – and there are many – could have written the letter that Ann Barnhardt wrote. It doesn’t matter that the OWS crowds come predominantly from the left side of the political spectrum, and that Ann Barnhardt approaches her politics from the right. Rush Limbaugh has picked up on her letter and read parts of it on his program, but he just as easily could have been reading a manifesto from the people at Zuccotti Park.
People from all political slants are seeing a corrupt and broken financial system, operating with impunity, stealing money outright from individual and now institutional investors, with the Obama administration doing absolutely nothing to prosecute the malefactors or fix the infrastructure problems. Behind all of this they see the machinations of the big banks and financial interests.
Whether this is a correct interpretation of what is going on can be argued. One might also say that both the CME and the large US banks have acted according to their instinct for self preservation, and that to have done otherwise would have threatened their existence down the road by setting a dangerous precedent. This argument has some merit, because these institutions must have known of the damage to their brand and their product by taking the action they did, yet they went ahead at great cost to their long term revenue stream. This is in truth an even more dangerous and worrisome conclusion than the simpler suggestion that these companies are nothing but thieves. It is a lot easier to believe that some players in the market are operating in a criminal manner, than to believe that the system is suffering from some problems that could easily lead to a catastrophic economic collapse.
But consider this: all along, the banks have “threatened” a catastrophic economic collapse if they were not given yet another bailout from the taxpayers. What if they were being sincere in their fears? They must have some sense of the linkages among all the big financial players, and the systemic risk that binds them together in health or havoc. If they truly believe that the failure of one of their number will drag down all 25 of them, then it is not just a few individual investors who have given thought to the fact that Financial Armageddon is now closer than ever.