Regulators Seek Help As Refco Sinks Deeper

In an attempt to bring stability to the crisis at Refco Inc., regulators have asked Goldman Sachs Group Inc. and other firms to buy or assume financial responsibility for its massive futures-trading operation, people familiar with the matter said.

The approach, made by senior regulators at the Chicago Mercantile Exchange and Commodity Futures Trading Commission, may calm fears among investors, lenders and trading partners who have been increasingly concerned about the future of the company. Any buyer would likely be expected to guarantee deposits of the unit and allow traders to unwind their positions. With $4.1 billion in customer futures accounts as of March, Refco is one of the world's largest brokers in those markets.

The approach to Goldman spread rapidly across Wall Street Friday afternoon, but a person familiar with the firm's thinking said it isn't interested. It is not known if the regulators have another buyer in the wings. Spokesmen for Refco and CME declined to comment, and a representative of the CFTC didn't immediately return a call. A Goldman spokesman declined to comment on any discussions it may have had with regulators. Goldman, which helped underwrite Refco's recent initial public offering, was hired by the firm this week to act as a financial adviser.

Earlier Friday, Refco announced that it had started unwinding proprietary and client positions at its main business, Refco Securities LLC. On Thursday, Refco put a 15-day halt to all business at another unit, Refco Capital Markets Ltd., citing a lack of cash to keep that business afloat. At the time, it said its core broker-dealer business remained on solid financial footing.

Love to read your thoughts on this subject.
This is 2/3s down the column.

http://www.prudentbear.com/creditbubblebulletin.asp

Credit Bubble Bulletin, by Doug Noland

More Trials and Tribulations of Wall Street Finance
October 14, 2005

I do not argue that Wall Street Finance is necessarily inherently corrupt. Instead, I propose that a highly energized, market-based Credit system offering enormous and easily attained financial rewards openly invites abuse and corruption. What’s more, the combination of Federal Reserve easy “money” policies and overly abundant marketplace liquidity virtually guarantees a gold rush mentality of wealth-seeking endeavors – legal, legitimate and otherwise (Why did Willie Sutton rob banks?).

This week’s news of fraud and deception at futures powerhouse Refco should come as no major surprise. After all, the Wall Street Finance infrastructure that had coddled and financed the likes of Enron and Worldcom is these days more powerful and commanding than ever. Sure, there were some hefty fines to pay – but their relevance was readily diminished by a few years of historic windfall profits courtesy of the Fed’s ultra-easy monetary accommodation. Those pushing the (risk or statutory) envelope were emboldened and windfall fortunes only more handily procured.

I contend that the defining feature of Wall Street Finance is the propagation of excess and self-reinforcing risk (excessive speculation, leveraging, asset inflation/Bubbles, unsound lending, and malfeasance). The past few years have witnessed a veritable (blow-off) explosion of derivative trading and securitizations, areas particularly ripe for abuse and fraud. Nonetheless, my view is in stark contrast to chairman Greenspan’s and the consensus view that contemporary finance provides an unparalleled capacity to recognize and manage risk. For now, Mr. Greenspan’s sanguine view receives ongoing support from the potent elixir of abundant marketplace liquidity and rising asset prices. There are indications, however, that the environment is in the process of changing. As Warren Buffett has commented, “You don’t know who’s swimming naked until the tide goes out.”

With hedge fund returns lagging, recent revelations of improprieties (Bayou Group and Wood River) are likely the proverbial tip of the iceberg (there are, after all, 8,000 funds!). And to what extent market fluctuations (currencies, interest-rates, energy, oil, equities…) played a role in this week’s collapse at Refco, only time will tell. For now, we should expect the wrecking ball of destabilizing volatility across the spectrum of securities markets to continue to chip away at marketplace confidence and liquidity. In textbook fashion, the strength of U.S. equity markets has narrowed over time, and we see of late that the few favored groups have a proclivity for abrupt and major downturns. Clearly, the market environment is becoming increasingly challenging for the leveraged speculating community. There will be ongoing pressure to rein in risk, counterbalanced by the necessity of posting positive returns.

