Global's Fractional Reserves
by Doug French: Who
Serves During Disaster?
the House Agriculture Committee, "I simply do not know where
the money is, or why the accounts have not been reconciled to date."
The public is outraged that the former CEO of bankrupt global financial-derivatives
broker and prime dealer in US Treasury securities MF Global doesn't
know where the missing $1.2 billion in client funds went.
the member a few exclusive clubs: he is a Goldman Sachs alum, former
US senator, and former New Jersey governor. After the incumbent
Corzine was beat by Chris Christie in the 2009 New Jersey gubernatorial
race, the MF board probably rejoiced, believing the guy to fix their
problems was suddenly available. Now he's in the club of taking
a mere 20 months to create the eighth largest bankruptcy in history.
As a stand-alone
entity, MF Global was born in 2007 when it was spun off from UK
hedge-fund giant, Man Group. MF booked revenues of $4 billion that
year from interest earned by using its customers' funds, an operation
that sounds like fractionized banking: short-term embezzlement used
to make profits.
the practice was sealed in English common law in 1811 in the court
case of Carr vs. Carr, where Master of the Rolls Sir William Grant
ruled that debts mentioned in a will included bank accounts since
the money had been deposited into the bank and wasn't earmarked
in a sealed bag. The deposit was thus a loan rather than a bailment.
The same Judge
Grant ruled the same way five years later in Devaynes vs. Noble,
despite an attorney's argument that "a banker is rather a bailee
of his customer's funds than his debtor
because the money
[his] hands is rather a deposit than a debt, and may therefore
be instantly demanded and taken up."
In 1848, in
Foley vs. Hill and Others, Lord Cottenham ruled,
when paid into a bank, ceases altogether to be the money of the
principal; it is then the money of the banker, who is bound to
an equivalent by paying a similar sum to that deposited with him
when he is asked for it.
The money placed in the custody
of a banker to do with it as he pleases."
It's been clear
sailing for bankers ever since. No questions asked.
At the same
time, people are surprised that a commodity brokerage firm would
misplace client assets. As Christopher Elias explains
for Thomson Reuters,
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."
are always insisting that fractional-reserve banking is A-OK, as
long as bankers inform depositors up front that the bank will be
using their customers' money to make loans and investments.
That is exactly
the case with MF Global. The company's customer agreements included
the following clause:
To Loan Or Pledge You hereby grant us the right, in accordance
with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate,
rehypothecate, loan, or invest any of the Collateral, including,
without limitation, utilizing the Collateral to purchase or sell
securities pursuant to repurchase agreements [repos] or reverse
repurchase agreements with any party, in each case without notice
to you, and we shall have no obligation to retain a like amount
of similar Collateral in our possession and control.
Back in 2007,
customer funds held by MF as collateral against commodities trades
could be invested in two-year Treasuries earning north of 4.5 percent.
But in the wake of the '08 meltdown, the Bernanke Fed has flattened
yields to be counted in basis points. With these low rates MF Global
revenues fell to $517 million in 2010.
The old bond
trader Corzine thought he could juice up MF's earnings with a little
financial razzle-dazzle. Thinking outside the box (and off the balance
sheet), Corzine moved $16.5 billion in assets into repos. A repo
involves putting up assets as collateral, assets to be repurchased
later, and borrowing money against those assets. MF used an off-balance-sheet
repo called a "repo-to-maturity" where the loan and the
collateral in the transaction have the same maturity. US accounting
rules consider the transaction a sale and the assets can be moved
off the balance sheet.
Most of these
assets were bonds from Italy, Spain, Belgium, Portugal, and Ireland,
all paying healthy coupon rates that would easily cover the repo
interest rate and provide a nice profit. MF Global would have virtually
no skin in the game (their customers provided it) and be earning
a nice interest-rate spread.
have been rocky in euroland, the collateral value of the short-term
bonds appeared safe with the guarantee provided by the European
Financial Stability Facility (EFSF).
With the $16.5
billion in assets moved off its balance sheet, MF Global then ramped
up a net-long sovereign-debt position of $6.2 billion on its balance
sheet exposure that was five times the company's net worth.
While the EFSF
guarantee would insure against the default of the sovereign debt
if the bonds were held to maturity, MF was still at risk to make
margin calls, if the bonds dropped in price day-to-day. Elias writes,
Wall Street cocaine, leveraging amplifies the ups and downs of
an investment; increasing the returns but also amplifying the
costs. With MF Global's leverage reaching 40 to 1 by the time
of its collapse, it didn't need a Eurozone default to trigger
its downfall all it needed was for these amplified costs
to outstrip its asset base."
So while MF
Global's eurozone bets had not defaulted, the company's liquidity
was drained making margin calls and trying to meet short-term-debt
obligations as the euro-crisis news flow out of Europe vacillated.
