The MF Global Bankruptcy Cheat Sheet; Where are the missing customer funds and how can customers and creditors preserve their rights?

Currently, over $500,000,000 in customer segregated funds is missing from MF Global Inc., the US broker/dealer and futures commission merchant (FCM) that filed for Chapter 11 bankruptcy protection last Monday, October 31, 2011. This is simply unprecedented in the futures industry, which passed relatively unscathed through the 2008 turmoil. When an FCM is about to declare bankruptcy, the brokerage accounts have historically been separated or sold from the failing entity to protect the integrity of the customer accounts. This did not occur with MF Global, and now the cash in 50,000 active accounts is frozen and subject to the actions of the trustee, James W. Giddens (the same trustee who was appointed to Lehman Bros.).

How could this have happened? Where are the missing funds? What can be done about it? This article will attempt to offer some theories and possible courses of action. Time is of the essence. Critical deadlines for that affect customer and creditor rights are rapidly approaching.

Please be advised: WE ARE NOT ATTORNEYS and nothing here should be construed as legal advice. The hope is that professionals with more time and resources will be able to use this information to protect their clients. All emphasis in quotations should be construed as ours, except as otherwise noted.

Part I - Background

The chain of events that led to MF Global's demise began with proprietary trades made in European debt. Izabella Kaminska of FT Alphaville outlines (emphasis original):

What caused MF Global’s downfall?

According to Bradley Abelow, MF Global’s Chief Operating Officer, much of the blame may lie with Finra’s unreasonable request for MF Global to add capital to support its off-balance sheet exposure to European sovereign debt and reveal them publicly. These were, as we have discussed, structured as repo-to-maturity trades. They were also maintained off-balance sheet.

In a personal declaration filed in Chapter 11 proceedings (H/T Zerohedge), Abelowwrites:

As a global financial services firm, MF Global is materially affected by conditions in the global financial markets and worldwide economic conditions. On September 1, 2011, MF Holdings announced that FINRA informed it that its regulated U.S. operating subsidiary, MFGI, was required to modify its capital treatment of certain repurchase transactions to maturity collateralized with European sovereign debt and thus increase its required net capital pursuant to SEC Rule 15c3-1. MFGI increased its required net capital to comply with FINRA’s requirement.

Upon this notice, Moody’s got a little skittish. As Abelow notes:

On October 24, 2011, Moody’s Investor Service downgraded its ratings on the Company to one notch above junk status based on its belief that MF Holdings would announce lower than expected earnings.

But that wasn’t good enough for Finra. They wanted the exact details of the trades revealed publicly in MF Global’s October results:

On October 25, 2011, MF Holdings announced its results for its second fiscal quarter ended September 30, 2011. The Company revealed that it posted a $191.6 million net loss in the second quarter, compared with a loss of $94.3 million for the same period last year. The net loss reflected a decrease in revenue primarily due to the contraction of proprietary principal activities.

Dissatisfied with the September announcement by MF Holdings of MFGI’s position in European sovereign debt, FINRA demanded that MF Holdings announce that MFGI held a long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity, including Belgium, Italy, Spain, Portugal and Ireland. MF Holdings made such announcement on October 25, 2011. These countries have some of the most troubled economies that use the euro. Concerns over euro-zone sovereign debt have caused global market fluctuations in the past months and, in particular, in the past week. These concerns ultimately led last week to downgrades by various ratings agencies of MF Global’s ratings to “junk” status. This sparked an increase in margin calls against MFGI, threatening overall liquidity.

This brought attention to MF Global’s precarious liquidity exposure to the likes of the CFTC and SEC, pushing MF Global into seeking out alternative arrangements before its liquidity position became too precarious:

Concerned about the events of the past week, some of MFGI’s principal regulators – the CFTC and the SEC – expressed their grave concerns about MFGI’s viability and whether it should continue operations in the ordinary course. While the Company explored a number of strategic alternatives with respect to MFGI, no viable alternative was available in the limited time leading up to the regulators’ deadline. As a result, the Debtors filed these chapter 11 cases so that they could preserve their assets and maximize value for the benefit of all stakeholders.

Specific to everyone’s concerns were, of course, were MF Global’s ‘repo-to-maturity’ sovereign debt trades.

Anyone following MF Global’s regulatory notices would though have been able to spot their disquiet early on.

On September 1, for example, MF Global filed the following:

As previously disclosed, the Company is required to maintain specific minimum levels of regulatory capital in its operating subsidiaries that conduct its futures and securities business, which levels its regulators monitor closely. The Company was recently informed by the Financial Industry Regulatory Authority, or FINRA, that its regulated U.S. operating subsidiary, MF Global Inc., is required to modify its capital treatment of certain repurchase transactions to maturity collateralized with European sovereign debt and thus increase its required net capital pursuant to SEC Rule 15c3-1. MF Global Inc. has increased its net capital and currently has net capital sufficient to exceed both the required minimum level and FINRA’s early-warning notification level.

The Company does not believe that the increase in net capital will have a material adverse impact on its business, liquidity or strategic plans. In addition, the Company expects that its regulatory capital requirements will continue to decrease as the portfolio of these investments matures, which currently has a weighted average maturity of April 2012 and a final maturity of December 2012.

Regulators’ concern no doubt centred around the fact that such off-balance sovereign positions could pose very real and sudden liquidity issue in terms of margin calls. They were probably also conscious of such things as Lehman’s notorious Repo 105 arrangement.

Most articles have posited or assumed that the counterparty to the $6.3 billion European debt repo-to-maturity trades was a large Wall Street entity, such as Goldman, JP Morgan or even Nomura. This is likely not the case because regulatory filings of the broker/dealer unit indicate that, as of March 31, 2011, the counterparty was an affiliate of MF Global Inc. See the audited financial statements of MF Globla Inc. (not those of the holding company, MF Global Holdings) filed with the SEC:

From Note 4:

Securities sold under agreements to repurchase $14,380,145,100 (1)

(1) includes $7,497,154,700 collateralized with European Sovereign debt and transacted with an affiliate

And from Note 11:

The Company entered into repurchase agreements with an affiliate that are collateralized with European Sovereign debt. The affiliate identified the market opportunity and manages the collateral associated with these transactions, although the Company retains the issuer default and liquidity risk. For these services the Company paid a management fee to the affiliate. The management fee represents approximately 80% of the trade date gain recognized by the Company from entering into these repurchase agreements.

The first question is, who is the affiliate? Given the interconnectedness of the large shareholders, directors and officers at MF Global within financial circles, the list could stretch into the hundreds, including any number of affiliates of J.C. Flowers Group and its funds. It was J. Christopher Flowers himself who helped launch Corzine's political career and who helped usher him into MF Global as CEO. And, throughout his tenure at MF Global, Jon Corzine remained an Operating Partner of J.C. Flowers & Co. LLC. His engagement letter was filed with the SEC here.

The second question is, wouldn't the likely fact that the repo-to-maturity trades were carried out with an affiliate lower the likelihood of crippling collateral/margin calls (setting aside for the moment, the conspiratorial view that the affiliate intended to sink MF Global)? Did FINRA take this into account when it forced MF Global to increase its regulatory capital and make subsequent disclosures that rattled investors and counterparties?

Based on the above disclosures and existing regulations, it's unlikely that substantial European debt trades were carried out with customer account funds. Even if MF Global had invested customer funds in sovereign bonds (subject to the limits of the applicable rules), it's unclear why it would not be able to account for them. Although distressed, all of the sovereigns that were invested in by the firm with its own money continue to be paid out at par. It's unlikely that MF Global invested $1 billion in customer funds (about twice the missing amount) in the high yielding Greek debt that was subsequently negotiated to be paid out at 50%.

Of much more interest are the provisions regarding repurchase agreements (repos) and resale agreements (reverse repos).

Part II - Key regulatory provisions regarding Investment of Customer Funds

This section is a bit legalistic, so casual readers may wish to skip forward to Part III.

CFTC Rule 1.25 governs Investments of Customer Funds, and it's position on sovereign debt is as follows:

(D) Sovereign debt is subject to the following limits: a futures commission merchant may invest in the sovereign debt of a country to the extent it has balances in segregated accounts owed to its customers denominated in that country's currency; a derivatives clearing organization may invest in the sovereign debt of a country to the extent it has balances in segregated accounts owed to its clearing member futures commission merchants denominated in that country's currency.

Provisions for repurchases and resales:

(2)(i) In addition, a futures commission merchant or derivatives clearing organization may buy and sell the permitted investments listed in paragraphs (a)(1)(i) through (viii) of this section pursuant to agreements for resale or repurchase of the instruments, in accordance with the provisions of paragraph (d) of this section.

(ii) A futures commission merchant or a derivatives clearing organization may sell securities deposited by customers as margin pursuant to agreements to repurchase subject to the following:

(A) Securities subject to such repurchase agreements must be “readily marketable” as defined in §240.15c3–1 of this title.

(B) Securities subject to such repurchase agreements must not be “specifically identifiable property” as defined in §190.01(kk) of this chapter.

(C) The terms and conditions of such an agreement to repurchase must be in accordance with the provisions of paragraph (d) of this section.

