Archives for November 2011

November 2011 - Page 8 of 9 - Money Morning - Only the News You Can Profit From

The Inside Story of How Our Financial Regulators Let Us All Down

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Did you hear the story about MF Global?

No, not the headlines about its bankruptcy – the real story.

If you haven't heard it yet, it goes something like this.

MF Global became a primary dealer only eight months ago.

"Primary dealer" is an elite status. It means the firm is one of only 22 government bond dealers that trades directly with the Federal Reserve's New York trading desk.

Only, the Federal Reserve doesn't regulate or oversee MF Global, the Commodities Futures Trading Commission (CFTC) does – or rather is supposed to.

But, even more incongruously, the CFTC isn't the first overseer of MF Global . It ceded that responsibility to the CME Group Inc. (Nasdaq: CME), which owns and operates the largest futures exchanges in the United States. The designated self-regulatory organization for more than 50 futures brokers, CME was supposed to be the cop on the beat.

However, t he not-so-funny thing about the relationship between MF Global and the CME Group is that MF Global recently boasted on its Website that it "was the top broker by volume at CME's metals and energy exchanges in New York and in the top three at its Chicago exchanges."

So, is it any wonder that the CME just last week audited MF Global's segregated customer funds and found them to be in compliance?

These are the same supposedly segregated funds which the CME is now saying may have been tampered with. According to the CME:

"It now appears that [MF Global] made subsequent transfers of customer segregated funds in a manner that may have been designed to avoid detection insofar as MF Global did not disclose or report such transfers to the CFTC or CME until early morning on Monday October 31, 2011."

How much money are we talking about? About $633 million – or 11.6% out of a segregated fund requirement of about $5.4 billion.

Do you see what I'm driving at?

So the real story is, t he Federal Reserve, which doesn't regulate MF Global but regulates all banks in the United States, lets a futures commission merchant with investment bank wannabe desires become an insider in its dealings. Meanwhile, a private for-profit enterprise that runs the self-regulatory apparatus that oversees its own customers steps in for a federal agency that's supposed to be in charge of commodities, futures and derivatives markets.

And that's only the tip of the iceberg.

Let me jump on the Securities and Exchange Commission (SEC) next, because you aren't going to believe this, either.

Subterfuge at the SEC

It's come to light recently that the SEC has been blatantly violating federal law for decades.

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Job Market Won't Normalize Until At Least 2023

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Disgruntled American workers have yet another reason for pessimism: At the current rate of job creation, the U.S. unemployment rate will not fall back to "normal" levels – below 6% – until 2023.

Through most of this year the U.S. economy has managed to create about 119,000 jobs per month, but that's barely enough to keep pace with population growth. Only job creation levels of well over 120,000 jobs per month will drive down the 9.1% unemployment rate.

For example, to get the unemployment rate below 6% by the end of 2014, job creation would need to be about 244,000 per month – more than double current levels.

"The sluggish recovery in employment is continuing, with private payroll growth still not even fast enough to keep unemployment from rising further in the medium-term, never mind bringing it down," Ian Shepherdson, chief U.S. economist at High Frequency Economics, told AFP.

That's grim news for millions of Americans.

Although a revived U.S. economy would go a long way to beefing up job growth levels, few see an imminent turnaround, including the typically optimistic chairman of the U.S. Federal Reserve, Ben Bernanke.

On Wednesday Bernanke revised the Fed's projections for the unemployment rate upwards, with estimates for 2012 now up from 8% to 8.6% and estimates for late 2014 at between 6.8% and 7.7%.

"Evidently … the drags on the recovery were stronger than we thought," Bernanke said at a news conference.

Blame Bernanke

Of course, Bernanke himself is partly responsible for the poor rate of job creation, according to Money Morning Global Investing Strategist Martin Hutchinson.

