The Finan­cial Sys­tem is a Farce: Part Three

by Eric Sprott and David Baker, Sprott Asset Man­age­ment

2011 was a merry-go-round of more bailouts, more defer­rals and more denial. Every­one is tired of the Euro­zone. It’s not fix­able. There’s too much debt. The politi­cians don’t know what’s going on. Noth­ing has struc­turally changed. We’re still on the wrong path. There’s more global debt than there was a year ago, and it’s the same old song: extend and pre­tend, extend and pre­tend,… around and around we go,… and it isn’t fun anymore.

Just as we wrote back in Octo­ber 2007, and again in Sep­tem­ber 2008, we feel com­pelled to state the obvi­ous: that the finan­cial sys­tem is a farce. It’s a com­plete, cycli­cal farce that defies all efforts to right itself. This past year con­tin­ued the far­ci­cal tra­di­tion with some notable scan­dals, defer­rals and inter­ven­tions that under­scored the system’s con­tin­u­ing addic­tion to gov­ern­ment inter­fer­ence. With the glar­ing excep­tion of US Trea­suries and the US dol­lar (which are admit­tedly two of our least favourite asset classes), it was not a year that rewarded stock pick­ing or safe-haven assets. Many devel­op­ments dur­ing the year bor­dered on the ridicu­lous, and despite some pos­i­tive news out of the US, we saw lit­tle to test our bear­ish view. If any­thing, our view was con­tin­u­ally re-affirmed.

Let’s start with MF Global. With more than two months passed since the scan­dal broke, fed­eral offi­cials are still unable to find the esti­mated US$1.2 bil­lion of miss­ing cus­tomer funds.¹ The whole episode has been a dis­as­ter for the CME, the self-regulatory body in charge of mak­ing sure the futures bro­kers play by the rules. Nor­mally in instances of bro­ker bank­ruptcy, the CME is sup­posed to back­stop client accounts and keep them liq­uid – i.e., allow them to con­tinue trad­ing while the bank­ruptcy gets set­tled. It never hap­pened in this case. Client accounts were frozen for weeks. Funds have remained miss­ing for months – an eter­nity for clients who were caught short. The great shock was watch­ing how inept and inca­pable the CME was in 1) pre­vent­ing the fraud in the first place and 2) recov­er­ing client assets dur­ing the after­math. The CME essen­tially copped out of their respon­si­bil­ity, offer­ing lit­tle more than some per­func­tory press releases along the way. They were also sur­pris­ingly quick to offer excuses for their non-action. Accord­ing to CME, it really wasn’t their fault, since CME had “no con­trol over the dis­po­si­tion of cus­tomer seg­re­gated funds that are held by MF Global and not by CME Clear­ing”.² Their on-site review of MF Global’s oper­a­tions the week before its bank­ruptcy sug­gested that the bro­ker­age firm was in full com­pli­ance of all the rules, so it wasn’t really the CME’s prob­lem. But of course it was their prob­lem. That’s what the CME is there for – to pro­tect clients in cases of fraud or bank­ruptcy. To pro­tect the “integrity of the exchange”.

In the weeks that have passed, a curi­ous web of trans­ac­tions have sur­faced between MF Global, JP Mor­gan and Gold­man Sachs. Before its bank­ruptcy, MF Global had been draw­ing down a $1.2 bil­lion revolv­ing line of credit with JP Mor­gan. In bank­ruptcy court, JP Mor­gan was able to nego­ti­ate a lien on some of MF Global’s assets in exchange for pay­ing $8 mil­lion towards bank­ruptcy costs. Accord­ing to Reuters, “The lien puts JPMorgan’s inter­ests ahead of MF Global cus­tomers who have not yet received an esti­mated $900 mil­lion worth of money from their accounts, which remain frozen as reg­u­la­tors search for miss­ing funds.”³ It is also alleged that JP Mor­gan accepted a roughly $200 mil­lion trans­fer from MF Global the day before its bank­ruptcy to cover an over­draft in MF Global’s trad­ing account held with them (it still isn’t clear if JP Mor­gan has the cash).⁴ MF Global also appears to have sold hun­dreds of mil­lions worth of secu­ri­ties to Gold­man Sachs in the days lead­ing up to its col­lapse, but did not imme­di­ately receive pay­ment for them from the MF Global’s clear­ing firm, none other than JP Morgan.

