The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Source:
S.E.C. Is Avoiding Tough Sanctions for Large Banks
NYT, February 3, 2012

More business regulations.

That is what survey after survey around the globe shows that the world’s populations wants. Despite a relentless propaganda campaign of misinformation, fabricated data and false narratives, the public has not been fooled by the 1%. The best efforts of a well funded group of ideologues — Free Market absolutists, anti-Democracy and Randians — these pro-corporate radicals has not yet succeeded in fooling all of the world’s population all of the time.

How do we know this? A 25 country survey last year by Edelman. They asked the question:  “When it comes to government regulation of business, do you think that your government regulates business too much, not enough or about the right amount?”

Most of the world thinks there is insufficient regulation across all industries. The United States, where 31% there was too much regulation. Ironic considering we originated the global financial crisis. The next closest country was Germany at 28%.

Significant pluralities or outright majorities stated that more regulatory oversight was required, with four exceptions: Singapore, UAE and the USA. Singaporeans at 21% were the lowest, but that is no surprise in a nation where spitting gum on the sidewall may lead to a caning. Only 33% of the Emirate residents said more regs were needed. In Sweden, the number is 31%. In the US, more business regulation was requested by 37% of Americans.

As we can can be seen in the chart below, most of the world has a very different perspective.

One major caveat: I would imagine the major events of the past few years probably has people thinking of disasters in specific industries: Banking, Energy Exploration and Nuclear Power. If the questions were asked about those specific industries, I believe the response for more regs would be much higher. And if the question was asked, “outside of banking, deep water oil drilling and nuclear plants” I assume we would get lower numbers.

Hence, this survey may be less about the ideology of regulation and more pragmatic about reigning in dangerous and disaster prone sectors.Too bad that concept never entered the surveyors minds . . .

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UPDATE: January 28, 2012 1:22pm

Apparently, Finance Remains Least-Trusted Industry in Annual Edelman Survey

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Source:
How the Public Sees Business Rules
FLOYD NORRIS
NYT January 27, 2012   
http://www.nytimes.com/2012/01/28/business/survey-takes-publics-pulse-on-business-regulations.html

Here’s another fun quiz, this one from Reuters Breakingviews:

Wanna know how much Capital that needs to be raised by Eurozone banks? How much of a haircut Greek bondholders are going to take?

Play with the sliders on this to find out:

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Click for interactive chart:

Source: Reuters

HFT shrinks spreads and provides liquidity. You’ve heard it all a thousand times, and more. It’s good for you; take your Soma! Honestly, today when investors hear those words, they are wise to the propaganda, and they discount it appropriately. The only “defense” thrown up by the for-profit exchanges’ catering to HFT at each and every turn, is that they have done so for our collective good. Because of that platitude!

But what if it weren’t true? I mean like really not true; like what if an academic study came out and stuff? What if such a study came out and demonstrated that HFT did NOT shrink spreads after all, because when you take trade sizes into account, effective spreads are in fact quite similar to the past!

We introduce into evidence: The Impact of High Frequency Trading on Stock Market Liquidity Measures, by Soohun Kim and Dermot Murphy. They have examined a somewhat liquid instrument, the S&P 500 ETF, SPY during different time periods. Using four independent models

Glosten and Harris (1988), Sadka (2006), Huang and Stoll (1997), and Madhavan, Richardson and Roomans (1997)

that each calculate the effective spread, all four models underestimate the spreads from 2007-2009 by 41 – 46%. Stated differently, spreads between 1997 and 2009 are actually quite similar when you account for size of trades.

Here are some nice tidbits from the study, although we encourage you to read it, as it is very readable right up until the letters and equations and sigmas and symbol thingies:

“In 1997-2006, the average size of a trade is 2,700 shares (with a standard deviation of 15,000 shares), while in 2007-2009, it is only 400 shares [we insert that the average trade size is now under 200 shares] (with a standard deviation of 6,600 shares). At the same time, the average number of consecutive buys or sells has increased from four to twelve. This corroborates our story that it is becoming increasingly common for traders to split their large orders into many smaller orders, in order to minimize price impact.”

