Confidence and trust makes the money world go around. The market tension, and eventual rout in 2007-2008, had very much to do with a breakdown in confidence and trust. The global banking system is dependent upon banks working with one another. This cooperation between banks is one way banks remain liquid and able to meet obligations. When these big firms start looking at each other with suspicion, liquidity could dry up. When liquidity dries up, the banking wheels grind to a halt.
Over the last year (plus), I have made a number of references to increasing levels of leverage in the banking and investment world. Now, the evidence is front and center with the failure of MF Global. For those not familiar with MF Global, the company has a history that goes back into the 1700’s. Until last week, MF Global was a broker of derivatives in the world of futures and options. The bankruptcy of MF Global is the 8th largest in US history (that little fact, alone, should catch your attention). So, even though you may have never heard of MF Global until recently, their failure is a very big deal.
What concerns me most is the very real possibility that, with the current environment in Europe placing unbelievable pressure on global banks, we now get another reason banks should be suspicious of one another.
There is a very serious concern that MF Global commingled, and lost, client money along with their own money. The concern is being driven by regulators searching for a missing $600 million in client money. Keep in mind that Wall Street firms are required to keep client money and their own money separate.
What killed MF Global were very risky investments in European sovereign bonds with a ton of leverage. Leverage is borrowed money. The amount of leverage we are talking about is estimated to be 40:1. Recall that the leverage ratios at big Wall Street firms in 2008 were at the same level. When dealing in 40:1 leverage ratios, a small movement in the wrong direction can be devastating. Most of the bad investments appear to have been in MF Global’s own proprietary funds. This type of investing of the firm’s money is referred to as prop-trading. You can kind of see the picture here.
MF Global makes bad bets in their own investments, with large amounts borrowed to make those investments (40 borrowed dollars to 1 of their own). When the bets go bad, the lenders start asking for more collateral. This is why MF Global burned through billions in cash and exhausted their credit lines in a matter of months. It is another sad story of a multi-billion dollar company collapsing in months.
Adding to the problems is that all of these Wall Street firms think their bad bet exposure is hedged with exotic investments like credit default swaps (CDS). The problem is those exotic investments are contracts, and all contracts have counter-party risk. If the other party in an insurance contract (like a CDS) goes bust, then the contract is broken and leaves no insurance on the bad bet(s).
I have to say I am hardly surprised. Jon Corzine, the head of MF Global, is a former Goldman Sachs head honcho, as well as former governor of New Jersey. What a great mix – a former partner of one of the most corrupt companies, in a corrupt industry, who then turned politician.
The bottom line here is that missing customer money, the supposed breach of customer trust, the possibility that client money could be tied up in litigation, yet another regulator got caught flatfooted, and the banks are starting to be leery of the other banks, is not good. We all saw a movie just like this back in 2008. Again, caution is the name of the game so long as Wall Street is still up to the same old tricks. The smart people all warned that the bank bailouts would not save the economy. Instead, they would send the message to the big banks that they could take bad bets and be bailed out by the taxpayers. Let’s check the score: Economy – Not saved : Wall Street – Still making bad bets.
In addition to this disturbing news, we still have major problems in Europe, and our economy is floundering. Add all that up, and I don’t see an end to the volatility that we’ve seen since this year.
Do you have an investment strategy that seeks to protect your portfolio against volatile economic conditions? Call me to schedule a free review of your current investment portfolio – 913.693.7918.
John P. Chladek, MBA, CFP® is the President of Chladek Wealth Management, LLC, a fee-only financial planning and investment management firm specializing in helping families and couples who are not yet retired realize their financial goals. For more information, visit http://www.chladekwealth.com.
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