Shadows On The Wall Of The Cave
Before I offer my cheery view, let me ask some questions, the likes of which were first asked in this column in March of 2005.
1) REFCO has significant contingent liabilities of heretofore unknown characterization. What percentage of the liability is naked short sales - failure to deliver? Specifically? (That one wasn't asked, but if you go back and read the rants, you will find it was, in a general way). REFCO has two DTC accounts, "REFCO Securities, Inc." and "REFCO Securities, LLC - Securities Lending." How big a part did the latter play in this?
2) Ex-Clearing (non-CNS settlement) is a large problem, and we know there are many hundreds of millions of FTD's from the FOIA requests. Where are those contingent liabilities booked and represented on the balance sheets of the publicly traded brokers? I've read their 10K's and can't find them. They are large enough to be material. So where are they?
3) How does the system deal with the legal risk of issuing electronic book entries that have no associated bundle of voting rights, nor any of the other rights of a genuine share, in the event of a class action lawsuit against the issuing company? Given that the FTD's are not entitled to legal redress as they aren't real, who shoulders that liability, and where is that liability represented on the books of these publicly traded entities?
4) When a clearing broker fails, like REFCO, what happens to the contingent liability of the fails? In a bankruptcy proceeding? Who is on the hook if the hedge fund client implodes (as they are doing frequently now) and then the clearing broker goes belly up? How is that handled?
5) Why are settlement failures occurring at all? Why does our system tolerate them? Rule 17A mandates that transactions be cleared and settled promptly. Why isn't that happening?
6) Who decided it would be a good idea to split clearing and settling apart, and pay all commissions and fees at clearing (the agreement to try to get shares), and require no performance in terms of delivery (settlement)? What other financial industry pays upon inking a non-binding contract to try to perform? Is that what Congress had in mind when it said both clearing AND settling had to happen promptly for there to be fair markets?
7) Why are participants given the ability to create electronic book entry shares at will, with no shares to back the electronic book entries? Why does the DTCC have an ex-clearing function that leaves the settlement up to the participants, out of view? Why wouldn't the participants abuse this as we see them doing daily? Who is stopping them?
8) The SEC and the DTCC take the position that they don't have the authority to get involved in settlement arrangements, as those are contractual. When did Congress authorize brokers to decide when, if at all, they will deliver, with no SEC oversight? That is the net effect of the ex-clearing and resultant SEC and DTCC passing of the buck.
The simple way of framing many of these is: Why won't the SEC make the system settle the trades promptly, as Congress mandates?
Those are some pretty decent questions that remain unanswered and ignored. Nobody fields them. My motives and CV are attacked regularly by anyone who is industry-based, but they don't actually answer the questions, or if a response is tendered, it is a carefully parsed non-answer, or partial answer.
Now to the big question - how do I think this will end?
My view is that it will end with a token reform of the current system that comes after the horse has bolted, at the expense of investors and taxpayers.
Here's how I think it will play out.
REFCO may well be swept under the rug - I heard a few minutes ago that Senate Hearings are to take place, and our first clue as to the direction this is likely to take will come from those hearings; by the questions that are asked, or rather aren't.
My fear is that we will have hours of acrimonious table pounding, long rants about how this is inexcusable, hangdog expressions from regulators who will make token attempts to defend their enabling these crooks to go public (we've already seen the first of this, where the SEC takes the position that they aren't in the business of verifying and double checking all the financial disclosures and such - begging the question what they are in the business of, in light of the 1933 Act) while facing sanctions for past crookery, hard line statements about how we won't tolerate this any longer, assurances that substantial parts of the business are viable, further assurances that the markets are healthy and viable, and ultimately blame being placed at the feet of the already acknowledged crooks.
What won't be done is a breakdown of the liabilities that caused the meltdown of the company. The question you won't hear asked is how much of the contingent liability arose from delivery failures. And if it is asked, expect a hubba de hubba answer, with plenty of hand waving, and assurances that it is minimal. But you won't hear a hard number, nor a commitment to make the facts known. Instead, you can expect to hear a lot of rhetoric, a fair amount of technical discussion, but the topic of naked short selling and the fact that the company was facing sanctions for participating in a massive scheme to serial kill companies will probably not come up.
This will be your signal that this will not end well.
If REFCO's failure is allowed to go through the media and the review process without any real examination of the impact that naked short selling played in bringing it down, then I would prepare for the worst.
So that begs the question, what's the worst? Total systemic collapse? Global meltdown? Hellfire and brimstone? Cats dancing with dogs, a rain of fire, locusts, Biblical-level calamity?
Nope. Unlikely. Too many asses on the line.
No, the likely end will be much more mundane. What we will see is a steadfast silence in the American media. Events like Dr. Byrne of OSTK being unable to get his shares for months will be ignored, as they have been to date. More of these clearing brokers will fail over time, and the domino effect will continue from REFCO - they are the first. There are more. Question is which one is next?
Once the next one fails, or a hedge fund implodes with significant exposure to fails, then you will start to see the cracks more obviously, and it will become clear to even the most dim that this is a significant systemic issue, not an isolated occurrence.