To be fair, on Novem­ber 22nd, the CME did offer to pledge $550 mil­lion as a guar­an­tee to the SIPC Trustee in the event that they did not recover all of the miss­ing client funds, but we cyn­i­cally won­der if that pledge was made after they finally fig­ured out where all the money had gone. The CME seems to have had a good idea by early Decem­ber, based on com­ments made by Com­mod­ity Futures Trad­ing Com­mis­sion (CFTC) mem­ber, Jill Som­mers.⁵ The bot­tom line is that MF Global’s client inter­ests and secu­rity appear to have been side-stepped to buy time for big­ger, more impor­tant play­ers to cover their losses (asses), and that is not the way the reg­u­la­tory sys­tem is sup­posed to function.

We’re not naïve – we know the gov­ern­ment will always pro­tect the inter­ests of the big banks over pal­try retail investors, but do they have to be so brazen about it? The MF Global episode is basi­cally shame­less. Then there’s Dodd-Frank. Remem­ber Dodd-Frank? It’s the mas­sive finan­cial reg­u­la­tory reform act that was signed into law by Pres­i­dent Obama back in 2010. We are cer­tainly not fans of cum­ber­some over­reg­u­la­tion, but in its essence, Dodd-Frank was sup­posed to pro­vide a new frame­work to address the poten­tial fail­ure of a too-big-to-fail bank. There’s noth­ing wrong with that. Given the sheer size of the off-balance sheet deriv­a­tives mar­ket, we don’t see a prob­lem with at least attempt­ing to pre­pare for another large scale bank­ing fail­ure in the US. But almost two years later, we have to laugh at how lit­tle of the Dodd-Frank frame­work has actu­ally been imple­mented. Accord­ing to law firm Davis Polk, a mere 21% of the act’s 400 rule­mak­ing require­ments have become final­ized since the law passed in July 2010. Of the 200 Dodd-Frank rule­mak­ing require­ment dead­lines that have already passed, 74.5% of them have been missed to date.⁶ The lawyers must be hav­ing a field day with all the paperwork.

One part of the Dodd-Frank story that inter­ests us is the CFTC posi­tions lim­its rule set to go into effect on Jan­u­ary 17, 2012. The new posi­tion lim­its are aimed at pre­vent­ing exces­sive spec­u­la­tion in the com­mod­ity mar­kets which are believed by many, includ­ing our­selves, to have dri­ven wild fluc­tu­a­tions in the gold and sil­ver spot price over the past decade. Posi­tion lim­its are an obvi­ous threat to large futures spec­u­la­tors like the big banks, so it was no sur­prise when two Wall Street lobby groups, the Secu­ri­ties Indus­try and Finan­cial Mar­kets Asso­ci­a­tion (SIFMA) and the Inter­na­tional Swaps and Deriv­a­tives Asso­ci­a­tion (ISDA) launched a law­suit against the CFTC demand­ing that the new rules on com­mod­ity trad­ing be thrown out, or at the very least, delayed. The CFTC voted on the request to delay imple­men­ta­tion and offi­cially rebuffed it on Jan­u­ary 4th, which is a heart­en­ing devel­op­ment in an oth­er­wise cyn­i­cal saga.⁷ Back in Decem­ber, how­ever, the CFTC had already qui­etly waived the posi­tion limit fil­ing require­ments on all CME par­tic­i­pants until May 31, 2012.⁸ So even if the new rules go into effect this month, banks won’t have to report their posi­tion lev­els until May 31st either way. Given the lobby groups’ out­stand­ing law­suit against the new rules, com­bined with the CFTC’s appar­ent ten­dency to grant tem­po­rary reprieves, we don’t expect the new posi­tion limit rules to be enforced any time soon. Once sum­mer approaches, there will prob­a­bly be more delays and more defer­rals, grant­ing the big play­ers plenty of time to pro­tect them­selves. Extend and pre­tend. Delay and defer. That’s the song we sing on the merry-go-round.