(D) Upon the default by a counterparty to a repurchase agreement, the futures commission merchant or derivatives clearing organization shall act promptly to ensure that the default does not result in any direct or indirect cost or expense to the customer.

And, regarding concentration limits:

(ii) Repurchase agreements . For purposes of determining compliance with the concentration limits set forth in this section, securities sold by a futures commission merchant or derivatives clearing organization subject to agreements to repurchase shall be combined with securities held by the futures commission merchant or derivatives clearing organization as direct investments.

(iii) Reverse repurchase agreements . For purposes of determining compliance with the concentration limits set forth in this section, securities purchased by a futures commission merchant or derivatives clearing organization subject to agreements to resell shall be combined with securities held by the futures commission merchant or derivatives clearing organization as direct investments.

As to the specific requirements of the repurchase and resale agreements, with some interesting bankruptcy provisions (emphasis ours):

(d) Repurchase and reverse repurchase agreements . A futures commission merchant or derivatives clearing organization may buy and sell the permitted investments listed in paragraphs (a)(1)(i) through (viii) of this section pursuant to agreements for resale or repurchase of the securities (agreements to repurchase or resell), provided the agreements to repurchase or resell conform to the following requirements:

...

(12) The agreement makes clear that, in the event of the bankruptcy of the futures commission merchant or derivatives clearing organization, any securities purchased with customer funds that are subject to an agreement may be immediately transferred. The agreement also makes clear that, in the event of a futures commission merchant or derivatives clearing organization bankruptcy, the counterparty has no right to compel liquidation of securities subject to an agreement or to make a priority claim for the difference between current market value of the securities and the price agreed upon for resale of the securities to the counterparty, if the former exceeds the latter.

To be thorough, another excerpt from Rule 1.25 that contains a bankruptcy clause:

(9) For purposes of §§1.25, 1.26, 1.27, 1.28 and 1.29, securities transferred to the customer segregated account are considered to be customer funds until the customer money or securities for which they were exchanged are transferred back to the customer segregated account. In the event of the bankruptcy of the futures commission merchant, any securities exchanged for customer funds and held in the customer segregated account may be immediately transferred.

And, a final excerpt from Rule 1.25 that allows the FCM's own funds and securities to be deposited into segregation, which we will return to in a bit:

(f) Deposit of firm-owned securities into segregation. A futures commission merchant shall not be prohibited from directly depositing unencumbered securities of the type specified in this section, which it owns for its own account, into a segregated safekeeping account or from transferring any such securities from a segregated account to its own account, up to the extent of its residual financial interest in customers' segregated funds; provided, however, that such investments, transfers of securities, and disposition of proceeds from the sale or maturity of such securities are recorded in the record of investments required to be maintained by §1.27. All such securities may be segregated in safekeeping only with a bank, trust company, derivatives clearing organization, or other registered futures commission merchant. Furthermore, for purposes of §§1.25, 1.26, 1.27, 1.28 and 1.29, investments permitted by §1.25 that are owned by the futures commission merchant and deposited into such a segregated account shall be considered customer funds until such investments are withdrawn from segregation.

A variant of the repurchase/resale structure is that of the tri-party repo, in which a third party custodian intervenes between the seller and the buyer. A New York Federal Reserve white paper explains:

Description of Tri‐Party Repo Market

The tri‐party repo market is large and important, but not very well understood. It represents a significant part of the overall U.S. repo market, in which market participants obtain financing against collateral and their counterparties invest cash secured by that collateral. Large U.S. securities firms and bank securities affiliates finance a large portion of their fixed income securities inventories, as well as some equity securities, via the tri‐ party repo market. This market also provides a variety of types of investors with the ability to manage cash balances by investing in a secured product. The “tri‐party” label refers to repo transactions that settle entirely on the books of one of two “Clearing Banks” in the U.S. market: Bank of New York Mellon (BNYM) and JP Morgan Chase (JPMC). The Clearing Bank is thus a third party involved in the repo transaction between a “Dealer” (party, not necessarily a Broker‐Dealer, borrowing cash against securities collateral) and a “Cash Investor” (party lending cash against securities collateral). 1

The attractiveness of the tri‐party repo market is driven by the treatment of repurchase transactions in bankruptcy, the use of securities as collateral (including daily margining and haircuts), and the custodian services of the Clearing Banks which provide protections that do not exist for bilateral repo investors or unsecured creditors. As a result, the U.S. repo market contributes significantly to the liquidity and efficiency of the U.S. Treasury and Agency (including Agency MBS) securities markets, which collectively make up approximately 75% of the total collateral in the U.S. repo market. The importance of the U.S. repo market is underscored by the fact that it is the market in which the Federal Reserve operationally implements U.S. monetary policy.

Whether or not tri-party repurchases and resales are permitted for investments of customer funds under Rule 1.25 is unknown, but they would certainly be available to MF Global using its own money. A timely article also published by the New York Fed highlights a current quirk of the US tri-party repo market (repo being generalized for both repurchases and resales), the resolution of which has been delayed, and also points out a key bankruptcy provision (emphasis ours):

The Unwind Defined

The centerpiece of the current reform effort is the elimination of the wholesale daily unwind of tri-party repos, on both maturing and continuing term trades. The unwind consists of an extension of credit to a dealer by its clearing bank to facilitate the settlement of the dealer’s repos (for more details, see this New York Fed staff report.) The clearing banks return cash to cash investors and collateral to dealers each day and, in the interim, extend credit to dealers against their entire tri-party repo book. This unwind temporarily transfers the risk of a dealer’s default from cash investors to the clearing bank. When new repos are settled and continuing term trades are re-collateralized, the exposure to the dealer is transferred back from the clearing bank to cash investors (including new investors).

Why Eliminate the Unwind?

In a recent blog post, I argued that eliminating the wholesale unwind of tri-party repos could reduce fragility in that market. The delays in the reforms, however, leave the market just as vulnerable to the risk that a clearing bank might refuse to unwind a dealer’s trades as it was during the recent financial crisis. If a clearing bank refused to unwind a dealer’s repos, the dealer would almost certainly be forced into bankruptcy, because the dealer would probably not be able to attract new funding that day. That event could create instability in the tri-party repo market that could in turn spill over into other markets. While this risk is not new, its continued existence remains a serious concern.

Part III - An ominous letter written by MF Global

So why are repurchase and resale contracts relevant to the instant case of the MF Global bankruptcy proceedings of both the holding company and the broker unit? We'll let MF Global speak for itself, as it wrote a lengthy letter to the CFTC dated December 2, 2010 after the CFTC, under the direction of Dodd-Frank, had issued proposed reforms to its Rule 1.25, which governs how customer funds may be invested by a broker. We highlighted the original comment letter and posted it here.

The ironic, if not prophetic, introduction:

As a general matter, we applaud the CFTC for seeking new ways to ensure the safety and liquidity of investments made by futures commission merchants under CFTC Rules 1.25 and 30.7. However, as we set forth below, we believe the specific amendments being proposed: (a) are unnecessary, considering that the current permissible investments under Rule 1.25 have not, to our knowledge, resulted in any FCM's inability to provide customers their segregated funds upon request or to continue as a solvent entity, (b) will, in many cases, create new investment risks and logistical difficulties for FCMs, and (c) may well change the pricing dynamics for customers and the industry at large. Recognizing the CFTC's concerns, however, we have set forth our own proposed amendments which we believe satisfy the CFTC's desire for the enhanced security of customer segregated funds without the risk of significantly increasing costs to customers.

On fixing something that is not broken (until it is):

B. The Investments Currently Permitted Under Rule 1.25 Have Not Put Customer

Funds at Risk.

We believe strongly that the CFTC's proposed amendments endeavor to "fix something that is not broken." Indeed, the evidence is clear that the investments permitted and safeguards required under Rule 1.25 have met the CFTC's stated "objectives of preserving principal and maintaining liquidity" of customer segregated funds. Sec Rule 1.25(b). Among other things, since the CFTC's 2004 expansion of permissible investments under RuIe 1.25, we are not aware of any FCM that has been unable to liquidate and provide to their customers upon request any segregated funds invested under Rule 1.25 (or under Regulation 30.7 either, for that matter).4

Further, since this expansion, no FCM to our knowledge has failed or otherwise been unable to meet any other of its financial obligations as a result of investments made under Rule 1.25.5 In short, we believe the current investment criteria set forth under Rule 1.25 have worked, including over the past two years of market instability and uncertainty - the ultimate stress test. Nevertheless, the Commission has proposed changes so sweeping that they may in fact increase systemic risk by imposing new burdens on otherwise effective, efficient and liquid settlement processes. Such a radical overhaul, in our view, is unnecessary considering the Rule's stellar track record. At most, the CFTC should be adjusting only slightly the products, counterparties and concentration percentages currently permitted. 6

Per the Federal Register, we know the expansion of permissible investments in 2004, noted by MF Global, was in fact that of repurchases and resales. Prior to that, CFTC Staff Letter 84-24 permitted investments of customer funds in repurchases and resales, but only with explicit permission by the customer. The National Futures Association (NFA) and others were unfortunately successful when they argued against notification and opt-out provisions, having considering the possibility of counterparty default, but apparently not that of the FCM itself.