Consider this: There are many hundreds of millions of electronic book entries trading around in the system, treated as genuine by the participants, for which no offsetting share or parcel of voting rights exists. That wholesale stock creation machine has generated a second float for hundreds of companies, and is so large that it can never be covered without vaporizing the system - there isn't enough cash with all the folks out there that have played the game to cover all the shares. This is the systemic risk.
I don't for a second believe that the bad guys in this will be forced to do what the law requires, which is to settle the trades, and buy the shares in. Rather, I think that REFCO will provide some hints, as does the new law that quietly passed recently wherein the FDIC is empowered (read burdened) with moving "derivative contracts" from failed institutions to healthy ones. Those institutions include securities firms. The term market participants is used. I find this ominous.
One of the questions I've been asked is "what happens to the naked short obligations in a BK for a clearing broker like REFCO, assuming that the hedge fund clients have stuck them with contingent liabilities that they have been carrying on their books?" I don't know, and none of the attorneys I've talked to are sure.
I have a sneaking suspicion I know how it will play, though. I think that our regulators and elected officials will come up with some euphemistically termed workout, the "Fallen Soldiers and Grandmothers and Future Children of America, Anti-Terrorism and Drug Addiction, Good For the Environment, Protect Our Financial Futures" bill, which will come up with some sanctioned way to get the market system out of their bad trade - and the taxpayer will foot the bill. How will that work?
I envision a mandated cash return to shareholders at some premium, say $1.50 on the dollar, where the failed institutions can pay cash to shareholder owed the shares, rather than being forced to buy in the market to cover their debts. It will be lauded as a fair and decent ending to a dark period - who will be able to complain about receiving $1.50 for every dollar of stock they hold? Any ingrates will be branded as greedy opportunists who want to get rich off a national crisis, and thus reprehensible, or traitorous. Forgotten will be the fact that they bought it at $20 and that it now trades for a dime because of the hundreds of millions of fake shares the participants flooded the markets with. The cone of silence will descend on that too, and instead we will be treated to a flurry of feel good articles about the bright future of the newly sanitized markets, suitable for retirement savings, Grandma's mad money, your children's education funds.
I envision this being sanctioned "for the good of the markets, for stability, to put this bad period behind us and let us move forward, having learned our lessons." It will have to be an act of Congress, as it will be fundamentally illegal, and unethical, and will end this particular chapter of the rip off of the investor by the machine, and will require Congressional approval. But it will also be necessary, as the alternative will be the meltdown of the financial markets as desperate hedge funds and prime and clearing brokers struggle to cover a fraction of the open positions that made them hundreds of billions, and which long ago was converted into jets and mansions and ski chalets and pied a terres on Maui or Aruba or St. Baarts.
I don't see that happening.
What I see happening is the aforementioned bill, and healthy institutions taking on the contingent liabilities of the failed ones, and like Perelman in the S&L fiasco, being compensated for taking them over, likely with tax credits and concessions that will be a windfall for the new stewards of the problem - in the S&L crisis, Ron Perelman (Revlon king and a Milken adherent) took on the failed Vernon Savings and First Gibraltar, with a total of $12.2 billion in assets, and a sweetheart $5 billion FSLIC assistance package (to help cover the workouts). For this stewardship, he paid $315 million, and in return he got almost $900 million in tax deductions. Walter Fauntroy, the Washington, DC Representative, in the House Banking Committee hearings on the scandal, commented upon hearing all the pieces of the deal, asked one of my favorite questions of all time: "Why is it only white folks who get that kind of a deal?"
I fully expect that sort of a solution to a problem of Wall Street's own creation, a creature of regulatory complicity and unbridled greed triumphing over our rule of law.
I see the taxpayers ultimately bailing out Wall Street via some sort of the aforementioned mechanism, because Wall Street is too big, and too important, to be allowed to suffer the consequences of doing the time for the crime.
Wall Street is too important to be allowed to fail, even if it means shafting investors who have already been fleeced of their savings, and then shafting them again by creating a tax burden they will be forced to shoulder, so that Wall Street can keep the place in the Hamptons and the Maybach and the Gulfstream.
Most won't even know or understand what has been done to them. That will be the art of it. It will be so complex and so impossibly boring that they will doze off even as every man, woman and child is clipped for a future $3 or $4K, and investors robbed of hundreds of billions get $1 back for every $50 they lost.
That's the worst case that I can see, as the ramifications of allowing a clearing and settling system to print shares at will become clear. The wilder, destabilized markets scenarios are too fanciful. I'm far too cynical and pragmatic to believe that a worst case where the bad guys all go to jail, and the investors win as their stocks go through the roof, will ever happen. We may see covering in the larger issues, if there is liquidity. We will likely see a heating up of delisting companies, to clear maybe 30% of the problem by removing the liability at a stroke of the regulatory pen. But we won't ever see investors winning on this one.
That's now how Wall Street works.
I've spent the last 3 years studying it, and it hasn't ever worked that way.
But look at the bright side. It won't all be bad.
Just imagine how safe everyone will be in this new, improved market!
I really hope I'm wrong on this.