“The spread is underestimated because empirical market microstructure models only identify the price impact of a single trade, when we should be identifying the cumulative price impact of many small trades”

“We see that, for the SPY, the average number of seconds between trades has steadily decreased over time, from 67.5 seconds in 1997 to 0.1 seconds in 2009. This decrease is likely because of the sheer increase in the number of transactions over time: on average, there were about 200 buy and sell transactions, each, in 1997, while there were about 250,000 in 2009. The average volume, in shares, has increased from 400,000 shares to 130.0 million shares.”

“If we collapse consecutive buy or sell orders into a single transaction by summing over volume, we find that little has changed from the early to late sample periods – the size, variation and distribution of these collapsed trades stays somewhat stable over time.”

So, umm yeah. Maybe all along we should have been focusing, not on the size changes in spreads, but rather the size changes of their noses, instead.

Source:
Themis Trading Blog
January 19, 2012

Asset Safety in the post-MF Global World
December 26, 2011
David R. Kotok

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We wish our clients, referring consultants, professional colleagues, friends, and all of our readers a happy holiday season and a healthy new year. We also encourage them to ask very hard questions as they work to keep their money and investments safe.

We start this yearend message with a reminder of who we are. We are a separate account manager. That is why we do independent research. We look at what rating agencies say, but we make our own evaluations about credit issues. We do not take custody of clients’ funds. We favor a three-silo approach to money management: we believe that custody, advice, and transactions should all be separately accounted for and independent of each other. That advice would have avoided Madoff, Nadel, and MF Global. It also requires the investor to dig deep into the account arrangement that he/she uses.

We look at the world as an organization of interdependencies. Some are negative and some are positive. They are intertwined. They come in all sizes and shapes. We are using these metaphors to describe the global construction of finance, economics and government. In today’s world there is no complete isolation, not in Russia (Putin protests), not in Syria (City of Homs), not even in despotic North Korea. In today’s world, one may deceive, steal or oppress but one cannot permanently hide.

We start with a perspective articulated by Tommaso Padoa-Schioppa five months before his death. See the Per Jacobsson Lecture, Basel, June 27, 2010 (hat tip Steve Ganns). Google will take you to the full text and to the Padoa-Schioppa bio.

With brilliantly constructed prose, Padoa-Schioppa said:

“Humans sharing common interests constitute groups of different sizes on a scale that goes from the condominium to the population of the world. Goods like a garden, the judiciary system, navigation on the Rhine, or the biosphere, are ‘public’ for jurisdictions such as a town, a country, a continent, or the planet.

“It follows that also government – as provider of public goods – needs to be constructed at different jurisdictions and to refer to different constituencies. Government must be plural and multi-level. The Jacobin aspiration to concentrate public power in the hands of a single ruler produces both oppression and ineffectiveness.

“The present crisis stems largely from the inconsistency between the increasingly cross-national span of markets – be it regional or global – and the persistently national span of government: lack of an international monetary order providing a degree of macroeconomic discipline, regulatory competition among financial centers to attract bits of global financial industry, etc. This defective aspect of the relationship between markets and government – one of the most important flaws in the market-government nexus leading to the crisis – cannot be simplistically described as a ‘lack’ or an ‘excess’ of government. The defect lies in the level rather than in the quantum of government and has deep roots in the field of practices and in that of ideas.”

Wow! If ever we saw a summary of interdependence issues applicable to the global financial arena, this is it. Moreover, it only took him three paragraphs. We will leave you to ponder this, dear reader, and will move on with this as a context.

Here is some specific food for thought as we enter the New Year. We offer these citations and examples to the many readers who inquired about our writings on MF Global, on rating agencies, on the Fed’s primary dealers and on the state of the financial world. Those commentaries are archived at www.cumber.com.

On August 3, 2011 (notice the date) Moody’s wrote the following as part of a credit report on MF Global. “In summary, there are clear positive indicators of management’s ability to execute.” Moody’s then reaffirmed the Baa2 rating and said, “MF Global recently obtained the Primary Dealer status with the Federal Reserve Bank of New York. Achieving this milestone is a credit positive because it should 1) broaden MF Global’s secured funding base, 2) add positive momentum to its brand and franchise building efforts, and 3) expand the size and capital efficiency of its US treasuries trading operation.” Moody’s had earlier affirmed the Baa2 rating, on February 3.