While the end-of-week focus was on Refco and inflation data, Delphi’s bankruptcy was a decisive blow to the tottering auto sector. Auto and auto-related bonds were hit hard, while GM and Ford Credit default swap prices surged to levels not seen since last spring’s marketplace tumult. Yet - and a curious departure from that period’s market response - Treasury yields this week rose sharply instead of their typical precipitous decline at the first inkling of heightened systemic stress. It is very tempting to view this as a major marketplace development.

Confidence that the Fed would cut rates in the event of a bout of marketplace angst has for sometime underpinned not only the U.S. bond market but the stock and “risk” markets as well. A player speculating in the higher risk sectors (say, auto bonds, Credit default swaps, junk, emerging markets, homebuilding stocks, energy, etc.) could at least partially hedge market exposure with (leveraged?) holdings of Treasuries. And while the various risk markets have tended to become more highly correlated over time, faith has held strong that bond prices would spike concurrently with any turbulence that might encompass the “risk” markets. I would furthermore propose that the predictability of bond market rallies in response to tumult in the “risk” markets has played a major role in stabilizing leveraged speculator performance. Diversification among various asset classes (large bond exposure?) has been a fundamental feature of relatively stable positive hedge fund returns and, hence, a crucial element fostering systemic leveraging. A less accommodative and predictable Treasury market would mark an important development with respect to speculator returns and, importantly, market and liquidity dynamics.

Returning to our ongoing question: Why can’t booms last forever? Well, we can continue to focus on Financial Sphere inflation and the resulting strong inflationary bias that that has engulfed the global oil and energy sector. This development has now significantly altered the likely possibilities of Fed policy actions. The probability of a scenario of much higher rates has increased significantly, while the likelihood that the Fed would be quick to ease policy has largely diminished. And while market rates are adjusting to this new reality, I believe that market players have not yet adjusted risk portfolios to this much less hospitable backdrop. Keep in mind that up until recently the market perceived that the Fed was in the “eighth inning” and that cuts would like commence in earnest early next year.

There is a prominent dichotomy with respect to Wall Street Finance: unprecedented Credit and speculative excesses have fomented asset Bubbles, economic booms, myriad distortions and untold corruption, right along with an historic speculative Bubble in Credit insurance/protection. This is a huge systemic issue that I expect will become more of a factor in the unfolding environment. In the first place, I don’t believe Credit is an insurable risk. Credit losses are not random, independent or quantifiable events, such as auto accidents, house fires, health issues or death. Credit, by its nature, is very cyclical and non-random.

The problem lies in the reality that the Credit insurance “business” will always appear extraordinarily profitable during the boom cycle (today in mortgages), with losses coming out of the woodwork on the downside (today in airlines and auto parts). Importantly, cheap and abundant Credit insurance incites greater lending, debt issuance and speculative excesses, fomenting problematic aged financial and economic Bubbles. Protracted Bubbles, then, guarantee commensurate down-cycles that prove devastating to the inflated Credit insurance marketplace. It’s the nature of the beast.

Fed “reflationary policies” incited aggressive risk-taking behavior throughout the markets (including speculating in GM, Ford, Delphi and other auto-supplier Credit default swaps); Dallas Fed president Robert McTeer led the cheer for consumers to all “hold hands and buy SUVs;” and booming ABS and mortgage finance ensured sufficient liquidity to create a global energy shock our system is today ill-structured to handle. The inflationary backdrop (including energy, healthcare, and pension liabilities) has thus far largely destroyed the old-line U.S. airline and auto-parts industries. And while the prognosis for General Motors and other industrials is not encouraging, the changing environment has me peering further out into the future.

The rampant inflation in asset markets (homes and securities, in particular) has set the stage for Credit “insurance” disaster – including Credit default swaps, GSE guarantees, mortgage insurance, bond insurance, financial risk arbitrage and myriad federal guarantees. Perhaps even more than leveraging, this Credit Insurance Bubble is the System’s Achilles heel. Inflated home prices, reckless lending and corruption are today sowing the seeds for enormous Credit losses throughout ABS, MBS and mortgage arena. But that is jumping ahead… a bit.

