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As recently as a few weeks ago, the European Union
directed its member nations to draft their own independent legislation for
dealing with the resolution of a failed G-SIFI (Globally Significant
Financial Institution). At the same time, we have all sorts of seams opening
in the currency, bond, and commodity markets. The Swiss Franc is now
un-pegged from the Euro, there have been wild swings in the bond markets in
Europe due to the aforementioned action, and oil is in an absolute free-fall.
There are many geopolitical (and likely criminal) maneuverings behind all of
these phenomena, however the chaos in the financial world thus far has been remarkable
in that there hasnÂt been much given everything
going on.
There has been news of some smaller brokerages biting the
dust thanks to these swings, but yet nobody Âbig has gone down  yet. Are they that good?
That insulated? That lucky? ThatÂs for people of a
higher pay grade to answer, but the bottom line is that the environment is
absolutely RIPE for another Cyprus or MFGlobal. Will it happen this time
around? CouldnÂt tell you. Maybe itÂll be next time. Or maybe itÂll happen
this time, but not impact the US. Since everyone already thinks America is
bulletproof I am guessing most will go with the latter of the two
possibilities.
IÂve been talking an awful lot
again about the bail-in, but a reader pointed out that he still doesnÂt understand exactly what it is, and, more importantly, how an
institution gets into the position where it needs (or wants) one. HeÂs a smart one, this reader, so I figure if heÂs got questions then so do a whole bunch of other folks and thatÂs perfectly all right. ThatÂs why I do
this. So this week IÂm going to focus on some of the
anatomy and try to give everyone a sense of the sorts of things that put a
bank/broker or just a broker into a position where theyÂd seek to invoke the bail-in.
On the positive side, although not for those folks
impacted, we have a live example of how the bail-in works, right here in
America to use as a template. I donÂt wish to
further malign Mr. CorzineÂs already shredded
reputation, but as his penchant for fast travel suggests, he could probably
outrun any criticism we might toss his way.
Anatomy of the Bail-In  The Mechanism
LetÂs talk about a brokerage
first since this is where MFGlobal was situated. Brokerages generally have
two components  the brokerage side and the dealer
side. Formally, they are referred to as broker-dealers by the regulators
because of this. So there are two sides. One side you see when you walk in
and talk to your broker and sit in his posh office and the other side, which
you never see  and usually neither does the broker.
It is this unseen side you need to worry about in this instance. Your hundred
thousand dollar brokerage account isnÂt very
noteworthy in the grand scheme of things other than that the broker-dealer
might use shares that you hold in your portfolio to lend out to other parties
so they can short a particular stock. Hmm, that is kind of going against your
best interests isnÂt it?
Your broker calls you with a Âhot
tip or a Âsure winner and you go with it, then theyÂre enabling
short-sellers out the back door. Nice huh? And they all do it, but I digress.
The brokerage side deals with clients such as yourself,
maybe some pension funds, trust funds, perhaps an institutional client or two
depending on what theyÂre into and so forth. It is
pretty benign. On the other side of the operation there is the dealer side
and they can be into all kinds of stuff, which, thanks to the USFederal court
system, can get you into a pile of trouble. To keep it overly simple, think
of the dealer side of the broker-dealer arrangement as a giant client. The
dealer operation has accounts, holds positions, buys and sells positions, and
makes a market in all of the above. They might do this with regards to stocks
and bonds as well as options and other derivatives. The dealer side can
borrow money to do all of the above as well, usually from commercial banks.
When they borrow money to engage in transactions it is called leverage.
Anatomy of the Bail-In  A Scaled-Down, Working Example
LetÂs say the dealer has a
million dollars in assets  cash and positions. If
they make 10% in a quarter, theyÂve added another
$100,000. Ok, easy enough, but they want to make more than that. So letÂs say they go out and borrow another $500,000 at 5% per annum and
invest the whole enchilada for a quarter and make the same 10%. So now
instead of $100,000 in earnings, they have $150,000 Â a 50% increase. Their interest expense for the quarter is $6,250
so their gross profit on the loan is $43,750. They give the $500,000 back
plus the $6,250 in interest and everyone is happy. Their assets have swelled
to $1,143.750. So where theyÂd made 10% originally,
using leverage, they turned that gain into a 14.375% gain. Not too shabby.
