MF Global Collapse May Have "Apocalyptic" Consequences For The Eurozone

Why The UK Trail Of The MF Global Collapse May Have "Apocalyptic" Consequences For The Eurozone, Canadian Banks, Jefferies And Everyone Else

In an oddly prescient turn of events, yesterday we penned a post titled "Has The Imploding European Shadow Banking System Forced The Bundesbank To Prepare For Plan B?" in which we explained how it was not only the repo market, but the far broader and massively unregulated shadow banking system in Europe that was becoming thoroughly unhinged, and was manifesting itself in a complete "lock up in interbank liquidity" and which, we speculated, is pressuring the Bundesbank, which is well aware of what is going on behind the scenes, to slowly back away from what will soon be an "apocalyptic" event (not our words... read on). Why was this prescient? Because today, Reuters' Christopher Elias has written the logical follow up analysis to our post, in which he explains in layman's terms not only how but why the lock up has occurred and will get far more acute, but also why the MF Global bankruptcy, much more than merely a one-off instance of "repo-to-maturity" of sovereign bonds gone horribly wrong is a symptom of two things: i) the lax London-based unregulated and unsupervised system which has allowed such unprecedented, leveraged monsters as AIG, Lehman and now as it turns out MF Global, to flourish until they end up imploding and threatening the world's entire financial system, and ii) an implicit construct embedded within the shadow banking model which permitted the heaping of leverage upon leverage upon leverage, probably more so than any structured finance product in the past (up to and including synthetic CDO cubeds), and certainly on par with the AIG cataclysm which saw $2.7 trillion of CDS notional sold with virtually zero margin. Simply said: when one truly digs in, MF Global exposes the 2011 equivalent of the 2008 AIG: virtually unlimited leverage via the shadow banking system, in which there are practically no hard assets backing the infinite layers of debt created above, and which when finally unwound, will create a cataclysmic collapse of all financial institutions, where every bank is daisy-chained to each other courtesy of multiple layers of "hypothecation, and re-hypothecation." In fact, it is a link so sinister it touches every corner of modern finance up to and including such supposedly "stable" institutions as Jefferies, which as it turns out has spent weeks defending itself, however against all the wrong things, and Canadian banks, which as it also turns out, defended themselves against Zero Hedge allegations they may well be the next shoes to drop, as being strong and vibrant (and in fact just announced soaring profits and bonuses), yet which have all the same if not far greater risk factors as MF Global. Yet nobody has called them out on it. Until now.

As Reuters points out, it was not so much the act of creating "repos-to-maturity" that imperiled MF Global, but what is a secret gold mine for those privy to it - the process of re-hypothecation of collateral.

[h]ypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.

In the U.S., this legal right takes the form of a lien and in the UK generally in the form of a legal charge. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default.

In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital).

Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. 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 the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.

But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated.

In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior 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.

Keen to get in on the action, U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules.

Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organisation.

Potentially as simple as having MF Global UK Limited, an English subsidiary, enter into a prime brokerage agreement with a customer, a U.S. based prime broker can immediately take advantage of the UK’s unrestricted re-hypothecation rules.

This is exactly what Lehman Brothers did through Lehman Brothers International (Europe) (LBIE), an English subsidiary to which most U.S. hedge fund assets were transferred. Once transferred to the UK based company, assets were re-hypothecated many times over, meaning that when the debt carousel stopped, and Lehman Brothers collapsed, many U.S. funds found that their assets had simply vanished.

A prime broker need not even require that an investor (eg hedge fund) sign all agreements with a European subsidiary to take advantage of the loophole. In fact, in Lehman’s case many funds signed a prime brokerage agreement with Lehman Brothers Inc (a U.S. company) but margin-lending agreements and securities-lending agreements with LBIE in the UK (normally conducted under a Global Master Securities Lending Agreement).

These agreements permitted Lehman to transfer client assets between various affiliates without the fund’s express consent, despite the fact that the main agreement had been under U.S. law. As a result of these peripheral agreements, all or most of its clients’ assets found their way down to LBIE.