Then there’s Europe and the Euro­pean Cen­tral Bank (ECB). Back in Decem­ber, the mighty ECB had to step in with yet another mas­sive liq­uid­ity injec­tion to avert a total melt­down in the EU bank­ing sys­tem. On Decem­ber 21st, they flooded 523 sep­a­rate EU banks with a “Long Term Refi­nanc­ing Oper­a­tion” (LTRO) pro­gram total­ing €489.1 bil­lion ($626 bil­lion).⁹ The pro­gram con­sists of loans that are due in three years and will charge an accom­mo­dat­ing 1% inter­est rate. The liq­uid­ity injec­tion will allow the EU banks to par­tic­i­pate in a delight­fully con­ve­nient carry-trade whereby they can take the bor­rowed money at 1% inter­est and invest it in var­i­ous sov­er­eign debt auc­tions that will likely pay them 3% or higher. The banks will keep the dif­fer­ence in profit, and the EU PIIGS coun­tries get to breathe eas­ier know­ing they’ll be able to sell their garbage paper to the EU banks at sup­pressed rates as long as the LTRO loan money lasts. And the best part? It doesn’t involve any money print­ing, so there’s really no risk of infla­tion, you see? So just so we’re on the same page, if every­thing goes accord­ing to plan this year, Euro­pean sov­er­eign gov­ern­ments will fund their debt auc­tions with bor­rowed money lent to them by over 500 Euro­pean banks who have them­selves bor­rowed hun­dreds of bil­lions of euros from the Euro­pean Cen­tral Bank,… who as far as we can tell, bor­rowed those euros from the var­i­ous EU sov­er­eign states (or sim­ply printed them). Do you get it? Do you see the cir­cu­lar­ity? Do you see the can being kicked down the road? And guess what? Since €489.1 bil­lion is clearly not enough to avert dis­as­ter this year (most EU banks are so under­cap­i­tal­ized they’ve sim­ply parked the bor­rowed LTRO money back with the ECB at 0.25% inter­est), the ECB has promised to launch another LTRO injec­tion this com­ing Feb­ru­ary!¹⁰ No won­der gold was down in Decem­ber. They com­pletely solved the Euro­pean debt crisis!

Last but not least, we must men­tion an alarm­ing com­po­nent of this year’s National Defense Autho­riza­tion Act (NDAA) that was qui­etly signed into law by Pres­i­dent Obama on Decem­ber 31st, 2011. This year’s defense bill, offi­cially known as Sen­ate Bill 1867, includes a spe­cific pro­vi­sion that seems to grant the US gov­ern­ment the power to detain accused ter­ror­ists, includ­ing US cit­i­zens, indef­i­nitely, with­out trial.^11,12 There has been much uproar and con­fu­sion over the lan­guage used in the sec­tions of the Bill related to the sub­ject, and it’s still not clear how the Bill will change  the exist­ing laws related to ter­ror­ism deten­tion in the US, but it doesn’t bode well for con­sti­tu­tional free­dom within the coun­try. There’s obvi­ously no direct mar­ket impact to the leg­is­la­tion, but we men­tion it only to remind investors how quickly the rules can change when gov­ern­ments feel vul­ner­a­ble. ‘Polit­i­cal risk’ should no longer only be applied to min­ing invest­ments in third world coun­tries. In 2012, it may apply to us all.

It’s very dif­fi­cult to pre­dict what lies in store for the stock mar­ket this year. Any­thing could hap­pen. Gov­ern­ment inter­ven­tion in the finan­cial sys­tem has never been more extreme. We hope the exam­ples above have shed some light on that. As we enter 2012, there are sig­nif­i­cant debt-related finan­cial risks fes­ter­ing within the three great eco­nomic the­atres of the world: the US, Europe and China. The mar­ket may rally, it could crash, it could tread water, we just don’t know. A lot will depend on how the cen­tral banks react. But we are eager to main­tain the posi­tion­ing that we held in 2011. We will main­tain our expo­sure to pre­cious met­als equi­ties and bul­lion. We will main­tain our large gross short weight­ings in our hedge funds. We are con­fi­dent that they will pro­tect us on this far­ci­cal merry-go-round that seems to spin faster and faster with every pass­ing day.