The MF Global letter continues on this issue:

d. Repurchase and Reverse Repurchase Transactions

The CFTC proposes to reduce counterparty concentration limits on reverse repurchase agreements to 5% of an FCM's portfolio (currently there are no limits), citing the potential credit risk posed to FCMs by investing a substantial portion of their funds with one counterparty. In our view, this proposal will unnecessarily restrict a very liquid and secure investment that has provided important flexibility as well as reasonable returns for FCMs and their customers. We believe the CFTC should focus on the critical fact that the customer segregated account and the secured amount will be fully collateralized with qualified Rule 1.25 products at all times, even in the event of a counterparty default on a reverse repurchase agreement.

Commission and clearinghouse rules require that FCMs routinely transact and fund margin requirements involving large transactions executed against considerable time constraints, often on an intra-day basis. However, the CFTC's proposed concentration limits could severely undermine an FCM's ability to meet these obligations efficiently, thereby creating particular risk for intra-day funding requirements. The CFTC should recognize that imposing a 5% counterparty concentration limit would (a) require FCMs to have relationships with a minimum of 20 (and as many as 25 or more) different counterparties, which would at best be difficult to manage, and would significantly increase systemic risk, and (b) decrease liquidity and increase operational risk, due to a significant increase in the number of required transactions and the resulting potential fails. We believe that introducing these new risks is unwarranted, especially as there is no evidence that any FCM has been unable to timely return customer funds or meet margin requirements as a consequence of investing customer funds with a limited number of reverse repurchase counterparties.

We also believe the CFTC's proposed prohibition on in-house and affiliate repurchase and reverse transactions is unnecessary because such transactions (a) may only involve Rule 1.25-permissible securities, (b) are conducted within a regulated entity and, (c) are contained within properly titled Rule 1.25 segregated accounts, as are the related cash and security movements. Eliminating these transactions is inconsistent with the CFTC's stated objective of reducing FCM investment risk, since FCMs would be unable to enter into and execute such transactions with and through entities and personnel with whom they have created an effective, efficient and liquid settlement framework.

Consequently, we recommend that FCMs not be subject to a 5% counterparty concentration limit on reverse repurchase transactions, and that they continue to be able to enter into repurchase and reverse repurchase transactions with affiliates and on an in-house basis. However, to the extent the Commission continues to be concerned with the safety of such transactions with unaffiliated third parties, we recommend that it consider (a) limiting FCM repurchase and reverse repurchase transactions to those external counterparties maintaining a certain level of capital (such as $50 or $100 million), or (b) reducing the counterparty concentration limits to only 25% per counterparty.

To sum up, the CFTC was considering the ban of the very transactions with affiliates that would eventually precipitate MF Global's demise. Further, it was going to severely restrict the ability of MF Global to enter repurchase and resale contracts with customer funds. So what happened with the proposed regulation reform?

Part IV - The private meetings between the CFTC and MF Global

Shortly after MF Global had written the letter to the CFTC arguing against various regulatory reforms, Jon Corzine met personally with CFTC Commissioner Bart Chilton regarding "Segregation and Bankruptcy" rulemaking.

Make of that as you will. While MF Global representatives appeared in numerous meetings with CFTC staff, sometimes with representatives of other firms, it is the high level private meetings that are of interest. On December 21, 2010, Jon Corzine again met with CFTC staff to discuss, among other things, the same "Segregation and Bankruptcy" rulemaking.

Perhaps more interesting was one of two private conference call that took place on July 21, 2011, this one with the two ex-Goldman Sachs CEOs, Jon Corzine and CFTC Chairman Gary Gensler.

Note the memorandum at the bottom:

Conference call on topics relating to the Regulation 1.25/30.7 rulemaking including MMMFs, asset-based and issuer-based concentration limits, counterparty concentration limits, in-house transactions and repurchase agreements with affiliates.

Although one would not know it from the "Alternatives to Credit Ratings" title, the notes regarding concentration limits directly relate to allowable investment of customer funds.

Finally, there was another related conference call later that same day, this time with Jon Corzine and Commissioner Bart Chilton again:

By July 21, 2011, problems with European debt were again in the forefront and it would be only days before a tremendous slide in US equities would commence that would eventually lead to 20% plus declines in the major indexes. Had the changes to CFTC Rule 1.25 been implemented as other rulemaking areas were at the time, MF Global would have been under serious pressure to unwind some or all of its repo-to-maturity transactions and bring the European debt it had bought onto its balance sheet.

Was the CFTC unduly influenced by the private meetings with MF Global to delay implementation of Rule 1.25 reforms? Is this in part why Chairman Gensler has recused himself from the MF Global investigation?

Part V - The Bankruptcy Proceedings & A Call to Action

On October 31, 2011, bankruptcy proceedings were initiated for its holding company, MF Global Holdings Ltd (MF Holdings) with concurrent SIPC-led liquidation proceedings for its broker/dealer/FCM unit, MF Global Inc. Two days later, on November 3, the bankruptcy judge in the MF Holdings proceedings, Martin Glenn, issued an Order which, among other things, authorized the use of cash collateral by MF Holdings in an amount up to $8 million. In return, as MF Holdings largest creditor (over $1 billion), JP Morgan was given first lien status on unencumbered property:

(i) First Lien on Unencumbered Property. Pursuant to § 364(c)(2) of the Bankruptcy Code, a valid, binding, continuing, enforceable, fully perfected first priority lien on, and security interest in, all tangible and intangible prepetition and postpetition property in which the Debtors have an interest, whether existing on or as of the Petition Date or thereafter acquired, that is not subject to valid, perfected, non-avoidable and enforceable liens in existence on or as of the Petition Date (collectively, the “Unencumbered Property”), including, without limitation, any and all avoidance actions, unencumbered cash, intercompany indebtedness owed by one or more non-debtor entities to either or both Debtors (including, without limitation, any and all amounts owed by MF Global Inc. to each Debtor), accounts receivable, inventory, general intangibles, contracts, securities, chattel paper, owned real estate, real property leaseholds, fixtures, machinery, equipment, deposit accounts, patents, copyrights, trademarks, tradenames, rights under license agreements and other intellectual property, capital stock of the subsidiaries of each Debtor and the proceeds of all of the foregoing; provided that, the Debtors shall not be required to pledge in excess of 65% of the capital stock of their direct foreign subsidiaries or any of the capital stock or interests of indirect foreign subsidiaries (if adverse tax consequences would result to the Debtors) or other assets that would be unlawful to pledge as determined by a final order of a court of competent jurisdiction; and provided, further, that the Court will reconsider at the Final Hearing (defined below) both the grant of liens on avoidance actions and whether the superpriority administrative claim shall be applicable to proceeds of avoidance actions, solely with respect to any further authorization to use Cash Collateral in excess of amounts authorized to be used pursuant to this Order.

Boomberg Businessweek explains the relevance of the highlighted text above:

Senior Lien

JPMorgan Chase, based in New York, was given a senior lien on all MF Global's available assets in exchange for letting it use $8 million in cash collateral during the company's first day in bankruptcy court.

Wilmington Trust has taken over from Deutsche Bank AG, which resigned, as trustee to more than $1 billion in unsecured notes. Other unsecured creditors include Headstrong Services LLC, owed $3.9 million, New York-based law firm Sullivan & Cromwell LLP, owed $596,939, and Oracle Corp., owed $302,704.

JPMorgan Chase was also given rights to what a judge said may be the only asset for unsecured creditors: so-called avoidance actions, the lawsuits that let creditors win back assets transferred out of the estate 90 days before its bankruptcy filing. The judge said he doesn't usually permit such extraordinary rights for a lender, and left the door open to re- evaluate JPMorgan's request at a Nov. 14 hearing.

In other words, in exchange for the use of $8 million in cash, JP Morgan may get to keep any and all assets it may have withdrawn from MF Global within the last 90 days, whether they be thousands or billions, which would have otherwise been subject to investor claw-back lawsuits.

How would this affect the liquidation proceedings of the MF Global broker unit and the attendant issue of missing customer funds? With the lack of critical facts at this stage, one can only speculate, but the following is one of many potential scenarios.

We know from the annual regulatory filings of MF Global and MF Holdings that they maintained repurchase and resale derivatives books that measured tens of billions of dollars in size. As stated in Part II, JP Morgan is one of only two tri-party repo custodians in the US and would could have refused to unwind some of MF Global's tri-party repos, keeping custody of the cash or collateral. As the New York Fed article pointed out, this alone could trigger bankruptcy.

While no allegation of impropriety is being made here, the fact that JP Morgan may soon attain a permanent shield against clawback claims out to get the attention of all unsecured creditors. The final hearing on the Order and attendant issues will be held in the MF Holdings bankruptcy case on [Updated pursuant to an Order on 11/9] November 16, 2011 at 3:30 pm Eastern. Final objections to the Cash Management Motion must be received by no later than 5:00 pm Eastern on November 11, 2011. Final objections to the Cash Collateral Motion must be received by no later than 5:00 pm Eastern on November 21, 2011.

With respect to the missing customer funds at the MF Global broker unit, we also pointed out in Part II that a provision of CFTC Rule 1.25 regarding investment of customer funds allows an FCM such as MF Global to segregate its own securities in the customer accounts.

