MF Global bond offerings make case for requiring ultra transparency

In his Bloomberg column, William Cohan looks at the reasons that investors in MF Global bonds felt duped.

Had MF Global been required to provide ultra transparency and disclose on an on-going basis its current asset, liability and off-balance sheet exposure details, each of the ways that investors might have been duped would have gone away.

On July 28 and again on Aug. 3, MF Global raised $325 million by selling bonds -- the first a 3.375 percent convertible-note offering, due 2018; the other a 6.25 percent senior note offering, due 2016.... 

Not surprisingly, in addition to all the other lawsuits that MF Global executives and board of directors are facing, one brought by the buyers of these notes is wending its way through federal court in the Southern District of New York. 

The plaintiffs make a compelling argument that they were duped by the public statements of Jon Corzine, MF Global’s former chief executive officer, and the company’s Securities and Exchange Commission filings.

Had their been ultra transparency, the investors would not have had to rely on MF Global's representations.  They would have had the information they needed to verify the facts for themselves.

The class-action complaint claims that MF Global’s collapse was caused by management’s “wholesale disregard for its purported risk management and internal controls as MF Global sought to transform itself from broker-dealer to a full service investment bank at all costs.”... 

the plaintiffs cite the statements MF Global made in its 2011 Form 10-K about its abundant liquidity as evidence that the company was intentionally misleading investors. 

“Our policy requires us to have sufficient liquidity to satisfy all of our expected cash needs for at least one year without access to the capital markets,” reads the form. “To manage our liquidity risk, we have established a liquidity policy designed to ensure that we maintain access to sufficient, readily available liquid assets and committed liquidity facilities.” 

The plaintiffs argue these statements were false. “MF Global was suffering from severe liquidity pressures” -- as quickly became evident -- “based on its exposure to the European debt crisis through its enormous holdings of European sovereign debt,” according to the complaint. “MF Global was materially undercapitalized.”

With ultra transparency, it would have been easy for the investors to see if MF Global was experiencing severe liquidity pressures.

Further, the plaintiffs claim, whereas the offering documents for the bonds claimed that the use of proceeds would be partly for “general corporate purposes” -- a typical catch- all -- MF Global management knew that large chunks of the $650 million were “desperately needed to provide required liquidity and working capital given the then-deterioration in value of MF Global’s $6.4 billion holdings of European sovereign debt.”...

Again, with ultra transparency, investors could have determined with the market value of MF Global's $6.4 billion holdings of European sovereign debt was and seen that most of the proceeds would be used to plug the hole between the cost of these securities and the then current market value.

And few tears should be shed for sophisticated investors who miscalculate the risks of owning securities in companies that are highly leveraged and have new management intent on changing business plans. (By last summer, it was certainly no secret that Corzine intended to change the way MF Global conducted its business by making big bets with other people’s money. He said as much publicly on several occasions.)

It is one thing for investors to miscalculate risk when they have access to all the useful, relevant information in an appropriate, timely manner under ultra transparency and quite another when the true condition of the firm is hidden by opaque reporting practices.

Still, the level of deception by MF Global’s executives and board members demands that they be held personally accountable for the losses suffered by these bondholders -- just as they should be held personally liable for the losses suffered by MF’s customers. 

It seems to me, demanding this level of accountability -- which, of course, their lawyers will say is unjustified -- is the only way Wall Street executives will begin to take seriously their fiduciary duties to their customers, counterparties and creditors. 

At the moment, though, that is just a columnist’s fantasy. No MF Global executives have been held accountable for their actions, more than six months after the firm’s collapse and billions of dollars of other people’s money have been lost. 

Come to think of it, no one else on Wall Street has been held accountable for blowing up our economy, either. How can this still be the case?

Ultra transparency brings accountability to Wall Street.  With this information, market participants are able to exert discipline on Wall Street.  Particularly when their is a gap between what they represent as the condition of their firm and what is the actual condition.

Bill Gross takes on Fed's zero interest rate policy

In his February 2012 Investment Outlook, Bill Gross examines the critical assumptions behind the Fed's zero interest rate policy and finds they do not hold and as a result the policy is doing more harm than good.

Regular readers know that over the last year this blog has run several posts on this topic that came to the same conclusion (see here, here, and here).  In fact, the similarities between his Investment Outlook and this blog's posts in looking at the critical assumptions behind the Fed's zero interest rate policy suggest that he too is a regular reader.

• Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside.
• Most short to intermediate Treasury yields are dangerously close to the zero-bound which imply limited potential room, if any, for price appreciation.
• We can’t put $100 trillion of credit in a system-wide mattress, but we can move in that direction by delevering and refusing to extend maturities and duration....

The transition from a levering, asset-inflating secular economy to a post bubble delevering era may be as difficult for one to imagine as our departure into the hereafter....

Yet the imagination and management of the transition ushers forth a plethora of disparate policy solutions.... 

Fed Chairman Ben Bernanke ... preannounced an awareness of the deleterious side effects of quantitative easing several years ago in a significant speech at Jackson Hole. Ever since, he has been open and honest about the drawbacks of a zero interest rate policy, but has plowed ahead and unleashed his “QE bowser” into the wild with the understanding that the negative consequences of not doing so would be far worse. 

Actually, it his belief that the negative consequences of not doing so would be far worse.

Walter Bagehot, the man who wrote the book on modern central banking, would say that this belief is not true and that the negative consequences far exceed the benefit.  Mr. Bagehot said that rates should not drop below 2% and John Maynard Keynes deferred to his judgement.

My goal in this Investment Outlook is not to pick a “doggie bone” with the Chairman. He is makin’ it up as he goes along in order to softly delever a credit-based financial system which became egregiously overlevered and assumed far too much risk long before his watch began. 

Like Mr. Gross, I do not want to step into the Bagehot/Bernanke debate.

This blog has consistently focused on the alternative to the Fed attempting to address over-leverage in the financial system through monetary policy.  The alternative is to have the banks function as a safety valve between the excesses in the financial system and the real economy.

Banks can act as a circuit breaker by absorbing the losses on the excesses in the financial system today and restoring their book capital through future retained earnings.

My intent really is to alert you, the reader, to the significant costs that may be ahead for a global economy and financial marketplace still functioning under the assumption that cheap and abundant central bank credit is always a positive dynamic. When interest rates approach the zero bound they may transition from historically stimulative to potentially destimulative/regressive influences. 

Much like the laws of physics change from the world of Newtonian large objects to the world of quantum Einsteinian dynamics, so too might low interest rates at the zero-bound reorient previously held models that justified the stimulative effects of lower and lower yields on asset prices and the real economy. 

It is instructive to mention that this is not necessarily PIMCO’s view alone. Chairman Bernanke and Fed staff members have been sniffin’ this trail like the good hound dogs they are for some time now. In addition, Credit Suisse, in their “2012 Global Outlook,” devoted considerable pages to specifics of zero-based money with commonsensical historical comparisons to Japan over the past decade or so. The following pages of this Outlook will do the same.  

At the heart of the theory, however, is that zero-bound interest rates do not always and necessarily force investors to take more risk by purchasing stocks or real estate, to cite the classic central bank thesis.  

First of all, when rational or irrational fear persuades an investor to be more concerned about the return of her money than on her money then liquidity can be trapped in a mattress, a bank account or a five basis point Treasury bill. But that commonsensical observation is well known to Fed policymakers, economic historians and certainly citizens on Main Street.  

What perhaps is not so often recognized is that liquidity can be trapped by the “price” of credit, in addition to its “risk.” 

Capitalism depends on risk-taking in several forms. Developers, homeowners, entrepreneurs of all shapes and sizes epitomize the riskiness of business building via equity and credit risk extension. 

But modern capitalism is dependent as well on maturity extension in credit markets. 

No venture, aside from one financed with 100% owners’ capital, could survive on credit or loans that matured or were callable overnight. Buildings, utilities and homes require 20- and 30-year loan commitments to smooth and justify their returns. Because this is so, lenders require a yield premium, expressed as a positively sloped yield curve, to make the extended loan. 

A flat yield curve, in contrast, is a disincentive for lenders to lend unless there is sufficient downside room for yields to fall and provide bond market capital gains. This nominal or even real interest rate “margin” is why prior cyclical periods of curve flatness or even inversion have been successfully followed by economic expansions. Intermediate and long rates – even though flat and equal to a short-term policy rate – have had room to fall, and credit therefore has not been trapped by “price.” 

When all yields approach the zero-bound, however, as in Japan for the past 10 years, and now in the U.S. and selected “clean dirty shirt” sovereigns, then the dynamics may change. Money can become less liquid and frozen by “price” in addition to the classic liquidity trap explained by “risk.”  