"It's Bernanke's fault," Hutchinson said. "The very low interest rates are causing companies to substitute capital for labor. You can see the effect in today's very good third-quarter productivity number — employers are using less labor per unit of output and more capital, which they can get cheaply. The effect is that job creation is very slow. That's the very opposite of 1983 when interest rates were very high and job creation averaged about 400,000 a month."

The high unemployment rate has become a major problem for U.S. President Barack Obama, whose attempts to address the issue have had little impact.

Hutchinson said there isn't much that the president or Congress can do to create jobs, although that cutting federal spending would help "because it would free bank funds for lending to small business."

It's the Fed that could have the greatest impact.

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Huge Internet Attack on Corporations Good News for Cybersecurity Stocks

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The so-called "Nitro" digital data blitz on 48 chemical companies in the United States and the United Kingdom is the latest expansion of a cybersecurity pandemic that's stripping companies of billions in profits, while leaving consumers vulnerable to identity theft and worse. According to computer security firm Symantec Corp. (Nasdaq: SYMC), the "Nitro" attack was […]

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Three Ways to Defend Your Wealth

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Keith Fitz-Gerald joined Fox Business "Varney & Co." host Stuart Varney to talk about why these markets require investors to defend their wealth. He outlined three things every investor should do now to safeguard their profits amid global economic instability. Loading the player …

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Approval of Keystone Pipeline Will Pump Profits Out of Canadian Oil Sands

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With U.S. President Barack Obama expected to approve the long-delayed Keystone XL oil pipeline late this year or early in 2012, several companies already producing in the Canadian oil sand fields stand to benefit.

The 1,700-mile pipeline, which could be finished as soon as mid-2013, will carry 700,000 barrels of crude per day from the Canadian oil sands in Alberta to refineries in Port Arthur, TX.

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The Rush to Debut Groupon IPO Is One More Reason to Avoid this Tech Trap

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Social media stocks were all the rage this summer, but that enthusiasm is certainly on the wane as we approach the Groupon IPO.

And rightfully so.

This would-be tech titan is more like a tech trap.

Groupon is expected to price its initial public offering (IPO) today (Thursday) and start trading tomorrow, after its last push this week to generate investor interest.

Groupon plans to sell 30 million shares in a price range from $16 to $18, giving the company a market value of $10.1 billion to $11.3 billion.

That's a drastic 44% to 50% cut from the $20 billion valuation the company had earlier this year. And what's worse is that a lack of investor interest may result in an even lower number.

But the fact remains Groupon hasn't proven it's worthy of long-term investment.

"I wouldn't touch it with a ten-foot pole," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "This isn't a stock for an investor looking for a long-term play with stability."

Why the Rush for a Groupon IPO?

Groupon delayed its initial plan to debut in the summer, and now seems eager to come to market. The fact that it's hurrying the process amid a number of obstacles has raised some eyebrows.

To begin with, this is hardly a good time to list on an exchange. The European debt crisis continues to whipsaw markets from one day to the next. For example, the Dow Jones Industrial Average enjoyed a 339-point, 2.9% gain on Oct. 27, but that gain was followed just two trading days later by a 276.10-point, 2.3% drop.

Market volatility is a big reason why the U.S. IPO market has been stagnant since July, despite a strong start to the year.

"Why are Groupon investors in such a hurry to cash out? What's the rush? Is there something lurking behind the scenes of which we are unaware?" wrote accounting professors Anthony H. Catanach Jr. and J. Edward Ketz in The New York Times. "Or is the rush to the IPO because Morgan Stanley, Goldman Sachs and Credit Suisse want to collect their fee (which is tied to the market value of the stock issued) before the company's value drops further?"

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One Man's Mission: Building the World's Safest Bank

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One Canadian entrepreneur may well be forging an innovative path to changing the global banking landscape – for the better. And in the process he may build the world's safest bank.

Eric Sprott, the billionaire resource investment guru, is buying 51% of Ontario currency trader Continental Currency Exchange Corp., with the aim of making it into a financial institution that, refreshingly, will not make loans.