And now we get back to the topic at hand: MF Global, why and how it did precisely what Lehman did back then, why it did this in London, and why its failure is a symptom of something far more terrifying than merely investing money in collapsing PIIGS bonds.

I don’t think you understood what I said - TOTAL, COMPLETE ECONOMIC COLLAPSE OF EUROPE AND THE UNITED STATES.

Haven’t you been following what is going on in Europe? do you read Ann Barnhardt’s blog, especially this week?

I suggest you start with Monday, Dec.5th, and work your way through everything until today. It’s a wake-up call when someone like her says we may have a total economic collapse - system wide - before Christmas.

http://www.barnhardt.biz/

Disclaimer: I don’t know what I’m talking about and need Freeper guidance.

I am a hard wired, genetically programmed prepper and a hard asset person and have been for a long time. If tshtf, I’m as good as I can be.

However, I am surrounded by successful, soft asset, 401k, etc. people (my children, among others) who do not see the world as I see it.

When I bring up the potential threat, they remind me about the FDIC and that if the bank(s) fails, then the next day it reopens with a new owner and name and their accounts are just as liquid and just as safe.

Barnhardt and Zero Hedge are good but it is like pointing at cracks in a big tall building that is in New York City and isn’t relevant to their lives. While I think that it can land on their heads, I am not making the case. I need intellectual ammo.

Could the government just provide liquidity on demand accounts, i.e. checking, passbook savings, etc. and convert all others in timed commitments like CD’s, 401k’s, etc. to a “government bond at 2-3% and no withdrawal until the government says you can” type of arrangement? (I think I just made this up but it makes sense at some level.)

What is the scenario for these kids?

Not to make light of your concern, but way back in the mid 1980’s and again in the 1990’s there were a series of “economic survival” books and 2 I remember were written by the same author whose name I cannot recall except to say it was an Indian name. These books had the self same theme, the coming collapse, why it would happen and what to do about it to protect yourself.

It didn’t happen then and although no one can say with certainty whether or not it will happen before Christmas, I personally would like to place a small wager of say $1000 that it will not. Of course if I lose then the $1000 you win will be worthless. Perhaps we could make the wager in gold?

LOL! Even though I do not feel like laughing.

I’ve been unemployed since January. All my coins, gold and silver, have been spent trying to keep my dad, who has Alzheimers, in adult foster care. It appears, by New Years Day, all my efforts will be for nothing. We’ll be out of money and the only financial support he will have is his pensions and social security which can pay for his medical care and immediate support, but not the mortgage, credit card payments, or the car payments.

At this point in time I suspect the only really stressful moment will be determining when to rush to the bank and withdraw all those worthless paper dollars.

I’m not sure what is in store for our kids.

My nephew, age 19, is trying to get a job with a railroad, at the same time he is seeking financial aid to attend college and earn an associates in welding tech.

I suspect that for the young, they must research what jobs will help rebuild our economy and take a path towards jobs that meet those goals. Maybe becoming a machinist, a millwright, or a carpenter; or maybe learning computer assisted manufacturing. The truth about work is timeless: if you love what you do for a living, it isn’t really work.

I tell young people if you don’t know what you want to do with your life, join the military. It doesn’t matter which branch. I guarantee that within two weeks of starting recruit training (BOOT CAMP!) you will likely know what you want to do the rest of your life, and it ain’t the military! But it is a good interlude where young minds can learn to become organized and self-disciplined, and maybe earn the seed money to start a business. The opportunities are there, they just need to recognize them.

For the young, there is always a future. We should encourage them to think positive for they have the time to follow differing pathways of discovery. Some will end in disappointment but some will open other avenues of opportuniaty. Just keep going forward and do not get discouraged.

I hope this helps you, Ron. For the youngsters, I think there is potential in the future. It is those like ourselves I worry about.

I know what you’re trying to say, for I too, had your hard core belief in our capititalist system. But something is wrong now with our economy and even the whole system, and I can’t quite put my mind to exactly what it might be.
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The problem is easily identified as debt. Debt incurred by spending and promising to spend more then can be afforded. The solution is as easily identified as cutting both current spending and future spending.