This is extremely relevant, because under no circumstances should any once-proprietary firm securities or cash be returned to either MF Global or MF Holdings, as they would likely become assets to be dispersed to the MF Holdings creditors.

This point must be made to the trustee, James W Giddens, and SIPC in the MF Global liquidation proceedings. Either (a) any proprietary firm securities and/or cash recovered should be divided pro rata among the MF Global customer, or (b) firm securities and/or cash should be excluded from the customer accounts and no distribution of recovered assets should be made as though MF Global or MF Holdings were ordinary customers.

Exactly how funds or securities would be missing is unclear, but it is conceivable that they might have been lost in an unwound repo or tri-party repo transaction (not related to the repo-to-maturity transactions, however), especially if proper procedures were not followed. Accordingly, if a material portion of the missing customer funds or securities are those of MF Global or MF Holdings, this would remove a major obstacle to the return of nearly all of the legitimate customer funds. As such, this should be immediately explored by the Trustee.

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We will continue to update on this blog and through Twitter (EBatEPJ) as events unfold. If anyone wishes to reach us, please use the comments below or email "english at economicpolicyjournal.com".

UPDATE: According to the Financial Times, MF Global sold $1.5 billion of its European debt portfolio at a loss just prior to filing for bankruptcy. Also, the New York Fed itself was among the parties making collateral calls on MF Global in the week leading to its failure.

UPDATE 2: Pursuant to an Order entered late day on November 9, the hearing on November 14 was pushed back to November 16 at 3:30 pm Eastern, but objections to the Cash Management Motion must be filed by November 11, 5:00 pm! The deadline for objections to the Cash Collateral Motion have been pushed back to November 23, 5:00 pm.

UPDATE 3: From various comments and emails, it's apparent the final paragraphs of this article were not clear. A minor edit has been made, and the following will provide more information. The assertion was not that the unwound repo or tri-party repo was related to the European debt repo-to-maturity trades. The assertion was that these would be separate repos. Consider: lots of customers hold their accounts in securities, such as T-Bills, not necessarily cash. Let's say the customer accounts were getting low on cash after some big withdrawals, but there were plenty of securities in the customer accounts. MF Global might have repo'd them to satisfy cash withdrawal requests. If the cash were not there upon repo maturity, or if JP Morgan (or other) as custodian (assuming tri-party repo) did not want to provide intraday credit, the repo would not have unwound, and the counterparty or custodian would be left holding the customer securities.

City of London to Leverage the BRICs

Last week, when we learned of the first set of cash-settled foreign currencies that would be cleared by LCH.Clearnet, it seemed an odd assortment. From FXWeek.com:

London-based CCP is set to launch clearing for NDFs in six currencies in mid-November, having shelved plans for options clearing while banks discuss settlement-related issues with regulators

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LCH.Clearnet plans to launch its widely anticipated foreign exchange clearing platform for non-deliverable forwards (NDFs) in mid-November, sources close to the offering's development tell FX Week.

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The new clearing service, dubbed ForexClear, has been in development since late 2010. LCH.Clearnet declined to comment for this article, but it is understood the platform will launch with NDFs covering six currencies against the US dollar: Chinese yuan, Brazilian real, Indian rupee, Russian ruble, Korean won and Chilean peso.

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While it had initially been expected to cover FX options and NDFs, the clearing house is understood to have temporarily shelved options pending discussions that were initiated in June between the US Federal Reserve and the major banks about the management of settlement risk for options.

Only yesterday, we learn that the local exchanges in many of these countries are joining forces to cross list their markets. From the FT:

Six of the world’s largest emerging markets exchanges have unveiled an alliance, in an unprecedented arrangement that aims to capture increasing investor interest in key “Brics” markets at a time when exchanges globally have been consolidating.

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Under the alliance Hong Kong Exchanges and Clearing, BM&FBovespa of Brazil, the National Stock Exchange of India, Bombay Stock Exchange, Johannesburg Stock Exchange and the two Russian exchanges that are in the process of merging – Micex and RTS – will cross-list each others’ stock index futures contracts. They will be listed in the local currency of each exchange, it was announced at the annual meeting of the World Federation of Exchanges in South Africa.

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The bourses will also work towards devising a Brics index that traders could use to gain broad exposure to emerging market indices.

_

The development is a sign that exchanges in the Brics countries see an opportunity to expand globally at a time when their rivals in developed markets in the US and Europe are battling pressure on their margins from competition in cash equities trading from rivals and “dark pools”.

...

The idea for the alliance was devised by HKEx, which first approached the other exchanges in June. Romnesh Lamba, head of the market development division at HKEx, told FT Trading Room: “From a revenue and investor perspective, we don’t expect there will be cannibalisation of each others’ markets.”

...

The first stage of the project will see the exchanges begin cross-listing of financial derivatives on their benchmark equity indices by June 2012. The members will look to develop new products for cross-listing on their exchanges, which would be traded in local currencies.

As a reminder, LCH.Clearnet provides clearing services for the Hong Kong Mercantile Exchange (HKMex), the commodities wing of HKEx, and some have theorized the HK Merc was DOA until LCH was brought on board. As another reminder, foreign exchange is Geithner's loophole to Dodd-Frank. So, it looks like CLS Bank will leverage the developed world while LCH leverages the developing.

More here, at the now-free (and defunct) FT Tilt:

http://tilt.ft.com/#!posts/2011-10/32431/brics-exchanges-forge-global-alliance

France & Belgium Front-Run Germany; More Evidence for the Malmgren Hypothesis

The markets went vertical yesterday, after the Financial Times printed an article in the final hour of US trading that suggested Europe was close to a bailout solution for its larger banks. A careful read, however, suggests it confirms more the Malmgren Hypothesis (namely, a German withdrawal from the EU and EMU) than an imminent agreement on the EFSF. From the euphoria-inducing FT (emphasis ours):

EU examines bank rescue plan

By Peter Spiegel and Alex Barker in Luxembourg

_

European Union finance ministers are examining ways of co-ordinating recapitalisations of financial institutions after they agreed that additional measures were urgently needed to shore up the region’s banks.

_

Although the details of the plan are still under discussion, officials said EU ministers meeting in Luxembourg had concluded that they had not done enough to convince financial markets that Europe’s banks could withstand the current debt crisis.

“There is an increasingly shared view that we need a concerted, co-ordinated approach in Europe while many of the elements are done in the member states,” Olli Rehn, European commissioner for economic affairs, told the Financial Times. “There is a sense of urgency among ministers and we need to move on.”

“Capital positions of European banks must be reinforced to provide additional safety margins and thus reduce uncertainty,” Mr Rehn said. “This should be regarded as an integral part of the EU’s comprehensive strategy to restore confidence and overcome the crisis.”

...

In a sign that European governments were preparing to act, Wolfgang Schäuble, the German finance minister, said Berlin could, if necessary, reactivate support mechanisms it put in place in 2008 to recapitalise the banks. The mechanisms had expired and the German government had until now insisted they were not needed.

...

Markets have been unsettled again this week by troubles at Dexia, the Franco-Belgian lender, which holds €3.5bn in Greek bonds and €15bn in Italian bonds and has been struggling to raise enough short-term cash to run its day-to-day operations.

The French and Belgian governments said they would take “all necessary measures” to prop up Dexia.

...

Some European officials had hoped to avoid a large-scale effort to shore up eurozone banks until the bloc’s €440bn bail-out fund is formally given powers to recapitalise financial institutions in countries not covered by bail-out programmes.

_

But the process of getting the fund new powers has proved slower than expected, with three countries – including Slovakia – yet to approve the EFSF’s overhaul. Because the EU risked being overtaken by events, Mr Rehn said finance ministers meeting in Luxembourg agreed on the need to act through national capitals while co-ordinating their approach.

A first step would likely be to ensure all countries have mechanisms in place to prop up their banks.

_

Mr Rehn cautioned that while there was “no formal decision” to begin a Europe-wide effort, co-ordination among EU’s institutions – including the European Central Bank, European Banking Authority and the European Commission – on necessary measures had intensified.

...

The last quoted paragraph's mention of the ECB notwithstanding, we read these developments as a fiscal bailout of the troubled Euro banks, not a monetary one. Meaning, no money printing, more good money being sent after bad, and no bailout of the periphery.