Plus, remember they make a few bucks lending out the shares you bought on
that hot tip so someone else can place a bet that your hot tip stock will go
down. Again, this is overly simplistic, but you get the idea here. The
borrowed money is cheap  in fact, 5% is probably on
the very high side of what they pay in interest, but is a round number.
LetÂs say now that things donÂt work out. The invested $1.5 million goes down by
10% in a quarter. They lose $150,000 plus the $6,250 in interest and
suddenly, when they give back the loan and the interest; theyÂre left with $843,750. This creates an obvious problem when all of
their assets are already deployed. ThereÂs red ink
to the tune of $156,250. Generally, what will happen is another loan will be
obtained or some assets sold off or maybe a little of both and the loss will
be absorbed.
Anatomy of the Bail-In - Reality
Now the illustrative example above uses a very tame
leverage ratio. There was 50 cents of debt for every dollar of assets  or a ratio of .50:1. Understand that leverage ratios of 25:1 and
even as high as 40:1 have not been uncommon. That means for the million
dollars in the example above, there might be as much as $40 million
in leverage (debt). So letÂs use the 25:1 ratio and
assume the same 10% loss. Suddenly the loss is 2.5X (a $2.5 million loss
against a million in assets) the amount of the dealerÂs assets rather than being .15X (a $150K loss against a million in
assets) as in my example, not to mention the interest. Oops. Now the firm
needs cash. They have a creditor to pay off. Well, how about those folks on
the brokerage side? Well, gee whiz, they have $3 million in assets. LetÂs just snag the $2.5 mil from there and use that to pay off the
creditor. But thatÂs stealing and is illegal, right?
Wrong. Not anymore. That is precisely what happened in
the case of MFGlobal, Sentinel Group, and Peregrine Financial  all to varying extents. The dealer side made bad bets and when it
came time to pay off those bets, they went to their clients, raided the
accounts, and then the injustices in the black robes gave it jurisprudenceÂs stamp of approval and the bail-in was on. Now weÂve got precedent and case law supporting overt theft. Instead of
impeaching the judges, imprisoning them along with the principals of the
firms who pulled the stunts to begin with, the establishment comes up with a
new set of nomenclature (G-SIFI, bail-in, etc.) and begins the process of
normalizing the idea of stealing something that doesnÂt belong to them.
And perhaps the most ironic of all? The not-so-USFed, that
shining knight on the white horse, buyer of last resort, standout of the
bailout? It is in hock too and its leverage ratio is absolutely stunning.
77:1 at last count. Yes you read that right -77:1. It was at 22:1 when the
financial crisis started ripping through middle classes throughout the globe
in 2008 and when you hear all these morons on television talking about how
healthy US (and global for that matter) banks are, remember that someone is
eating all these garbage mortgages, derivatives and other nuclear financial
waste. ItÂs the central banks. Wait a second though;
the central bank regulates the underlings, right? Maybe on the surface, but
this is another bright and shining tidbit that illustrates who owns who. The
not-so-USFed simply does what it is told.
A great question right now would be this: If everything
is getting so much better then why are they still leveraging up at the Âfed? ShouldnÂt they be unwinding? They
say theyÂre unwinding. But theyÂre not unwinding, theyÂre continuing to
eat more and more garbage generated by their owners. Now this could go on
quite a while, but not forever and it wonÂt end in a
pretty fashion when it does end.
Anatomy of the Bail-In  Implications for ÂDepositorsÂ
So thatÂs the broker-dealer
version of the bail-in. The bank side isnÂt much
different in concept. Thanks to the repeal of the Glass-Steagall Act, which separated
broker-dealer operations and the savings/loan operations of commercial banks,
the same thing can happen to you if you have deposits in a commercial bank.