Remember that the Fed maintains that primary dealer status confers no special financial creditworthiness and that the primary dealer designation should not infer it. The Fed specifically disclaims special status. Obviously, a rating agency thinks differently. Perhaps the Fed will take note during the New Year, as it considers the damage that has been done since the Greenspan-Corrigan decision (1992) to remove Fed surveillance of primary dealers.

On December 13, 2010, Standard and Poor’s rated MF Global BBB- with a “stable outlook.” S&P said, “The company has been in a prolonged turn-around mode for the past two years, but we consider the most recent strategic plan of the new CEO Jon Corzine to be sound. This plan focuses on developing the firm’s historic broker model into more of a broker-dealer model, which should eventually increase and diversify revenue and lead to better profitability.”

So, 2011 witnessed the MF Global saga. The firm became a primary dealer with the Federal Reserve, had its investment-grade rating reaffirmed, and then blew up. What does that say about positive and negative interdependencies and “level” vs. “quantum” of government? Tommaso, we offer you posthumous praise and wonder if your spiritual ears must be ringing.

We have written extensively about the hypothecation issue and will introduce some further evidence below. Let’s close the rating agency discussion with the following sarcastic quote.

“The function of a ratings agency is to visit the field at the end of the battle and shoot the wounded.” – John Heimann (former US Comptroller of the Currency), spring, 1998; source, Brookings (hat tip, Barry Ritholtz). Readers may note that the Global Interdependence Center is hosting a conference on rating agencies, February 29 in Philadelphia. See www.interdependence.org for details.

Now, on to explaining why we are so harsh on the City of London and why we see hypothecation as such a huge risk. We believe that no new safety became available in the City between the Lehman debacle and the MF global affair. Here is an example of a government (the UK) saying something is unsustainable and then doing nothing about it. Tommaso’s level and quantum are both violated. The interdependencies are clearly negative. Proof follows.

Reuters reported that, “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, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead, it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500).”

More from Reuters: “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 organization. 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. In fact this is exactly what Lehman Brothers did through Lehman Brothers International.”

Here is the actual text of a paragraph from an MF Global account document executed with a client.

“7. Consent To Loan Or Pledge

You hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate, 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.”

Source: Thomson Reuters, “MF Global and the great Wall St re-hypothecation scandal”

Reuters’ research noted that “Once in the system collateral is being pledged and re-pledged over and over again either through sale and repurchase agreements or re-hypothecation as demonstrated by a review of SEC filings. For instance, Goldman Sachs disclosed recently that it had re-pledged $18.03 billion of collateral received as at September 2011, Oppenheimer Holdings re-pledged approximately $255.4 million of its own customers’ securities in the same period, Canadian Imperial Bank of Commerce re-pledged $72 billion in client assets, Credit Suisse sold or re-pledged CHF $332 billion of assets (received under resale agreements, securities lending and margined broker loans), Royal Bank of Canada re-pledged $53.8 billion of $126.7 billion available for re-pledging, Knight Capital Group delivered or re-pledged $1.17 billion of financial instruments received, Interactive Brokers re-pledged or re-sold $7.9 billion of $16.7 billion available to re-sell or re-pledge, Wells Fargo re-pledged $19.6 billion as at September 2011 of collateral received under resale agreements and securities borrowings, JP Morgan sold or re-pledged $410 billion of collateral received under customer margin loans, derivative transactions, securities borrowed and reverse repurchase agreements and Morgan Stanley re-pledged $410 billion of securities received.”

Here is a paragraph of text from the detailed margin-account disclosure agreement of Morgan Stanley Smith Barney:

“We may borrow money to lend to you or other margin clients and pledge your securities as collateral for such loans. You authorize us to lend any security in the margin credit portion of your Account, together with all attendant rights of ownership, either separately or together with the assets of other margin clients, to us or to others without notice to you. In connection with such loans, and securities loans made to you to facilitate short sales, we are authorized to receive and retain certain benefits, including interest on your collateral posted for such loans, to which you may not be entitled. In addition, we may receive compensation in connection with such loans. In some circumstances, such loans may limit your ability to exercise voting rights of the securities lent, either in whole or in part.”