Here are the details of the Dexia bailout by France and Belgium from WSJ Marketbeat blog (via ZeroHedge):

• Franco-Belgian lender Dexia is set to park assets worth in excess of EUR180 billion into a so-called bad bank, a vehicle backed by guarantees from the French and Belgian governments, in an effort to disentangle itself from gripping liquidity strains, people familiar with the matter said Tuesday.
• The bad-bank plan is part of a deeper makeover under which Dexia is considering selling all its core units and which may effectively lead to a dismantling of the lender.
• Under a plan submitted to Dexia’s board on Monday, the bank would ring fence into a special vehicle all the assets it inherited from an aggressive expansion push early in the past decade as well as units that can’t be sold under current market conditions, the people familiar with the matter said.
• These assets would include a portfolio of bonds worth EUR95 billion and about EUR30 billion in loans deemed non-strategic, they said. Dexia Crediop and Dexia Sabadell, the bank’s municipal lending units in Italy and Spain, respectively, would also be folded into the bad bank, the people familiar with the matter said. The European sovereign debt crisis has cast a cloud on most financial assets in Southern European countries, making it virtually impossible for Dexia to find buyers for the two units.
• Over the past year, Dexia had succeeded in reducing short-term financing needs stemming from its large portfolio of long-term bonds. Yet, in recent weeks, the bank was increasingly struggling to raise funding at affordable costs. With little hope that liquidity strains would ease in the short term, management came to conclusion that Dexia could no longer carry the oversized bond portfolio alone, one person familiar with the matter said.
• In a first step, Dexia may continue to carry the bad-bank vehicle on its books, but France and Belgium will give its guarantee to securities the bank must issue to meet refinancing needs, the people familiar with the matter said. Longer term, Dexia may transfer bad bank ownership to France and Belgium, these people said

As a reminder, here are some excerpts from the Malmgren Hypothesis, wherein the EU member states support their own banks to the exclusion of the broader institutional Euro framework:

The Germans have already concluded that if they are going to write any further checks then they are going to write them to their domestic institutions and protect their domestic investors. Necessarily, this means that many Eurozone countries will default on their debt. It now seems this will happen within a matter of days. Germany has, therefore, already announced its intention to ring-fence and support their own banks and only their own. This may ultimately involve the nationalization of some or even all the German banks. This is necessary because a falling Euro will further weaken the ability of the other Eurozone members to meet their commitments and thus increases the risk of multiple sovereign defaults. Eurozone countries that are going to default will do so virtually simultaneously rather than sequentially.

...

The nationalization of the German banks, or the creation of a purely German Bailout mechanism, will immediately cause the markets to blow out the spreads on all debt instruments around the world with the possible exception of certain G7 countries like the US and the UK. Note that even the UK has massive bank exposures to the continent especially in Ireland. Ireland may get a bailout from the UK (again) but it is hard to imagine the UK writing a check to anybody else. This would force other Eurozone members to consider how to deal with their own bank debt problems: France, Italy, Belgium all leap to mind but the market will be bound to pressure others from Cypress and Eastern European countries to Bank of America. In fact, the entire banking and payments systems will be subject to entirely unknown shocks and logistical problems should this announcement be made.

Greece defaults and Germany will shore up the German banks. Other countries will either have to do the same or the market’s will discern which countries cannot bailout their banks due to lack of funds. The UK will be asked whether it is going to support the Irish banks. I suspect the UK will say yes but they may not be ready to answer the question when it comes. Any delay will force the UK government to reveal that the UK banks are cash rich. This will raise questions about their lack of lending. Bank failures will probably occur. Small institutions may bring significant consequences. We will see if the French have the resources to manage their banks. Christian Noyer insists that they do, but he would.

Accordingly, it appears France and Belgium have front-run the Germans to ring-fence Dexia ahead of a similar announcement (regarding Deutsche Bank or Commerzbank, for instance). Who will be next: Italy (Unicredit, Intesa Sanpaolo), Spain (Sabadell, Banco Popular, Bankinter), Austria (Raiffeisen), Norway (DnB NOR), Switzerland (UBS), or France again (Soc Gen, BNP)?

Attack on Bank of New York Mellon Continues; US & Schneiderman File Suit Over Forex Fees

From the New York Times (emphasis ours):

U.S. and New York Sue Bank of New York Mellon Over Foreign Exchange Fees

By ERIC DASH and PETER LATTMAN

Published: October 4, 2011

The New York attorney general and the United States attorney in Manhattan filed separate lawsuits on Tuesday against the Bank of New York Mellon, accusing it of cheating state and other pension funds nationwide out of foreign exchange fees over the last decade.

In a civil lawsuit filed in state court, the attorney general, Eric T. Schneiderman, said that the Bank of New York Mellon had consistently overcharged customers for processing foreign currency transactions. He is seeking about $2 billion, which is the ostensible ill-gotten profits that the bank generated over the last decade.

Preet S. Bharara, the United States attorney in Manhattan, filed a civil complaint in Federal District Court in Manhattan that also charges the Bank of New York Mellon with defrauding its customers in the foreign exchange markets. Whereas Mr. Schneiderman is seeking redress on behalf of state pension funds, Mr. Bharara is seeking hundreds of millions of dollars in penalties on behalf of the United States.

...

Mr. Schneiderman’s lawsuit charges that the bank guaranteed that customers would receive the most competitive or attractive rates available on any given trading day. In reality, the lawsuit says, the Bank of New York Mellon provided the opposite: the worst or nearly the worst of the rates available to the bank. Then it earned nearly $2 billion — or as much as 75 percent of its foreign exchange revenue — by pocketing the difference, the suit contends.

The New York attorney general’s action comes after similar moves by authorities in California, Florida, Massachusetts and three other states that are looking into the foreign exchange practices of the Bank of New York Mellon and one of its main competitors, the State Street Corporation. The Securities and Exchange Commission and Justice Department are also in the middle of investigations, according to corporate filings from the banks.

The inquiries began almost two years ago when a group of whistle-blowers made up of plaintiffs’ lawyers and Harry M. Markopolos, the financial investigator who first sounded the alarm about Bernard L. Madoff’s Ponzi scheme, sought out the New York state attorney general’s office to bring lawsuits against the bank.

...

It is not the first time Mr. Schneiderman has squared off against the Bank of New York Mellon. He recently moved to block a proposed $8.5 million settlement involving the bank and the Bank of America over troubled loan pools issued by Countrywide Financial. The suit accuses the Bank of New York Mellon of fraud in its role as trustee overseeing the investment pools, a claim the bank has denied.

_

Solvency Crises Coming to a Head; Brace Yourselves for BAC Restructuring and Possible German Exit from the Euro

History tends to makes fools of those that speak of "imminent" institutional collapse. It's much safer to use the time-unconstrained term "inevitable" and wait for the eventuality. The inertial resistance to structural change is difficult for most to fathom. Yet, there are those fleeting and few-between periods when resistance snaps on multiple fronts, and a new global reality emerges. Here are two shoes waiting to drop:

1) Europe (to be, or not to be a union):

http://www.pippamalmgren.com/77.html (htRobertWenzel)

Were she not a major insider, we would tend to dismiss the leading bullet points from her article of September 13, 2011 as a bit hyperbolic.

News to expect in the coming days and weeks:

• Greece defaults
• Germany protects German banks but other countries cannot do the same thus quickly provoking multiple sovereign defaults and or bank failures, all of which may easily lead to a payments crisis in the global banking system. Derivatives are particularly at risk in terms of operation and execution.
• The Euro falls in value especially against the US dollar
• The Germans announce they are re-introducing the Deutschmark. They have already ordered the new currency and asked that the printers hurry up.
• The Euro falls even more on any news that Germany is withdrawing from the Euro.
• Legal wrangling begins as to the legality of Germany’s decision. Resolution takes years.
• Germany insists that the Euro continues to exist even they do not use it any longer. They emphasize that European unification will continue and suggest new legal instruments to strengthen European Unification including new EU Treaties.

Read on, though (and you should read every word), and the supporting information and logic is robust (brackets and emphasis ours):

The Germans have already concluded that if they are going to write any further checks then they are going to write them to their domestic institutions and protect their domestic investors. Necessarily, this means that many Eurozone countries will default on their debt. It now seems this will happen within a matter of days. Germany has, therefore, already announced its intention to ring-fence and support their own banks and only their own. This may ultimately involve the nationalization of some or even all the German banks. This is necessary because a falling Euro will further weaken the ability of the other Eurozone members to meet their commitments and thus increases the risk of multiple sovereign defaults. Eurozone countries that are going to default will do so virtually simultaneously rather than sequentially.

_

Eurozone countries may or may not have the resources to nationalize their banks. Therefore, we have to expect that bank failures are a real possibility. Apparently, the Europeans are warning the US to come up with a plan to nationalize Bank of America given that it is already in a precarious position, despite the injection of capital from Warren Buffet. The multiple lawsuits against Bofa and other banks alone will render the US banking system vulnerable to any dramatic announcement out of Europe. But, no doubt US banks have immense exposures to European institutions and some may even have sovereign credit risk directly on their balance sheets.

_

It is hard to overestimate the shock that this will bring to the financial markets. Risk aversion will set in quickly as people start to consider the multiple possible consequences, some unintended, of such a decision. Huge fortunes will be made and lost in this moment in history.

_

It is worth providing a review of the evidence that led me to this conclusion.

Next, she enlightens with several facts and dispels many myths. First, no check is coming:

Christine Lagarde’s speech at Jackson Hole revealed the recognition that there was a risk that Germany might not “write a check” to bailout the Eurozone members. She said, to paraphrase, “somebody needs to write a check or we are going to have historic multiple bank failures.” Everyone in the audience understood that no check is coming. The ESFS is not yet funded and a number of the contributors will not hand over cash if there is no collateral.

The German court decision was not a bailout approval:

The Federal Constitutional Court Press Release[viii] has also been misinterpreted by those who want to believe that bailouts will occur. The FT reported that the court ruled in favor of Chancellor Merkel. But, the reality is that the court took the authority to decide away from the Chancellor and gave it to the Budget Committee in the Bundestag. This committee has 48 members and each is certainly driven by the polls and cares about re-election. The Budget Committee is deeply likely to oppose any bailouts that will cost German taxpayers, just as Dr. Issing says.

