MF Global: The SERIOUS Issues Reach Mainstream Media

As I opined rather quickly when MF Global collapsed, the real risk is not that a futures merchant went under.  Brokerages go under all the time — I went through two “consolidations” after 2000 and in both cases my assets and trading accounts were simply moved over to a new entity.  How “forced” those were is open to some question, but from my perspective I went to bed one day with an account at “X” and woke up with one at “Y”.  Nothing disappeared.

The problem occurs when you wake up and assets have disappeared.  This has become a disturbingly-common pattern of late, from Bernie Madoff to Stanford and now MF.  As Reuters reports:

(Business Law Currents) A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients. 

MF Global’s bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous $6.2 billion Eurozone repo bet. 


What most people don’t understand is that when you open a brokerage account you allow your assets to be used to “borrow, pledge, repledge, transfer, hypothecate, rehypothecate,loan, or invest any of the Collateral

Absolutely standard  boilerplate language.

But here’s the problem — this is “in accordance with Applicable law.”

This use, incidentally, is why brokers scream that trades are “just $5!”

Well, yes.  But your money is being used by the brokerage, more or less, as collateral.

But there’s a difference between earning on your funds and securities (which brokerages do all the time) and stealing your assets.  The latter occurs when the law is circumvented — whether legal or not.

And it appears that it was — UK laws appear to contain no limits on the amount of hypothecation or re-hypothecation that can take place.  MF Global thus appears to have transferred client assets outside of US jurisdiction where they were then subject to much looser — effectively zero — in the way of risk controls!

But the underlying means by which this escaped surveillance is the same means by which both Lehman and Enron blew up — the use of off-balance-sheet vehicles to hide total risk exposure.

Specifically, these “repo to maturity” deals which our current law permits to be booked as “purchase and sale” agreements, thus realizing the expected coupon flows as “profit.”

The flaw in this reasoning is that a “true sale” must be just that — it must leave you with no obligation beyond the execution.  But that’s not true here — if the collateral declines in value either in the interim or at maturity the entity can be forced to make up that shortfall either through posting more margin or through an offsetting settling charge.

As such allowing this to be taken off the balance sheet is an outrage, as there is a continuing obligation and risk of loss that goes beyond the date when the agreement is consummated.  That is, it’s not a “true sale” despite being able to be counted as one under existing law.

The myth that is operative here is that lending to sovereigns is “zero risk” and thus the face value of a sovereign bond is the value at maturity.  This fiction leads to the accounting treatment.  But this is a factual lie — not only now, but always, because lending to a sovereign is nearly always, as a matter of both fact and law, unsecured.

As such there is nothing other than a bare promise standing behind these loans – and governments break promises all the time.

If you remember some of my earliest rants from 2007 they focused on the off-balance-sheet games that were being played at the time.  I called them nuclear financial weapons of mass destruction because they are — such vehicles are always a scam in some form, as the only reason to use them is to hide from customers, regulators and the common public the amount of risk you have on.

That is, they have as their essential purpose in each and every case the intentional hiding of the amount of leverage that the entity involved has taken on, and thus it serves to intentionally overstate the amount of loss that entity can absorb before it is rendered bankrupt.

In short, in each and every case the intent is to deceive and thus induce other parties to enter into transactions at terms they would not be willing to transact under were they to know the truth. 


We learned this when ENRON blew up with their infamous “barge” transactions and then once again in 2008.  Yet despite these two stunning examples and absolute proof that the essence of these transactions is the intentional hiding of risk and deception of clients and counterparties we have refused to prosecute these “instruments” as unconditionally unlawful acts despite the fact that their essential purpose is in every case the deception of others.

And now we have farmers and others who did the right thing — who engaged in ordinary financial practices that have existed for centuries and which should have involved no execution risk of materiality at all — who once again got robbed through the intentional hiding of risk and this intentional deception.

The damage is to systemic liquidity and confidence.  The games are still being played this morning over in Europe in a furious attempt to “restore confidence” but in point of fact the underlying scam lies here — and until it is addressed and stopped there will be no resolution or stability.

The Agriculture Committee this morning is once again playing “dog and pony show” while Eric PlaceHolder refuses to indict and Obama says that “nobody did anything unlawful.”  This is a blatant and outrageous lie by all parties in the government — off-balance sheet acts are in each and every case an act undertaken with fraudulent intent as their entire purpose is to conceal the risk and size of a given transaction.

And finally, let me reiterate what I’ve said since this story broke: So long as there are off-balance-sheet liabilities and derivative contracts have preference over deposits — both of which are true in the present time — this very same risk is present for anyone with a BANK OR INVESTMENT ACCOUNT OF ANY TYPE in The United States.  If you believe otherwise you are wrong.

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