I think up until very recently the politicians who engineered this (world wide) Ponzi scheme of ever escalating give aways funded by ever increasing taxes believed there horseshit scheme would last forever or atb least until THEY retired with their stash.

Now that realization has hit them they know exactly what must be done but the problem is to convince the “deliberately kept stupid public” of what must be done. The public was led to believe and mostly still does that if taxes are just raised on the “rich” who certainly don’t NEED all that money and in any case stole it from hard working middle class people, all the problems would go away and paradise will remain open.

That extreme cuts in both current and future spending will be made is a given. It is just a matter of when and how extreme. Will the “free stuff for me” crowd be upset? Will they riot? probably they will to some extent but it will in the end make no difference because if the cuts are not made soon the pain and the rioting will be that much worse and the so called “leaders” know this. Being politicians it is difficult for them to come right out and state the obvios and admit their past policies are all failing and we must make corrections to sustain the necessary programs now or else they will be lost forever or so diminished they will be all but gone.

SS will go private, of that I have absolutely no doubt and it will begin with all those entering the workforce and include those already in the workforce to a limited extent based on their age and how near retirement they are. The retirement age will be raised and perhaps some means testing done as well as removing the cap on SS pmts (I know it’s a tax increase but it may be necessary). There will be medical savings accounts made mandatory to new entrants into the work force and these accounts will fund the medical coverage for workers who retire.

Some changes will be radical and the ones who will scream the loudest are predictable and they must be ignored. Like that man said,(paraphrase) “The needs of the many outweigh the wants of the few”

Thanks!

You are correct on the advice to your nephew. I was a reluctant participant in the US Army, but, it turned out to be a life altering (in a positive way) experience.

My kids, though, are past that stage. One is an attorney, the other a successful programmer. They have assets to lose if there is a financial collapse. I can’t get them to see beyond what the FDIC can and cannot do for them. The concepts of the ATM not working and the government grabbing their retirement funds are what I cannot get across.

I can’t seem to formulate a plan for what they should actually do and sell it.

“SS will go private, of that I have absolutely no doubt and it will begin with all those entering the workforce and include those already in the workforce to a limited extent based on their age and how near retirement they are. The retirement age will be raised and perhaps some means testing done as well as removing the cap on SS pmts (I know it’s a tax increase but it may be necessary). There will be medical savings accounts made mandatory to new entrants into the work force and these accounts will fund the medical coverage for workers who retire.”

This is so sensible, one wonders why it hasn’t been the norm for these past 70 or so years. Really!

I suggest you print out what Ann Barnhardt has said this past week, Dec. 5th. throught Dec. 9th, at her blog.

http://www.barnhardt.biz/

She does a good job of explaining what is going to happen. She even says that taking the tax penalty when cashing out the 401K is worth it, as the government will seize all.

Good luck with your children. Maybe they’ll listen, maybe they won’t. But at least you’ve tried to alert them to the potential dangers of our future. That is all that we, as loving elders, can do to aid the young.

Our children roll their eyes and laugh behind our backs at the paranoia of the geezers. Until they actually lose their financial cushions and their futures, they are unlikely to listen to anyone who isn’t telling them soothing tales. And, when it actually happens, they will blame the capitalists, producers and conservatives because that is what they are conditioned to do.

I know countless families like yours. In the end, the culture won and we cannot protect adult children from consequences.

If the worst sort of collapse happens, how many of them will even be able to get from wherever they are to any sort of even relative safety?

In the end, most parents continue to worry, make sure their kids know there is some preparation ongoing by their parents and leave the rest to God.

At some point they may even ask you how you knew all this when every news source they respect has told them it can’t happen here. If we are very lucky, they will neither blame us nor give us up to the authorities in the name of fairness.

It’s painful, but no one I know has an answer. The best response I have seen is one family where the father has managed to set up two of his kids in business managing family real estate assets. One other child is in the military and the fourth has a slew of kids, a stubborn independent spouse, is on welfare, but knows that Dad has the means and the place for them all to be safe. Ironically, it is only the fourth who is a conservative and has the personal skills to survive after a collapse.

It is a strange world, these days.

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