The real reason the Swiss pegged to the Euro:

If any doubts remain about the German inclination to return to the DMark then consider these announcements. Switzerland announces a peg to the Euro. It was crystal clear at Jackson that the Swiss leadership expected an historic event to occur which would culminate in a rush into Swiss Francs. They tested the water by announcing a “fee” which would be applied to all non-Swiss purchasers of their currency. Within a few days they announce the peg. In short, Switzerland knows what is coming and has just barred the door to anyone who might try to escape the demise of the Euro by leaping into Swiss Francs.

Oh Canada (and Japan):

The statement by the central bank in Canada is similar. I happened to be in Canada when the statement was made. Canadians were deeply confused. After all, to paraphrase, the central bank said, “all the bad things we thought might happen, are now happening, so we are going to maintain a highly defensive position”. In other words, Canada is also gently warning the markets that it will do what it has to do to prevent the currency from suddenly accelerating in the event of a European currency implosion. The Japanese are hinting at this as well. According to Reuters the Finance Minister, “Azumi also said he was ready to step into the currency market to counter speculative moves, although Japan would likely struggle to gain G7 support for intervention.”[xi]

Who will benefit?

It therefore seems likely the US Dollar and US Treasuries will be a major net beneficiary of any failure to bailout Europe. As an aside, this means the market would undertake QE3 as it were. The Fed won’t have to do “operation twist” or consider QE3. [This was written before the September 21, 2011 FOMC meeting, in which OT was announced, but no balance sheet expansion (QE3).] They will be able to focus their attention on the inflation “target” and finding ways to justify letting it rise.

People read the Stark resignation wrong:

It is fascinating that Jurgen Stark’s resignation[xii] has caused people to think the chances of a bailout are increased when in fact his resignation signals that the risk is increased that no bailout will occur AND Germany will withdraw from the Euro. Stark has been a board member at the ECB until his resignation.

...

But, that was not enough to stop Stark’s resignation. When we look back in history we will see that all the important German policymakers resigned from the ECB before Germany formally returned to Deutschemarks, just as one would expect. It also seems too much of a coincidence to my mind that former Head of the Deutcshe Bundesbank and ECB board member Axel Weber leaves the ECB just before all the proverbial starts hitting the fan, goes to UBS as Chairman, and the next thing you know that describes the ways in which countries could leave the Euro including the potential costs if Germany left.

Bernanke's dream come true:

The Federal Reserve will have no choice but to make unlimited liquidity available to the market. They won’t need to announce QE3. The market will do it for them. But, the Chairman really wants to announce QE3 and may use these events as a reason to do so. [Oh, does he ever.]

Other market predictions:

Gold, diamonds, agricultural assets, energy prices and mined asset prices will rise. Default reduces the debt burden and allows growth and inflation to return. If central banks (other than the ECB) throw huge liquidity out into the market because of this event then the liquidity is going to lean away from paper financial assets other than the most trusted and liquid (US Treasuries), and lean toward hard assets.

She concludes that stagflation will accelerate:

The world is about to experience deeper stagflation. The cost of living will now rise even more but growth remains stunted. Policymakers will start to veer back and forth between dealing with unemployment and dealing with inflation. The years ahead will be referred to as “stop go” years because policy will at times try to stop price hikes and at other times policy will try to push growth. Luckily, the world has seen this movie before in the 1970’s. Hopefully, we have learned something from the past and it ends rather more quickly this time around.

Here is the official ECB legal counsel's policy paper on withdrawal and expulsion from the EU and EMU:

http://www.ecb.int/pub/pdf/scplps/ecblwp10.pdf (htTradeWithDave)

Bottom line: an exit from the monetary union, whether unilateral, coordinated, or forced, requires withdrawal from the European Union itself. Thus, if Malmgren is correct about Germany's return to the DMark, it is a de facto withdrawal from the EU under current agreements, despite what the politicians and pundits might say. [Interestingly, the paper notes that this would not preclude continued use of the Euro as a currency, secondary or otherwise.]

2) North America (Bank of America):

http://us1.irabankratings.com/pub/IRAstory.asp?tag=496

Some excerpts (brackets ours) from another must-read by RC Whalen (emphasis and brackets ours):

...The reference to DeMarco is regards his willingness to support the object of the [Soros-]Boyce-Hubbard-Mayer paper on widespad home refinance. We seem to recall a jazz band with a similar name. Actually it is streamlined home refinance. Read the BHM paper and you will understand why the economy is foundering and why the Obama/Geithner binary consciousness won't ever get it.

While the Fed can make a great fuss about intervening in the long end of the government bond market, the central bank cannot get liquidity into the consumer sector unless and until we restructure BAC and other large lenders. Our view is that "twist" by the FOMC is a response to the unwillingness of the Obama White House to embrace mass refinancing of performing mortgages a la BHM. Remember, psident Obama is the puppet and Wall Street as personified by Robert Rubin is pulling the strings.

BAC, Wells Fargo ("WFC"/Q2 2011 Stress Rating: "A") and other large servicers are not going to allow loans in portfolio or owned by investors ppay if they can at all avoid it. Fannie Mae and Freddie Mac, both big owners of high SATO paper, likewise are dragging their feet on refinancing. But the impending insolvency of BAC provides a catalyst to begin the restructuring of the US housing sector and the economic recovery. And yes it is very doable.

On the restructuring:

The answer is that consumer payments, swaps, taxes, interest and principal, FX and all of the other financial operations of BAC will continue uninterrupted. The banks, broker dealers and other operating affiliates of BAC do not file bankruptcy, but the debtor parent does ask for the court to protect the operations of the entire group. We've got some of our cash sitting in the El Segundo branch of Bank of America, N.A., BTW. We aren't moving.

So long as the subsidiary banks of BAC are book solvent and stable, these businesses can continue to operate and, most important, contribute income to the parent. Regulators led by the FDIC and Fed are going to support the restructuring because a commercial reorganization is clearly pferable to a Dodd-Frank resolution, for reasons we have discussed pviously.

...

Taking an aggressive approach to cleaning-up the subsidiaries of BAC could yield enormous operational savings and leave the restructured bank vastly more liquid and profitable. Let’s assume for this discussion that we write-down the bank level TCE and intangibles, and an additional $100 billion in parent equity downstreamed to banks, for $250 billion total bank level asset reductions/cleanup. We then recap the banks with new debt and equity raised by the parent.

Once these tasks are done, we can move to Pro-forma 2, which is BAC on exit from bankruptcy. In the table we show $1.4 trillion in total consolidated assets on exit, including some $1 trillion in bank assets, $200 billion in parent level TCE, no intangibles and $100 billion in new debt. This works with or without Merrill, which is said to be worth in the $30 billion range and could be sold during the restructuring.

BAC management then does the biggest IPO in US history for the most profitable and liquid large bank in the world. BAC's peers would be forced to restructure more rapidly just to remain competitive, but probably via debt conversion and without a bankruptcy. Credit creation in the US economy again becomes positive. Mission accomplished.

So, perhaps the White House and the Fed are not sleeping together after all, which we had agreed with here. If the mortgage refi plan mentioned by BHO is the new Freddie Mac Standard Mod, which rolls out today, October 1, then we could hardly characterize it as "massive" or "streamlined". It's the Classic Modification with lipstick. In particular, these requirements will prove major obstacles to widespread use:

• Borrowers must document an eligible hardship that is causing or expected to cause a permanent or long-term increase in expenses or decrease in income. (Unemployment and other temporary hardships are not eligible hardships.)
• Borrowers must have verified income available to make the modified mortgage payment. (Unemployment benefits are not an acceptable source of income.)

To get a bit wonkish again, see also the new servicing proposals by the FHFA here. The more "radical" of the two proposals would separate (bifurcate) the representations and warranties of the seller and servicer, and would allow for a fixed fee for servicing rights with a separate interest only (IO) security that is not tied to the mortgage servicing rights (MSRs). The former is a step in the right direction, but the latter simply seems to be a workaround to avoid Basel III capital requirements on MSRs for the big banks that are also mortgage servicers. Again, nothing revolutionary.

Bottom line: the current and future contemplated policies in the US are insufficient to deal with the fundamental insolvency of the large banks and with the pent-up dysfunction in the mortgage industry. With the big bank state attorneys general settlement now facing resistance from California, and New York Attorney General Eric Schneiderman continuing to turn the screws on Bank of America and Bank of New York Mellon, a major market-clearing event could be around the corner in the US, even if the EU survives.

As we write, the fingers of instability are mounting and, while the world might just manage to kick the can once more, there is a growing likelihood that the next phase of crisis is upon us. Brace yourselves, as when it comes, it will be necessarily worse than 2008.

Battle for the City of London Tips in Favor of the Queen; Poland to the Rescue

A short time ago, the financial relevance of the UK seemed in jeopardy, but two events announced only yesterday suggest the Square Mile will remain a major player in international trading, at least for the time being. First, the board of LCH.Clearnet, the country's largest counterparty clearinghouse, announced it had approved a buyout offer from the London Stock Exchange, edging out a materially lower offer from Markit, with a shareholder vote to determine the final outcome. Jeremy Grant explained a salient point earlier in the month in the Financial Times (emphasis ours):

But what about SwapClear, the over-the-counter (OTC) interest rate swaps clearing service under LCH.Clearnet?