In some respects, the market environment has returned to where I thought it was earlier in the year. I believed that “risk markets” had reached a critical juncture in the early spring. Market rates were moving higher, stocks were in retreat and then near debacle struck in auto Credit default swaps. I expected the leveraged players would be forced to shed risk, ushering in the end of the Credit boom cycle. Well, I was wrong. I today believe I was wrong because of the liquidity-creating power of a final unanticipated (for me, at least) bond market rally and declining mortgage rates. What transpired was a classic final melee, replete with negligent mortgage lending, wild Wall Street excesses, a Credit default swap boom, an emerging market boom, and a Global Liquidity Glut sufficient for $70 crude. Those having hedged against higher rates were forced to unwind and dreams of a 3% 10-year yield filled giddy traders’ imaginations. For good reason, events have unnerved the Fed, and I suspect it will be some time before they are again so eager to pander to an imperious Wall Street.

If I am correct, pieces are falling into place for the unavoidable adjustment to highly leveraged and speculative U.S. asset markets. I would expect stress in auto-related risk markets to be contagious. Higher market yields from this point are also problematic. The highly leveraged MBS marketplace is vulnerable to rising rates, wider Credit spreads and self-reinforcing hedging-related selling. The entire financial sector is vulnerable to the unfolding environment, and this reality should begin to manifest in widening sector Credit spreads. Further negative Refco revelations would likely push this process forward. Because of the complex nature of the expansive speculative Bubble, we are forced to analyze subtleties in various markets for indications of heightened risk aversion, de-leveraging and waning liquidity.

One would generally expect such speculative dynamics to ebb and flow depending on the prevailing sentiment of greed or fear. Yet this week Refco did remind us how prone fragile underpinnings are to sudden collapse. And, let there be no doubt, the shallow underpinnings of Wall Street Finance are - from here on out - highly susceptible to any slowdown in Credit expansion, any serious bout of risk aversion, or any meaningful move by the speculator community to de-leverage.

Goldman doesn't want any part of a bailout. Goldman wants the same thing it wanted when LTCM went belly-up in 1998...acquisition of assets for a dime on a dollar, either directly or indirectly.

What are you talking about?

This article is about Refco, LLC, the futures division of Refco, not about Refco Capital Markets Ltd. or Refco Securities, LLC, the two other Refco divisions, both of which are in the process of winding down.

Goldman isn't interested in Refco, LLC as they have enough fish to fry because of the fact that they were the lead underwriter of the Refco IPO, already the subject of a class action lawsuit, and buying any part of Refco at this point would be an obvious conflict of interest.

There's nothing to bail out in the futures division. This isn't due to some large customer defaulting and thus rendering Refco unable to pay CME Clearing. Refco, LLC is business-as-usual with futures settlements to CME Clearing and all others.

Meanwhile, the CME is monitoring the futures division on a real-time basis. Not only are all customer funds intact, Refco can't withdraw any capital or excess capital deposited with CME Clearing, all of which is over and above segregated customer funds.

In any case, most of Refco, LLC's customers' money is held by CME Clearing or other clearing houses, not Refco. In the unlikely event that customer seg funds were impaired, there's no way that CME isn't going to make them whole. They have a large contingency fund for that express purpose, and 79 other clearing members to hit up if needed.

No customer of a CME clearing member has ever lost a penny due to impairment of a clearing member firm's capital. The CME would be destroyed if that happened, and they're not going to let some clown at Refco take them down.

Man Financial, probably amongst others, is apparently interested in acquiring the $4 billion block of futures customers which Refco, LLC has. Probably happen next week. Refco, LLC customers will wake up one morning with a new broker and life goes on as usual.

The misinformation and hysteria surrounding this are amazing.

Quite aware of all you say. I worked in the industry for some years, specifically in both clearance and compliance, and I've traded w/REFCO for many years.