Source: http://www.morganstanleyindividual.com/customerservice/disclosures. Note: this is not unique to MSSB. Nearly all firms have similar language.

The client enters into this agreement by doing nothing. To avoid it the client has to opt out. Here is the line of text used in the account document. “Please note that you are automatically requesting margin privileges unless you check the ‘NO MARGIN’ Box.“

This safety-threatening risk is manageable if the client is alert and informed. Limit brokerage to a cash account. Set up custody in a way that does not give the custodian permission to use the assets. Deny the ability to lend or hypothecate. But the client or the investment adviser needs to be alert.

Also, note that there is usually a cost attached to the secure safekeeping of assets. Firms try to induce you to allow hypothecation because they make money off of your assets when they use them. It is worth paying for independent safety, in our opinion. At Cumberland, we use several custodians, including major brokerage firms and banks. We strive to set up these accounts around the principle of three silos. We recognize that there are times when clients need to use margin in order to borrow. That is okay as long as it is monitored. And when you pay back the loan, you can revoke the margin agreement if you do not plan to borrow again. In other words, pay attention to these details and take nothing for granted.

Let’s wish for better regulation and more transparency and honest execution in the new year. Maybe it will even happen in the UK. The world is a dangerous place these days. Vigilance is called for. Interdependencies are both positive and negative.

On that note, we reaffirm our best wishes for the New Year. We do not plan to drink and drive. We equate drunken driving to asset placement where there is open-ended hypothecation risk. You may survive but the danger is high. Stay safe and have a happy New Year.

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David R. Kotok, Chairman and Chief Investment Officer

I was pleasantly surprised this morning to see a WSJ article that suggests the SEC is beginning to use the tools of Quantitative Research in its enforcement: SEC Ups Its Game to Identify Rogue Firms. This is a positive step for enforcing the laws governing markets.

Recall 3 years ago, we asked if the SEC did Quantitative Research?

“I would suggest to the incoming head of the SEC to put together a blue ribbon of math professors, quant scientists and algo specialists to develop a few basic programs that ferrets thru market, options, and performance data looking for aberrational data series, and leading to criminals and fraud artists.”

Then again two years ago, during the option backdating scandal, we noted the advantages of using quant tools for law enforcement:

“It also points out the need for the SEC to develop a Department of Quantitative Analysis filled with math geeks and computers, doing nothing but sifting through data looking for investor fraud. I’d bet they would get more convictions than the rest of the SEC combined. (If someone in the SEC would call me, I’ll help you set it up).”

Mathematics provides an ability to sift through mountains of data to find anomalous results — whether you are looking for Alpha or Felons,  it matters not.  I am pleased to see that the SEC is adopting useful, cost-effective techniques. The bottom line is that the prosecutors whoa re charged with enforcing the rules have not been using the most current tools of the trade.

If this process continues to change — prosecutors actually pursuing criminals — perhaps we might begin to see investor confidence return to markets. Yes, this is only a small step — real improvement remains a long way off. But the camel’s nose is now in the tent, with more enforcement tools to follow.

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Previously:
Does the SEC Do Quantitative Research ? (December 13th, 2008)

Mathematical Proof: Companies Manage Earnings (February 13th, 2010)

SEC Budget vs Wall Street Spending (March 9th, 2011)

Source:
SEC Ups Its Game to Identify Rogue Firms
WSJ, DECEMBER 27, 2011
JEAN EAGLESHAM And STEVE EDER  
http://online.wsj.com/article/SB10001424052970203686204577116752943871934.html

Market share among U.S. banks

Top 3 Banks = 44%
Top 20 Banks = 92%
All Banks = 100%

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Source:
The Wild West of Finance
ADAM DAVIDSON
NYT, December 7, 2011
http://www.nytimes.com/2011/12/11/magazine/adam-davidson-wild-west-of-finance.html

“Why there hasn’t been more robust prosecution is a mystery.”