Footnotes:

1. Asso­ci­ated Press (Jan­u­ary 11, 2011) “MF Global trustee will meet with cus­tomers”. The Wall Street Jour­nal. Retrieved Jan­u­ary 11, 2012 from: http://online.wsj.com/article/APcb5dba3691894bb4a61b19357ebe8824.html
2. CME Group (Novem­ber 6, 2011) “CME Group State­ment Regard­ing MF Global”. CME Group. Retrieved Jan­u­ary 5, 2012 from: http://cmegroup.mediaroom.com/index.php?s=43&item=3202&pagetemplate=arti...
3. LaCapra, Lau­ren Tara and Gold­stein, Matthew (Jan­u­ary 3, 2012) “MF Global sold assets to Gold­man before col­lapse: sources”. Reuters. Retrieved Jan­u­ary 5, 2012 from: http://www.reuters.com/article/2012/01/04/us-mfglobal-goldman-idUSTRE803...
4. Pat­ter­son, Scott and Luc­chetti, Aaron (Decem­ber 21, 2011) “MG Global Trans­fer Draws Scrutiny”. The Wall Street Jour­nal. Retrieved Jan­u­ary 5, 2012 from: http://online.wsj.com/article/SB1000142405297020405840457711076166560264...
5. Roeder, David (Decem­ber 15, 2011) “Reg­u­la­tor: We know where MF Global cash went”. Chicago Sun-Times. Retrieved Jan­u­ary 5, 2012 from:
http://www.suntimes.com/business/9447562–420/regulator-we-know-where-mf-...
6. (Jan­u­ary 3, 2012) “Dodd-Frank Progress Report”. Davis Polk. Retrieved Jan­u­ary 5, 2012 from: http://www.davispolk.com/Dodd-Frank-Rulemaking-Progress-Report/
7. Prot­ess, Ben (Jan­u­ary 4, 2012) “New Lim­its on Com­mod­ity Trades Are Approved”. Deal­Book. Retrieved Jan­u­ary 6, 2012 from:
http://dealbook.nytimes.com/2012/01/04/regulator-refuses-to-delay-tradin...
8. CME Group Mar­ket Reg­u­la­tion Depart­ment (Decem­ber 20, 2011) “Tem­po­rary Waiver of Annual Update for Posi­tion Limit Exemp­tions”. CME Group. Retrieved Jan­u­ary 5, 2012 from: http://www.cmegroup.com/tools-information/lookups/advisories/market-regu...
9 Jones, Marc (Decem­ber 21, 2011) “Banks gorge on ECB loans, mar­ket cheer short-lived”. Reuters. Retrieved Jan­u­ary 11, 2012 from:
http://www.reuters.com/article/2011/12/21/us-ecb-3yr-loans-idUSTRE7BK0MC...
medium=feed&utm_campaign=Feed%3A+reuters%2FbusinessNews+%28News+%2F+US+%2F+Business+News%29
10 Cot­tle, David (Decem­ber 21, 2011) “ECB’s Mas­sive LTRO Gives Risk Assets Wings”. The Wall Street Jour­nal. Retrieved Jan­u­ary 5, 2012 from: http://online.wsj.com/article/BT-CO-20111221–703943.html
11 Miles, Donna (Jan­u­ary 6, 2012) “Obama signs Defense Spend­ing Bill despite hav­ing reser­va­tions”. Amer­i­can Forces Press Ser­vice. Retrieved Jan­u­ary 5, 2012 from: http://www.fortgordonsignal.com/news/2012–01-06/Viewpoint/Obama_signs_De...
12 US Library of Con­gress (Decem­ber 1, 2011) “112th Con­gress, 1st Ses­sion, S. 1867”. (See Sec­tions 1031–1032) Retrieved Jan­u­ary 11, 2012 from: http://www.gpo.gov/fdsys/pkg/BILLS-112s1867es/pdf/BILLS-112s1867es.pdf

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