Tuesday, October 23, 2012

"And no, I’m not counting on the Federal Deposit Insurance Commission (FDIC) to bail me out if one of the banks I deal with goes under. The FDIC’s Deposit Insurance Fund has a balance a little under $12 billion. That’s a lot of money, but not when you consider that it must cover about $10 trillion in customer deposits. That amounts to about 1.2% of funds on deposit."

Your Money Isn’t Safe in Any U.S. Financial Institution

by Mark Nestmann

In August 2011, encouraged by friends who I thought knew much more about these sorts of things than I do, I opened a small account to trade options and futures. The account was with MF Global.

You probably know the rest of the story. Just two months later, on October 31 – Halloween – I learned that MF Global had a shortfall in segregated funds of approximately $900 million. Trick or treat, anyone? MF Global promptly filed for bankruptcy protection. Later, the company’s bankruptcy trustee reported that the company had plundered $1.6 billion of customer assets.

At the time MF Global declared bankruptcy, the total value of my account came to $19,452.22. Of that amount, $1,900 of that was in a highly leveraged futures position (a bet against the euro). The balance of the account, $17,552.22, was (I thought) in a segregated and firewalled account to which no creditor of MF Global had access.

Boy, was I wrong. I could close out my position what I thought was the high-risk euro trade and pocket the cash immediately. But the supposedly segregated balance of my account had disappeared. I later learned that it had magically reappeared in MF Global’s operating account.

Fortunately, the bankruptcy trustee succeeded in retrieving some of these funds. On Dec. 15, 2011, it transferred 60% of the missing funds – in my case, $11,972.60 – to my account at the futures firm that took over my MF Global account. Then, just a few weeks ago, I received a check for an additional $1,594.18. That brings the loss from my segregated account with supposedly impenetrable legal protection down to $3,985.44, or about 23% of the original loss.

What went wrong?

The immediate cause of the bankruptcy, it turned out, was that MF Global’s president, former New Jersey Senator and Goldman-Sachs chairman Jon Corzine, had made a leveraged bet with MF Global’s assets, including segregated client funds, on euro zone sovereign debt. When Corzine’s bet headed the wrong way in the closing days of last October, it forced the company into bankruptcy.

Could this situation recur?

Yes, it could. The rules that allowed MF Global to convert $1.6 billion of segregated customer funds into an ultra-leveraged investment that ultimately bankrupted the company remain in place.

One reason it could recur is due to a practice called “re-hypothecation.” Hypothecation means “to pledge something as collateral.” If you borrow money to trade securities on margin – or if you own highly leveraged investments such as futures contracts – your broker will ask you to sign a “hypothecation agreement.” The agreement stipulates that your broker can borrow shares or other securities in your account to other customers or to the broker, up to the amount you have on margin.

Re-hypothecation occurs when a broker uses customer-pledged collateral to back the broker’s own trades and borrowings. Federal Reserve and SEC rules permit a “prime broker” (such as MF Global) to re-hypothecate an amount up to 140% of the customer’s liability to the broker. For example, if you purchase $100,000 of securities in your U.S. brokerage account, $50,000 of which is borrowed from the broker on margin, the broker may re-hypothecate up to 140% of the underlying collateral, or $70,000.

MF Global under Jon Corzine ratcheted up the leverage to a much higher level by playing regulatory arbitrage between the United States, the United Kingdom, and other countries. For instance, under U.K. rules, there’s no limit to the amount of collateral that brokers can re-hypothecate. U.K. brokers can, and apparently do, re-hypothecate 100% of the securities in a customer’s margin account. To take advantage of this arbitrage, MF Global apparently booked some of the trades from U.S. customers in the United Kingdom. Much of its activity took place off MF Global’s balance sheet, resulting in a phenomenon some call “hyper-hypothecation.”

All of this is perfectly legal. My MF Global contact states:

“Consent To Loan Or Pledge You hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, re-pledge, transfer, hypothecate, re-hypothecate, 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.”

Another set of rules relate to funds in segregated futures and securities accounts. The rules require firms like MF Global to set aside the amount it would owe its customers if the accounts were liquidated. However, there’s an enormous loophole in the rules: they only apply to domestic transactions. They don’t apply to accounts traded on foreign exchanges, or (as in my account at MF Global) that could potentially be traded on foreign exchanges. Incredibly, under these rules only options and futures positions themselves need to be segregated. This is why the funds I had invested in my own risky bet on the euro remained intact.

The rules don’t cover cash and securities. If that’s all you hold in a U.S. account that also trade on foreign exchanges, no segregation requirements exist at all.

It gets worse.

In August 2012, a federal appeals court upheld a ruling that gives the creditors of failed futures brokerage Sentinel Management Group precedence to the company’s assets over its former customers. The court confirmed a lower court ruling that Bank of New York Mellon had first claim on these assets because it had a secured position on a $312 million loan to Sentinel. The secured position, it turned out, was the money customers had in Sentinel’s supposed segregated accounts. The ruling makes it clear that U.S. financial institutions can use segregated customer funds to pay off other creditors. It certainly doesn’t bode well for the remaining $3,985.44 I have yet to receive back from the MF Global bankruptcy trustee.

In the meantime, Jon Corzine, who led MF Global into bankruptcy hasn’t been charged with any crime. I doubt he will, because from what I can see, what he did was 100% legal. Indeed, Mr. Corzine is now in the process of forming a new hedge fund, although I hope you can understand that I have no plans to invest in it.

Frankly, I’m terrified of the implications of hyper-hypothecation, combined with the lax rules for segregated accounts. Not to mention that U.S. courts have placed their stamp of approval on the practice of U.S. financial institutions inter-mingling supposedly segregated client funds with their own to make risky bets with borrowed money. It means that your money isn’t safe in any U.S. financial institution. Nor am I confident that the situation offshore is any better, especially in a country like the United Kingdom, which permits re-hypothecation of 100% of collateral value placed in broker custody.

Both in the United States and abroad, I’m maintaining as small a position as possible in segregated accounts, and maximizing actual market positions in securities, futures, and options. These positions are subject only to market risk – not to financial chicanery. I’ve also closed all margin accounts. I keep the money I need for day-to-day operation of my businesses and to pay personal expenses in the safest banks possible. I use Veribanc to obtain quarterly statements of these banks’ financial condition.

And no, I’m not counting on the Federal Deposit Insurance Commission (FDIC) to bail me out if one of the banks I deal with goes under. The FDIC’s Deposit Insurance Fund has a balance a little under $12 billion. That’s a lot of money, but not when you consider that it must cover about $10 trillion in customer deposits. That amounts to about 1.2% of funds on deposit.

Again, it gets worse.

The largest 25 banks in the United States have total deposits of $8.3 trillion. Not only does that sum exceed the amount of money on hand for the FDIC by many times, it also doesn’t include the enormous portfolios of derivatives these banks hold. And U.S. courts have now ruled that creditors of U.S. financial institutions, which surely include counterparties holding the opposite side of these derivative contracts, have the right to collect ahead of any obligation of financial institution to its customers. The “gross notional value” of those derivatives for these 25 banks comes to an almost unbelievable $249 trillion.

Given this reality, I think you can understand why I’m trying to minimize the money that I keep in segregated accounts or otherwise on someone’s balance sheet. Instead, I’m investing it in physical gold and silver.


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