Even if nodding in agreement, an observer might immediately comment that today’s yield curve is anything but flat and that might be true. Most short to intermediate Treasury yields, however, are dangerously close to the zero-bound which imply little if any room to fall: no margin, no air underneath those bond yields and therefore limited, if any, price appreciation. 

What incentive does a bank have to buy two-year Treasuries at 20 basis points when they can park overnight reserves with the Fed at 25? What incentives do investment managers or even individual investors have to take price risk with a five-, 10- or 30-year Treasury when there are multiples of downside price risk compared to appreciation? At 75 basis points, a five-year Treasury can only rationally appreciate by two more points, but theoretically can go down by an unlimited amount.  

Duration risk and flatness at the zero-bound, to make the simple point, can freeze and trap liquidity by convincing investors to hold cash as opposed to extend credit.  

Where else can one go, however? We can’t put $100 trillion of credit in a system-wide mattress, can we? Of course not, but we can move in that direction by delevering and refusing to extend maturities and duration. 

Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside. Still, zero-bound money may kill as opposed to create credit. 

Developed economies where these low yields reside may suffer accordingly. It may as well, induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper. 

Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. 

We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.

Opaque structured finance products allow Wall Street to 'swizz' market participants according to George Osborne's private secretary

As defined in the Oxford Dictionary, a swizz is something that represents a mild swindle.

The Telegraph carried a must read article on a structured product being offered by Barclays to its retail clients.

Since before the financial crisis began on August 9, 2007, your humble blogger has been advocating for disclosure.  One area I have focused on is disclosure of all the useful, relevant information in an appropriate, timely manner so that market participants could value structured finance products.

The reason it is important that market participants can value a security is that it is only with the ability to value a security that the market participant knows if the price that Wall Street is offering for the security is too high, what it should be, or a bargain.

Without the ability to value a security, Wall Street is in a position to take advantage of market participants through their marketing (think brokers...).  This situation is what the UK's George Osborne's aide would call a "swizz" and wonders why financial regulators would allow it to occur.

Please note that the same thing occurs with structured finance products sold to sophisticated investors. Examples of this include CDOs, subprime mortgage backed securities and interest rate swaps (think Jefferson County Alabama).

In short, the idea of a swizz applies to every opaque product created by Wall Street.

The only way to end this swizz is for global policymakers and financial regulators to adopt and fully implement the FDR Framework.  Under this framework, no financial product can be sold where all the useful, relevant information is not available in an appropriate, timely manner so that market participants can independently assess the risk of and value the product.

Greg Hands, personal private secretary to George Osborne and a junior member of the Treasury, said he had been offered the structured bond from Barclays as he was a customer of their stockbroking division. He said the complicated nature of the product revealed that banks still had a long way to go to make their offers transparent and suitable for investors. 

High levels of household debt and investments in unsuitable and complicated products was seen as one of the reasons for the financial crisis. 

Mr Hands, who worked in derivatives for eight years before becoming an MP, said the bond was almost impossible to price. "I do sometimes wonder about some of our banks and others with the marketing of their financial products," he said at a fringe meeting at the Conservative Party conference last week. 

No need to wonder Mr. Hands.  Yves Smith would tell you that the reason this product is being marketed is because no one on Wall Street is highly compensated for developing low margin, transparent products.

"I am a client of Barclays stockbrokers and I am amazed at some of the stuff they are putting out to purely retail individual investors, not high net worth clients." 

At the event organised by the Social Market Foundation Mr Hands then referred to the recent offer he had received from Barclays: "This is an exclusive offer until the 28 September," he said the offer document explained, before continuing: "It is a very complicated product that is a bond linked to the level of the FTSE. 

I used to price some of these products and it was not possible to price this product. I'm not saying Barclays is exceptional in this, I believe other banks are likely to be similar. But there are a very complicated set of options embedded in this product which are called in the world of derivatives an American style set of binary options where basically your capital is at risk if at any point during the next five or six years the FTSE falls below a certain level. 

"You could end up losing a considerable part of your capital which I don't think is particularly explicit in this product." 

There is no reason to believe that high net worth or sophisticated investors would be able to do a better job of pricing this product than an individual with experience like Mr. Hands.  The same lack of transparency into the true risk of the product would also be a barrier to their investment advisors in evaluating the product.