While LCH.Clearnet books OTC derivatives revenues on its accounts from the SwapClear service, this does not tell the full story on where SwapClear profits go. Some [profits] go to the OTC derivatives dealer-banks that form a curious governance mechanism for SwapClear, known as OTCDerivNet. The amount of profit that goes to these banks is dictated by a sliding scale of thresholds set out in an arrangement between LCH.Clearnet and the banks, revised last year.

It is a glass bead game that few even in the industry understand, but the bottom line is that any LSE deal with LCH.Clearnet would probably have to allow SwapClear to be ring-fenced somehow to allow the banks to carry on. I can’t see the SwapClear banks represented on the LCH.Clearnet board being enthusiastic, either, about exchange control of LCH.Clearnet (which is what you’d get if the LSE wants 51 per cent).

This is one hurdle that Markit, the LSE’s rival bidder, does not face. Perhaps that is why the LSE has offered a knock-out €21 a share price for LCH.Clearnet, above Markit’s €15 offered for 100 per cent of LCH.Clearnet.

So, the big London banks on the LCH board capitulated. But why? Perhaps they read the proverbial handwriting on the wall, as power centers on the Continent were jostling for a carrot-and-stick-induced LCH crossing of the channel. If London were to lose LCH, the Deutsche Borse/NYSE Euronext faction might shift the occidental financial axis firmly along a New York/Frankfurt line.

The carrot was that the EU is currently considering giving clearing houses access to central bank liquidity in a crisis (i.e., ECB bailout funds), similar to the arrangement between the Federal Reserve and the DTCC and CLS Bank. The stick was that the ECB would require clearing activities to be conducted within the EU (sic Germany) as a precondition to access, which would require a re-domicile of LCH on the Continent. On September 15, the UK threatened to sue the ECB over the issue, but only yesterday, the tide turned, as Poland intervened (emphasis ours):

Derivatives clearinghouses such as LCH.Clearnet Group Ltd. may face less pressure to move parts of their business from the U.K. to the euro area as European Union negotiators seek to resolve a clash between Britain and the European Central Bank.

Poland, which holds the EU’s rotating presidency, proposed changing a draft law on over-the-counter derivatives so that “no member state or a group of member states should be discriminated, directly or indirectly, as a venue for clearing services,” according to the document posted on an EU website. The U.K. said “there are a number of issues” requiring discussion before Britain can sign off on the law.

The new wording was added to negotiating texts after the U.K. said on Sept. 15 that it would sue the ECB over its plans to prevent some euro-denominated securities from being cleared outside the 17 countries that share the currency. The text was added to ease U.K concerns that the ECB may push for clearinghouses to relocate, according to an EU official familiar with the talks who couldn’t be identified because negotiations on the measures are private.

Bloomberg continues:

‘Highly Unclear’

“It is highly unclear whether the ECB has the power to make policy like it did in the July paper,” Damian Carolan, a lawyer at Allen & Overy LLP, said in a phone interview from London. “People were quite surprised how far it felt its jurisdiction to extend.”

The Polish proposal would put the U.K. “in a far stronger position in saying that the ECB has gone outside its remit,” Carolan said. “I don’t think it brings you legal certainty but it brings this policy decision clearly into the legal framework.”

The U.K. lawsuit hasn’t been officially registered with the EU Court of Justice in Luxembourg.

Clearinghouses such as LCH.Clearnet and Deutsche Boerse AG’s Eurex Clearing operate as central counterparties for every buy and sell order executed by their members, who post collateral, reducing the threat from a trader’s default.

The derivatives rules are scheduled to be discussed at a meeting of EU diplomats on Sept. 29, according to the EU official. Draft EU laws need approval from the European Parliament and national governments before they can take effect.

The seemingly unlikely bridge between the UK and Poland is made by Poland's finance minister, Jacek Rostowski, a "British-born economist and academic...[who]...will now chair meetings of EU finance ministers and hopes to take part in critical talks among euro-zone finance ministers." A hardliner for EU solidarity (though Poland has itself yet to join the euro), he has pushed strongly for the Greecian bailout and an IMF-style approach that, at least initially, favors growth over austerity. What concessions or favors he might have wrung from the UK are unknown, but we would not be surprised to see a British role in the EFSF cum pan-European bond, once the twin Hungarian calls for a crisis come to fruition.

Regardless, the LSE's vert just improved by a few inches. Not enough for a slam dunk, but enough to maneuver in the paint.

John Tsang Does Chicago

Hong Kong FinSec, John Tsang wrapped up his world tour this week in Chicago, meeting with some movers and shakers in both the political and financial realms (emphasis ours):

: FS promotes HK in Chicago

Sep 27, 2011 (M2 PRESSWIRE via COMTEX) --

Financial Secretary John Tsang continued the final leg of his US visit by meeting President and Chief Executive Officer of the Federal Reserve Bank of Chicago Charles Evans in Chicago yesterday.

They discussed Hong Kong's unique role as an offshore centre for renminbi banking, renminbi trade settlement and the issuance of renminbi bonds.

He called on Chinese Consul-General Yang Guoqiang, before visiting the Chicago Mercantile Exchange to meet its Executive Chairman Terrence Duffy.

He also called on Chicago Mayor Rahm Emanuel before attending an event to celebrate Cathay Pacific's launch of daily non-stop passenger flights between Hong Kong and Chicago.

Mr Tsang will visit Caterpillar Inc today before returning to Hong Kong.

Press Love Fest for NY Attorney General Schneiderman Ignites; Will He Be the One to Lock Up Goldman's Blankfein?

We mentioned the rising star of Eric Schneiderman the other day, wondering who was pulling his strings in the fight against the big banks. The next day, Ben Smith, of Politico asked, "Is Eric Schneiderman America's most powerful liberal?"

New York Attorney General Eric Schneiderman was too busy running for office during the first two years of the Obama presidency to really pay much attention.

“Obama ran on this visionary platform, and then something happened, between the time I started campaigning and the time I finished campaigning,” he recalled in an interview in the spacious, sparsely furnished office he won last year, around the corner from the New York Stock Exchange. “But it certainly looked different in December of last year than in June of ‘09.”

By that time, Schneiderman, a trim, impatient liberal, was preparing to be sworn in to a jobEliot Spitzer turned into the terror of Wall Street. And he was almost perfectly placed - and almost perfectly suited by temperament and ideology - to be one of the ringleaders of a nascent, post-Obama left, a kind of liberal tea party.

A New Yorker who represented the Manhattan’s Upper West Side, writes for The Nation, and has spent a decade fighting his party’s moderates, Schneiderman found himself in the position of being one of the few public officials who could try to erase an act that was the key root cause of early progressive disappointment with Obama: his relatively gentle handling of Wall Street in the wake of the 2008 economic crisis.

Just months after he took office, Schneiderman reversed the position of his predecessor - current Gov. Andrew Cuomo - and rang the alarm on a settlement being negotiated by 50 state attorneys-general he saw as too lenient toward the big banks.

Reading on, we learn the big banks might be in for a good old fashioned fishing expedition (emphasis ours):

There are sharp disputes over theory and facts in the bank settlement talks, and the reality can be hard to tease out from unreleased letters between the banks and the states and off-the-record, talks. As Schneiderman tells it, he became alarmed soon after taking office at what he saw as a failure do demand more internal bank documents, and at suggestions that the banks would be able to settle not just narrow issues around the handling of foreclosures, but broad questions about the securitization of sub-prime loans that underlay the 2008 crisis.

“I was concerned about the scope of the investigation that had been conducted, and I was concerned about what kind of release the banks wanted,” he said. “I wasn’t going to release claims that hadn’t been investigated.”

Miller says the AGs and federal agencies have copious files on the housing crisis, and bridled in particular at Schneiderman’s claim that the settlement could ever have included a release from claims involving securitization or other broad issues.

“He’s essentially made that up,” he said of Schneiderman. “The release will center on robosigning and servicing and issues that are closely related to servicing. It’s not going to be a broad release.”

...

Schneiderman argues that a deeper investigation would give the AGs more leverage for a more sweeping settlement, and that this is the last, best chance to get at issues at the heart of the troubled American economy.

“I think a more creative, robust settlement would be a good thing for this economy, and I think a thorough investigation that airs this out is critical for restoring public confidence,” he said.

Schneiderman doesn’t appear likely to back down, and he has deeply unsettled the fragile coalition of attorneys general, with several others joining him to press – demagogically, in Miller’s view – for a narrow release. Spitzer – who regularly calls to advise Schneiderman to follow an activist path – praised him to POLITICO for “continuing the notion that the New York Attorney General is the most effective outspoken voice in an environment where the federal regulatory agencies still haven’t flexed their muscles in a meaningful way.”

The love fest didn't stop there, because one day later, Nina Burleigh at Salon sycophantically asks a similar question, "Is New York Attorney General Eric Schneiderman the One to Finally Fight Big Money's Power in Politics?"