MF Global was
able to leverage up its euroland bets by way of the rehypothecation
of their clients' collateral. Hypothecation is pledging collateral
for a loan. Like the mortgage on your house.
MF posted cash, gold,
or securities as collateral to backstop their commodity futures
and derivatives trading. MF would then take those customer assets
to back its own trades and borrowing. Mr. Elias explains, "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."
Under US rules,
a prime broker is allowed to rehypothecate assets to the value of
140 percent of the client's liability to the broker. The rules are
more liberal in the United Kingdom, where there is no limit and
in many cases UK brokers rehypothecate 100 percent of collateral
value placed in their custody.
that by 2007, rehypothecation was half the shadow banking system.
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."
All of this
churning has created rivers of liquidity, much of it with no asset
backing. And what assets do provide backing aren't the quality they
used to be. The repo rules were liberalized in the Clinton era.
So instead of AAA government paper being required, AA sovereign
debt works just fine; after all, as James B. Stewart writes
for the New York Times:
law also allows commodities firms like MF Global to use segregated
customer funds as a source of low-cost financing for their own
operations, but they are required to replace any customer assets
taken from segregated accounts with supposedly ultrasafe collateral
of the same value, typically United States Treasuries, municipal
obligations and obligations whose payments of principal and interest
are guaranteed by the government." [emphasis added]
Of course all
this rehypothecating creates mountains of counterparty risk, all
dependent on dubious collateral that has been pledged multiple times.
The equivalent of having four mortgages on a house, each having
been sold to other parties who have been told their mortgage is
in first position. When the property value starts dropping or the
borrower doesn't pay, only one lender will get there first and legal
activity may be the biggest credit bubble of all time, according
to Elias. J.P. Morgan alone has rehypothecated over half a trillion
dollars in 2011, Morgan Stanley $410 billion, Goldman Sachs $28
billion, and the list goes on.
been told US banks have little exposure to European sovereign debt,
but according to the Bank for International Settlements (BIS), US
banks hold $181 billion in the sovereign debt of Greece, Ireland,
Italy, Portugal, and Spain. And while Germany is considered the
belle of the Continental ball, Grant's Interest Rate Observer
reports that Deutsche Bank is levered at 43:1 and the Bundesbank
has doubled its leverage since 2007 when it was geared at 75:1
these days the central bank is levered at 153:1.
is a problem if the slightest thing goes wrong anywhere.
When the cost of swapping euros for dollars soared at the end of
last month, a coordinated central-bank cavalry charged out of nowhere,
cutting swap rates and establishing temporary bilateral-liquidity
swap arrangements. Nobody but financial news junkies seemed to know
The truth about
the financial crash wasn't known until Bloomberg chased its request
for information all the way to the Supreme Court to obtain documents
that shed light on how much dough the Federal Reserve really
provided the banks during the 2008 meltdown.
it turns out Wachovia shareholders got lucky as the bank was floated
a secret loan from the Fed of $50 billion to keep the doors open
while a sale could be arranged with Wells Fargo for $7 a share rather
than shareholders having to take the buck-a-share offer from the
deal enables us to keep Wachovia intact and preserve the value of
an integrated company, without government support," Wachovia's
chief executive Robert Steel said
at the time.
Right, no government
support at all.
being among the bailed out, Corzine and MF Global are now joining
Lehman, IndyMac, Colonial, and all the small-fry banks lacking the
friends in high places needed to keep them afloat. In the fractional-reserve
world, markets don't decide the winners and losers; government does.
for the NYT, "SIPC will replace up to $500,000 of securities
and cash (but not futures contracts) missing from customer accounts
at member firms," and the notion of even covering futures accounts
floated on CNBC by Senator Debbie Stabenow, just as the FDIC
replaces deposits up to $250,000. But covering the losses of clients
and depositors is hardly the reflection of sound capitalism and
the honoring of property rights.
"If no business
firm can be insured, then an industry consisting of hundreds of
insolvent firms is surely the last institution about which anyone
can mention 'insurance' with a straight face. 'Deposit insurance'
is simply a fraudulent racket, and a cruel one at that, since
it may plunder the life savings and the money stock of the entire
So it's unlikely
Jon Corzine knows where the $1.2 billion in customer money went
any more than the president of a failed bank would know exactly
where the customer deposits went.
issue is that, day by day, Mr. Corzine looks to be merely a canary
in the fractional-reserve coal mine.
French [send him mail]
is president of the Ludwig von Mises
the author of Early
Speculative Bubbles & Increases in the Money Supply.
He received the Murray N. Rothbard Award from the Center for Libertarian
Studies. See his tribute to
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