The futures arm of REFCO is 100% capitalised, right this minute, courtesy of exchange and CFTC rules, and the vast majority of customer funds are segregated, quite literally untouchable. Plus, as you note, the Clearing Corp. has frozen REFCO's pb deposits. No problems at all here, except that some number of clients and some number of IBs are unquestionably heading for the exits, presumably on the ''other shoe about to drop'' theory. It won't, but they don't ''know'' that, so the policy of better-safe-than-sorry kicks in.

I've no idea why what I typed isn't perfectly clear to you. The very first sentence of the article says:

In an attempt to bring stability to the crisis at Refco Inc., regulators have asked Goldman Sachs Group Inc. and other firms to buy or assume financial responsibility for its massive futures-trading operation, people familiar with the matter said. (emphasis added)

I in turn responded that Goldman wants no part of a bailout (which is exactly what 'assumption of financial responsibility' is, just under another name). What's the problem here? Also, please note that the concept of 'conflict of interest' bothers Goldman about as much as the weight of their employees' fingernails. Conflict, schmonflict, afatc.

BTW, according to the Man people that I and my assistant spoke with Thursday and Friday, they probably will not step up and try to take over all of REFCO's retail accounts. Anything might happen, of course, but the logistics of undertaking such an action were described to me variously as ''overwhelming'', ''pretty thoroughly disruptive'', and ''impossible unless we can get their backoffice'' (this last was from, guess what, one of their backoffice honchos, when I asked about clearing issues and transference).

As ever, we will shortly see what's what.

While futures contracts are derivative instruments, the plain fact of the matter is that this situation differs nearly completely -- as regards futures -- from the LTCM debacle.

First, regulated futures markets are just that, heavily regulated. The thought police are everywhere in this industry, trust me on that one! LTCM was offshore, and subject to virtually no regulation, certainly none that mattered in the real world.

Second, counterparty capital (i.e. customer monies in this case) is at effectively zero risk; the exchanges in Chicago mark all current positions to market twice a day, and NY marks once a day. There is no 3-day settlement in these mkts, as there is in stocks; everything is settled daily. In short, REFCO's liability regarding futures trading is nil, zero, zip, right this minute. As an additional safety measure, too, the Clearing Corporation, which performs the mechanics of trade clearing, settlement, delivery and so forth, has frozen REFCO's capital account...just in case some more fit hits the shan. Aside from the financial media (don't get me started on Peter McKay, btw) trying to whip up a frenzy and scare a lot of IBs and retail traders, there is just about nothing to be scared of in a practical sense. Business as 99% usual next week and thereafter, bar soem really off-the-wall new developments at REFCO.

LTCM, contrarily, negotiated capital requirements and clearing bonds and fees directly with their counterparties, on a case-by-case basis. Anything went, any deal they could set up. Their only hard requirement came from their clearing firm, Bear Stearns, who demanded (and got!) a minimum deposit of $500 million as a precondition for clearing LTCM's trade (Jimmy Cayne always was about the smartest guy on the continent...and he was dead right about this deposit, too). As a result, they ended up operating, at one point, on about 30,000% leverage, conceivably much more if one casts a jaundiced margining eye at their huge swap spread-spread position (no, that's not a typo; it's a bizarrely complex trade that they had a shjtpotful of on). One good blip, and POOF!, away goes their tiny sliver of capital...which POOF! occurred in August 1998.

The danger to the markets worldwide this time isn't much at all, but some does exist. World Capital was a pretty freewheeling operation, and I've not the slightest doubt in the world that they've some pretty funky stuff on their books. Additionally, the mystery counterparty who had the $430 million dinger to REFCO that Bennett ponied up (a good story, that -- the original classic shell game), has yet to be named. It's easily conceivable that if said counterparty is in the dinger to REFCO for that amount, he/she/they might well be in the dinger to other parties.

If such a situation actually is the case, some number of financial firms might take a sizeable hit. Not a 'Going Out Of Business' hit, but a solid shot amidships at least.

This affair is going to end up being one of the most fascinating finance fiascos in history...and it's just getting started. I've been on it like white on rice all week, and it's already gotten so complex that I can't tell, as they say, ''the players without a scorecard''. It rates to become more so, too.

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