That's not a misprint.

Sprott plans to structure his new Continental Bank to take deposits and generate income from currency trading and by selling precious metals.

True private banks already operate on this model. They lend no money. They simply take deposits, provide brokerage, custodial, and management services, and charge a commensurate fee. But often their minimums are $1 million and up, leaving most depositors with only standard banking options.

And right now, those options aren't very appealing.

Breaking the Bank

You see, most banks today operate under a fractional reserve system, meaning they can lend out at least nine times the amount they have on deposit.

In the United States, the Federal Deposit Insurance Corporation (FDIC) insures up to $250,000 of deposits. However, if you have more than that, they can't help you. And more importantly, the FDIC could never cover all of the country's deposits if there were a nationwide bank run.

In fact, the FDIC probably couldn't even cover 5% of all U.S. deposits. Rather, the system is based on the hope that a multitude of bank runs won't occur simultaneously.

That's not the most reassuring way to stash away your money.

However, with Sprott's model, you could rest easy knowing your money was backed by hard assets – and not being loaned out and leveraged.

"Our firm, Sprott Inc., and Eric have taken a very committed view that the financial system requires a substantial reset," said Sprott Inc. Chief Executive Officer Peter Grosskopf. "Eric has always thought that offering consumers access to an unlevered bank is a good idea."

That's because Sprott knows that in a leveraged financial system, even small investment and loan losses can "break the bank."

His goal is to one day allow customers to hold their deposits in gold- or silver-backed accounts. Checks could be written against those accounts to make purchases, which would then be debited, just like any other account.

Scott Penfound, VP of operations with Continental Currency, said "it's the old commerce model of providing service instead of credit."

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Three Lessons From the Collapse of MF Global

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In today's politically charged atmosphere, it's nice to occasionally find a situation in which everybody wins. And that's exactly what we have with the collapse of MF Global.

Politically, this failure unites both liberals and conservatives.

Liberals can rejoice, rightly, that Wall Street's pushback against the "Volcker Rule" – the provision in the Dodd-Frank act that said banks should not engage in proprietary trading – has been exposed as completely spurious.

And conservatives can rejoice in the come-uppance of a man who represented the worst of modern Wall Street's obsession with trading and flirtation with left-of-center politics.

Indeed, Jon Corzine turned Goldman Sachs Group Inc. (NYSE: GS) from a respectable corporate finance house into a dodgy trading-dominated casino. And, as if that weren't bad enough, he pushed New Jersey to the edge of bankruptcy. What a career!

Of course, apart from enjoyable schadenfreude on both sides, there are lessons to be learned. But before we get to exactly what those lessons are, we must first perform an autopsy on MF Global to see exactly what went wrong.

How to Kill a Company in 19 Months

MF Global started as a medium-sized derivatives broker before taking over Refco – a major name in commodities brokerage – after that group's 2005 collapse. And while it may be hard to believe now, MF Global at one time was extremely well connected, effectively managed, and had a solidly established business.

Of course, that all changed when Jon Corzine took over in March 2010.

Fresh from his term as governor of New Jersey and flush with cash from his lengthy stint at Goldman Sachs, where he was chairman and CEO from 1994 to 1999, Corzine was determined to make MF Global a major investment bank.

To accomplish this goal, Corzine essentially bet on the same equation he had used in his transformation of Goldman – that brokerage plus hedge fund equals investment bank.

To that end, he took risks with its own capital and maintained an advantage over Goldman and Morgan Stanley (NYSE: MS) by having no banking license. The absence of a license meant MF Global was free from onerous banking rules on leverage and (potentially) on proprietary trading. And under Corzine's direction, MF Global made the disastrous decision of betting too heavily on European sovereign debt.

Corzine believed that bailouts would continue ad infinitum, and that investors would not be made to suffer losses on their investments in such debt. Naturally, under "mark-to-market accounting," the write-down in MF's positions gave the firm enormous losses.