Schneiderman, like Obama, comes from the low-drama school of political presentation. He doesn't get red-in-the-face mad. He doesn't seduce. He's earnest and self-effacing and pedagogical. But unlike the president, he has a steady refusal to back down and a ready willingness to fight. He is the antihero that boiling mad progressives hope can manacle and perp-walk those responsible for the financial crisis.

...

As if responding on cue to that taunt, the New York Post reported two days later that one of Schneiderman's staff attorneys had been moonlighting as a dominatrix for hire under the name Alisha Sparks. In her day job, she had negotiated deals with errant bankers, by night she was allegedly taking money to whip submissive men into states of bliss. Schneiderman promptly put her on unpaid leave on the basis of the charge that she had broken the rule against outside employment. His press secretary assured me that Sparks hadn't come anywhere near the current ongoing investigation. But financial bloggers immediately smelled a rat and suggested the outing was just the beginning of a coordinated dirty war on Schneiderman's office as he turns up the heat with bank subpoenas.

For the record, we're against the settlements as well, but just don't believe the Wall St. hero cop story. As always, we simply follow the money.

Salon continues with a few more details on what Schneiderman wants to get his hands on.

Schneiderman said his office is "digging into" earlier phases of the mortgage-backed securities era. "Origination, the pooling of loans by the banks, the securitization, sale," he said, and activities after 2004, when the housing bubble started filling with air, and the numbers of mortgages dropped. "That's when things started to shift and you can see this whole process of -- making money of these securitizations was so profitable, that it didn't stop when it should have stopped."

Around the same time, he noted, investors began scrutinizing MBS more carefully, and diverting money into the more complex but also troubled collateralized debt obligations. As everyone knows in hindsight, the quality of mortgages deteriorated, the quality of securities deteriorated, and it all collapsed. "We are looking at what caused that to happen and what people were doing and what people knew," he said.

If anyone has data on mortgage-related securitization volumes going back to 2004, we'd love to see 'em. But, off the top of our head, we can think of one investment bank cum Federal Reserve member bank that was a leader in securitization "innovation" around that time, and which would be a coup for a rising AG to take down. Yes, the world's most fashionable bank to hate, Goldman Sachs, and its God's-work-doing CEO, Lloyd Blankfein (who, buy the way, recently hired a criminal defense attorney).

Another Soros-funded Attorney General, Former Rand Paul Opponent Jack Conway, Threatens the Big Bank Settlement

George Soros is just itching for a crisis. A few weeks ago, the NYT reported:

“This crisis has the potential to be a lot worse than Lehman Brothers,” said George Soros, the hedge fund investor, citing the lack of an authoritative pan-European body to handle a banking crisis of this severity. “That is why the problem is so serious. You need a crisis to create the political will for Europe to create such an authority, but there is still no understanding as to what the authority will do.”

The other day, we wondered aloud why the New York Attorney General, Eric Schneiderman, was aggressively blocking the Bank of American and Bank of New York Mellon settlement regarding Countrywide RMBS. Maybe he's just an uncorrupted politician looking out for the best interests of the good investors of New York. Or maybe, he's being pressured by one of his largest campaign contributors, George Soros.

In a separate matter, Schneiderman has also been an active critic of the settlement among the big banks and state attorneys general. Add to that list another recipient of Soros' largess, the AG of Kentucky and none other than Rand Paul's former opponent for US Senate, Jack Conway.

Will Soros get the US leg of his crisis? With all eyes on BAC, focus might soon shift to BNY Mellon. As RC Whalen wrote the other day at the IRA Analyst (behind pay wall now):

We cannot help but wonder if that August 30, 2011 lawsuit by US Bank did not have something to do with the unexplained volatility in the BK CSUITE. "Bank of New York Mellon raised eyebrows after the closing bell Wednesday by announcing the departure of Chairman and Chief ExecutiveRobert Kelly, but analysts say the bank won't miss a beat under new leadership, and the stock didn't either," writes Steve Schafer of Forbes.

Skip a beat or skip away is the question we have in mind. Under Sarbanes-Oxley, the general counsel of BK has an affirmative duty to make members of the board of directors aware of any failure in terms of internal systems and controls or future risks. Looking at the public record, it does not appear that BK has yet acknowledged the problems regarding trustee activities that have been made public by the State of New York.

The auditor of BK as well as the outside counsel to the bank also have affirmative duties to report to the SEC any failure to disclose such risks to investors in the event that the board fails to make such disclosure. Again, we see nothing in the public record indicating any disclosure by BK regarding these allegations by the State of New York. And is it not interesting that the New York AG was not represented at last Friday's meeting of parties in the Countrywide put-back litigation? While the penalties for failure to disclose in the Sarbanes-Oxley law are bad enough, a litigation by the NY AG using the Martin Act is the big shoe waiting to drop on both BAC and BK. What will the NY AG do? Stay tuned.

Stay tuned, indeed. As the only competitor to JP Morgan in the US custodial securities business, BNY Mellon is more of a systemic risk than BAC, and adds an interesting dimension to the current financial crisis.

John Tsang Does New York

After visiting the City of London (and threatening to repatriate HSBC and Standard Chartered, no less), and a pit stop in Edinburgh, Hong Kong Financial Secretary John Tsang landed in the US this week. Tuesday, he met with Blackstone co-founder Stephen Schwarzman, and Wednesday with FRBNY president William Dudley. According to a prior press release, he was to have met with officials at NYSE Euronext. Next up: Chicago, where he will visit the CME, among other places.

http://7thspace.com/headlines/394794/fs_visits_new_york.html

Hong Kong (HKSAR) - The Financial Secretary, Mr John C Tsang, had a busy schedule lined up for the first leg of his visit to the United States in New York today (September 21, New York time).

First, at a breakfast roundtable with American Chinese business leaders and professionals, Mr Tsang gave an update on the latest developments in Hong Kong and enjoyed an open discussion on Hong Kong's unique role as the premier gateway to Mainland China.He called on the business community to grasp the opportunities in Hong Kong.

This was followed by an courtesy call on Consul General of the People's Republic of China in New York, Mr Sun Guoxiang.

He then attended a lunch hosted by the Federal Reserve Bank of New York (New York Fed), Mr William C Dudley.Mr Tsang shared with the bankers Hong Kong's development as China's global financial centre and as the offshore centre for Renminbi business, which is supported by the Central Government's national development blueprint, the 12th Five Year Plan.

In the afternoon Mr Tsang visited the Metropolitan Museum of Art, where he was given a guided tour of an exhibition titled "The Art of Dissent in 17th Century China: Masterpieces of Ming Loyalist Art from the Chih Lo Lou Collection", which is being held in collaboration with the Hong Kong Museum of Art.

Yesterday (September 20, New York time), Mr Tsang held a meeting with the Chairman, Chief Executive Officer and Co-founder of Blackstone, Mr Stephen A Schwarzman.

The New York visit runs from September 19 to 22.Mr Tsang, who is also visiting Washington and Chicago from September 22 to 27, seeks to forge stronger trade ties between Hong Kong and the United States.During the visit he will meet prominent figures from the political, financial and business sectors to discuss the global economy, provide an update on the latest situation in Hong Kong and promote the many unique advantages Hong Kong offers to entrepreneurs.

He will return to Hong Kong on September 28.

Source: HKSAR Government

Latest Fed Rat to Jump Ship Joins [Recently Downgraded] Citi; Cited as Expert in "Europe" and "Emergency Lending Programs"

Bernanke's learning the hard way how the pimpin game is played.

"You know the rules, your economist chose me."

After losing Brian Madigan and David Stockton to retirement, the latest of Bernanke's top three economic advisors to announce departure, Nathan Sheets, has just joined Citi as the firm's Global Head of International Economics. From BusinessWire:

NEW YORK, Sep 22, 2011 (BUSINESS WIRE) -- Citi today announced that Nathan Sheets has joined the Firm as Global Head of International Economics within Citi's Investment Research & Analysis division. Mr. Sheets will be based in New York. He will report jointly to Citi's Chief Economist, Willem Buiter, and to Citi's Global Head of Investment Research, Andrew Pitt. Mr. Sheets will work with Willem Buiter to lead the Firm's team of international economists, with a special focus on the position of the US in the global economy.

Mr. Sheets joins from the Federal Reserve Board in Washington D.C. where he served as Director of the Division of International Finance and as an Economist to the FOMC. Among his most notable accomplishments, Mr. Sheets acted as the Fed Chairman's international adviser at the onset of the European fiscal crisis in the spring of 2010. He was also a driving force behind the Federal Reserve Board's global emergency lending program.

Mr. Sheets acted as senior advisor to the U.S. Executive Director at the International Monetary Fund (IMF) while on leave from the Federal Reserve. In this capacity, he served as a liaison between the IMF and various U.S. government agencies.

Mr. Sheets received his Bachelors of Economics from Brigham Young University and his PhD from the Massachusetts Institute of Technology.

"We are excited to welcome Nathan to the firm. He brings with him an innate understanding of global macroeconomic issues and he will provide incredible guidance to our clients," said Andrew Pitt, Global Head of Citi Investment Research & Analysis.

Hamid Biglari, Citicorp Vice Chairman and Head of Emerging Markets and Content, added, "With over 18 years of experience with the Federal Reserve, Nathan's appointment underscores Citi's commitment to bring the highest quality insights to our clients."