-Raymond Brescia, visiting professor, Yale Law School

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Reuters has an outrageous article detailing the absurdity of the lack of prosecution of financial crimes in modern America. It is a shocking to watch the United States, a nation that once followed the Rule of Law, slip into a banana republic.

“Four years after the banking system nearly collapsed from reckless mortgage lending, federal prosecutors have stayed on the sidelines, even as judges around the country are pointing fingers at possible wrongdoing.

The federal government, as has been widely noted, has pressed few criminal cases against major lenders or senior executives for the events that led to the meltdown of 2007. Finding hard evidence has proved difficult, the Justice Department has said.

The government also hasn’t brought any prosecutions for dubious foreclosure practices deployed since 2007 by big banks and other mortgage-servicing companies.

But this part of the financial system, a Reuters examination shows, is filled with potential leads.

Foreclosure-related case files in just one New York federal bankruptcy court, for example, hold at least a dozen mortgage documents known as promissory notes bearing evidence of recently forged signatures and illegal alterations, according to a judge’s rulings and records reviewed by Reuters. Similarly altered notes have appeared in courts around the country.

And it gets much worse.

• Despite laws against it, banks have foreclosed on active-duty U.S. soldiers who are legally eligible to have foreclosures halted. Attorneys representing service members estimate banks have foreclosed on up to 30,000 ACTIVE military personnel, mostly while they were in Iraq and Afghanistan.

• There has been — literally — “tens of thousands of fraudulent documents filed in tens of thousands of cases.” Sworn affidavits have been filed containing false information. This is easily prosecuted perjury.

• The size and scope of the fraud on the U.S. court system is unprecedented in U.S. history

• NY State court judge Arthur Schack, ruled in 2010 that pleadings by the Baum Law — who handle 40% of NY foreclosures — were “so incredible, outrageous, ludicrous and disingenuous that they should have been authorized by the late Rod Serling, creator of the famous science-fiction television series, The Twilight Zone.“  There has been no fraud prosecution to date.

• Banks have routinely filed falsified mortgage promissory notes — in some cases, six different documents have been filed, all claimed to be the original. At the least 5 must be forgeries — an easy felony to prosecute.

Read the entire article if you want to be outraged and send your blood pressure skyrocketing.

The fraud is rampant, self-evident, easy to prosecute. The only reason it hasn’t been done so far is that this nation is led by corrupt cowards and suffers from a ruinous two-party system.

We were once a great nation that set a shining example for the rest of the world as to what the Rule of Law meant. That is no more, as we have become a corrupt plutocracy. Why our prosecutors cower in front of the almighty banking industry is beyond my limited ability to comprehend.

Without any sort of legal denouement, we should expect an angry electorate and an unhappy nation.

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Source:
Special Report: The watchdogs that didn’t bark
Scot Paltrow
Reuters Dec 22 2011
http://www.reuters.com/article/2011/12/22/us-foreclosures-idUSTRE7BL0MC20111222

“There’s No Reason to Own a Bank”: Barry Ritholtz’s 3 Reasons to Avoid Today’s Hot Sector

Source: Yahoo Finance

The (sizable) Role of Rehypothecation in the Shadow Banking System
Singh, Manmohan ; Aitken, James
July 01, 2010

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This paper examines the sizable role of rehypothecation in the shadow banking system. Rehypothecation is the practice that allows collateral posted by, say, a hedge fund to its prime broker to be used again as collateral by that prime broker for its own funding. In the United Kingdom, such use of a customer’s assets by a prime broker can be for an unlimited amount of the customer’s assets while in the United States rehypothecation is capped. Incorporating estimates for rehypothecation (and the associated re-use of collateral) in the recent crisis indicates that the collapse in non-bank funding to banks was sizable. We show that the shadow banking system was at least 50 percent bigger than documented so far. We also provide estimates from the hedge fund industry for the – churning – factor or re-use of collateral. From a policy angle, supervisors of large banks that report on a global consolidated basis may need to enhance their understanding of the off-balance sheet funding that these banks receive via rehypothecation from other jurisdictions.

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