Mr Hands said that only at the bottom was there a suggestion that "structured products are not for everyone" or investors should "seek independent advice". He said many retail investors did not have access to suitable advice. "This is basically what you would call on the street a swizz....

Last night, a spokesman for Barclays said: "Barclays Stockbrokers provides a service through which clients can trade a wide range of securities. We make available from time to time structured products which enable sophisticated investors to express a view on the market. The literature complies with FSA guidelines and makes it clear investors' capital is at risk."

The problem currently is and has been since well before the beginning of the financial crisis that disclosure is inadequate.

Disclosure and the hunt for yield

A Telegraph article reported on the Bank of England's Paul Fisher's speech in which he discussed the implications for financial market stability from investors hunting for yield in a low rate environment.

As predicted under the FDR Framework, investors are crowding into those assets where they have access to all the useful, relevant information in an appropriate, timely manner.  Included in these assets are debt with government guarantees and high grade corporate bonds.

Mr. Fisher is concerned that as spreads on these assets tighten to pre-credit crisis levels, investors will turn to securities they do not understand to pick up additional yield and this will in turn create financial instability in the future.

This is ironic.

At least in the US, it is an explicit goal of zero interest rate policies to force investors into riskier assets.  The Fed has gone so far as to reduce the supply of risk-free assets by purchasing treasury securities.  By doing so, they have artificially depressed the yield across the entire treasury yield curve.

This mis-pricing of the risk-free rate carries over to all other debt securities.  As the spreads over treasuries on these other debt securities return to their pre-credit crisis level, this is an indicator that these debt securities are over-priced.

Why?

Because the mis-pricing of the risk-free securities is now embedded in the pricing of the other debt securities.  For example, say that under the Fed's policy the risk-free securities are trading for 0.25% less than they would without Fed intervention.  This same 0.25% is now embedded in the pricing of the other debt securities when their spreads return to pre-credit crisis levels (otherwise the spreads would be 0.25% higher than pre-credit crisis levels).

It appears that Mr. Fisher is making an artificial distinction by focusing only on those debt securities for which investors do not understand what they are betting on when the largest categories of debt securities are mis-priced too.

"Investors know – and must remember – that there is no such thing as a free lunch, and that additional return involves additional risk," said Mr Fisher, the Bank's executive director of markets and a member of its interim Financial Policy Committee. 

Intelligence gathered by the Bank has flagged up a "number of pockets of increasing risk appetite and a few specific markets which have been showing signs of excess," he said, with the trend most marked in the US. 

Investors are on the hunt for higher yields, or returns, against the backdrop of the massive emergency injection of liquidity into the financial system by the world's central banks. They [central banks] bought up government bonds in vast quantities, which pushed down the yields from these "safe" assets and encouraged investors to look elsewhere. 

The worry is that the lower yields on these traditionally low-risk assets is now coinciding with an apparent shortage of high-quality assets, therefore prompting investors to move into products where the risks are not so understood, Mr Fisher said in a speech to institutional investors released yesterday. 

Mr. Fisher's statement suggests that the stated intent of Fed policy poses risks to financial stability.  Having identified the risks, the question becomes what is the appropriate response by policy makers.  The choices include:

• The Fed stops pursuing zero interest rate policies and the purchase of risk-free debt securities.  This will increase the supply to the market and ease the pressure to move into products where the risks are not understood.

• Governments actually making sure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

• Reminding investors that the last time they purchased debt securities they did not understand, think sub-prime mortgage backed CDOs, they lost a bundle.

Mr. Fisher opts for reminding investors.

... "The combination of portfolio rebalancing and this reported shortage of specific high-quality assets might have wider implications for financial stability if it encourages investors to look for additional yield by moving into more illiquid products ... or into more complex products (which they might not fully understand)," Mr Fisher said. 

He highlighted exchange traded funds (ETFs), which are traded like shares. Their rapid growth has been characterised by "increasing complexity, opacity and interconnectedness, and ... if left unchecked, could grow to pose risks to the stability of the financial system", he said. 

It is not surprising that ETFs are becoming increasingly complex and opaque.  Wall Street is engineering them this way because they know that the regulators are not requiring that all the useful, relevant information be disclosed in an appropriate, timely manner.

However, the most immediate threat to markets was seen as problems around governments' debt and the potential impact on European banks.