The mechanism is precisely the same. The broker-dealer side conjures up some
idiotic bet based on some computer program written by someone who thinks that
the global financial system is nothing more than his or her personal playpen.
In typical fashion, they win enough times to get cocky and of course as this
happens, the greed kicks in and the bets get bigger. Eventually thereÂs a loser and by this time theyÂve pumped
for the goalposts and hiked the leverage ratio up to about 40:1 or even
higher.
When it all crumbles and everyone starts scrambling, bear in mind
that the law has now made your bank deposits available to do a bail-in and
make good on that bad bet. And since youÂre now an unsecured creditor rather than a depositor, you a) have
no FDIC protection, and b) have no recourse. If you were a secured creditor,
you might have a chance to recoup something, albeit not anywhere near what
youÂd lost, but at least a token. What happens next
is your unsecured credit (think bondholders) is converted to equity and you become
a stockholder in a failed bank. Congratulations.You woke up on a Friday
morning having $25,000 in bank deposits and literally by the time the bank
opens Monday you have x shares in a busted bank. And yes it can happen that
fast. Anyone who doesnÂt think it can, should
remember Lehman in 2008. While it wasnÂt a bail-in
at that point, look at the velocity with which that outfit hit the mat, never
to get up. Look at Cyprus. Friday afternoon there are tremors and by Monday
morning, the banks are locked up like Fort Knox and the ATMs are out of
money.
The US has already crafted its resolution mechanisms
along with most of the G20. The EU has just ordered its member nations to the do the same.
In my opinion, anyone who stores more than a trivial amount
of cash in a commercial bank should be sentenced to spend the next month in
Massachusetts figuring out how many of Tom BradyÂs
precious pigskins were improperly inflated.
The biggest problem with the above is that even if you
understand the mechanism and what a firm might have to be engaged in to get
themselves in trouble, it is very difficult to find out exactly what the
dealer side of a broker-dealer firm is up to. TheyÂre
obviously secretive, claiming proprietary interests. Most will tell you their
capital ratio though and that is a start. Your best bet if you insist on
being in paper or even have decided that youÂre
willing to risk a small position in paper is to spread it out amongst several
firms or, better yet, use the Direct Registration System so that your assets
are held in your name at the issuerÂs transfer agent
rather than being held in street name at your broker. I realize the whole
system is intertwined and something big enough to topple firm A might take
firm B with it as well. However, that is an inherent risk for those who wish
to engage in this activity.
Regarding the Direct Registration System, many companies
stopped issuing paper certificates years ago, citing cost (funny, the
shareholder usually was on the hook for that), but even if a firm doesnÂt offer an actual certificate you can still have your shares held
in your name at the issuerÂs transfer agent. There
is a popular misconception out there that you canÂt
do it unless the issuer will provide a paper certificate. All broker-dealers
have a means by which you can DRS your positions. Many are reluctant to
assist though because, frankly, not having your shares in street name in
their Âhouse costs them
money. If DRS is something you are interested in and your broker is
uncooperative, then find someone who will cooperate. The good news is that
there are firms who are not obstructive in this regard.
Also an inherent risk is that even if you start to smell
a rat that you wonÂt be able to extricate your
assets in time. Much in the way banks are making people wait inordinate
periods of time to get cash (if the paper itself is a con job then think
about Âelectronic paper or
digitized currency), firms can take up to 10 working days or more to effect
transfers. In our fast-paced financial climate where the world can literally
change in a weekend, 10 days might as well be 10 years. Also, those pesky
daily limits on your ATM card, put in place for your own Âsecurity as you were told when you asked
about it, could be lethal as was the case in Cyprus.
My goal here isnÂt to make
things sound hopeless; that is not the intent, but rather to present you with
the risks involved when you engage in these very basic financial activities.
Most people donÂt even consider these risks because
until recently they either didnÂt exist as in the
case of the bail-in or werenÂt relevant as in the
case of banks being so stingy with their cash withdrawal policies. This is
one of those times when you simply MUST advocate for yourself because these
other folks are firmly invested in your continued ignorance, apathy, and
ultimately inaction.
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