MF Global filed for Chapter 11 bankruptcy Monday after credit downgrades led to margin calls on some of the $6.3 billion in Eurozone sovereign debt the bank held. The position was five-times MF Global's equity.

And so MF Global failed just 19 months after Corzine took over.

As I said earlier, we can take some time to bask in the schadenfreude of all this, or we can take the opportunity to relearn some important lessons – three to be exact.

Those lessons are:

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MF Global Bankruptcy Exposes Vulnerability of U.S. Banks to Eurozone Debt Crisis

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The bankruptcy of MF Global Holdings (NYSE: MF) was a distressing signal to investors that it is possible for U.S. financial institutions to fall victim to the Eurozone debt crisis.

MF Global filed for Chapter 11 bankruptcy Monday after credit downgrades led to margin calls on some of the $6.3 billion in Eurozone sovereign debt the bank held. The position was five-times MF Global's equity.

Although the major U.S. banks have less exposure relative to available capital, their many tendrils in Europe – particularly to European banks – will inevitably drag them into any financial meltdown in the Eurozone.

Even the U.S. banks' estimated direct exposure to the troubled European nations of Portugal, Ireland, Italy, Greece and Spain (PIIGS) is disturbingly high – equal to nearly 5% of total U.S. banking assets, according to the Congressional Research Service (CRS).

And according to the Bank for International Settlements (BIS), U.S. banks actually increased their exposure to PIIGS debt by 20% over the first six months of 2011.

But the greatest risk is the multiple links most large U.S. banks have to their European counterparts – many of which hold a great deal of PIIGS debt.

"Given that U.S. banks have an estimated loan exposure to German and Frenchbanks in excess of $1.2 trillion and direct exposure to the PIIGS valued at $641billion, a collapse of a major European bank could produce similar problems inU.S. institutions," a CRS research report said earlier this month.

Of course, the major banks say their exposure to the Eurozone debt crisis is much lower because they've bought credit-default swaps (CDS) to hedge their positions. Credit-default swaps are essentially insurance policies that pay off in the event of a default.

Unfortunately, this same strategy was one of the root causes of the 2008 financial crisis involving American International Group (NYSE: AIG) and Lehman Bros.

"Risk isn't going to evaporate through these trades," Frederick Cannon, director of research at investment bank Keefe, Bruyette & Woods Inc., told Bloomberg News. "The big problem with all these gross exposures is counterparty risk. When the CDS is triggered due to default, will those counterparties be standing? If everybody is buying from each other, who's ultimately going to pay for the losses?"

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The Narrowing Spread Means Higher Crude

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I just left Baltimore, where I met with the Oil & Energy Investor and Money Morning editorial teams to discuss some interesting new developments.

This was followed rather quickly by a flight to Frankfurt, Germany, for meetings on a potentially major push in the European approach to a rapidly changing energy landscape.

I will fill you in on both later, because today we need to talk a bit about an important matter unfolding in oil…

The Crude Spread is at a Four-Month Low

On Friday, the spread between the Brent price in London and the quote for West Texas Intermediate (WTI) in New York declined to below 20% of the WTI price.

The straight nominal difference of $17.27 is now the lowest it's been since July 6.
And at 18.46%, the spread as a percentage of the closing WTI price (the better way to gauge its actual impact on prices in the United States) is narrower than at any time since June 29.

These changes have been rather dramatic – and quick.

On Oct. 20, the same figures were $25.57 and 30%.

Recall that what has transpired for the past 306 consecutive daily trading sessions, continuously since Aug. 13, 2010, is itself unusual. For that entire period, the market has priced Brent higher, despite it being an inferior grade of crude relative to WTI.

I have discussed the reasons before, but this time around, we need to consider what the shrinking spread actually reveals.

A part of the explanation lies in where the market is going.

However, another part – perhaps even the primary explanation – reflects how traders have been maintaining the spread as other pressures were building in that same market.

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