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On Trust

Friday, 27 July 2012 15:25 Written by 

The unseen glue which holds the credit system and the Western World together is trust. We take it for granted and do not consider how it affects every aspect of our lives. What has traditionally separated the West (particularly the English-speaking World) from the Third World is the strength of contract law and the general faith that there will be enforcement of penalties meted out through judicial process to those who break their bond. This trust has been eroding more recently at a rate which is becoming more apparent even to the non-observer.

 

Consider the melt down of MF Global in late October 2011. Though not the largest hedge fund to collapse in recent years ($1.6 Billion as of April 2012), a line was crossed that differs from previous examples. In this case, management had been dipping into client funds that were hypothecated (legally separated) from other fund activities basically to pay off bad bets made on European Sovereign debt. This illicit transfer of protected client funds (at least $700M in transfers and $175M in loans) is a clear legal violation and to this day, the vast majority of these funds haven’t been repaid. The fund’s CEO, former NJ Governor Jon Corzine (and smartest guy in the room according to Joe Biden) is yet to be indicted (only subpoenaed on December 8, 2011 before a House committee) though congressional investigators produced memos quoting internal MF emails stating that Corzine gave “direct instructions” to use customer money to cover the company’s own shortfalls prior to bankruptcy. Question: How can an investor have faith that his assets are being protected even when they are supposedly kept in safe financial instruments such as money market funds? Question: How can an investor have confidence that this will not happen in the future when the judicial process fails to indict those who are guilty (albeit politically powerful) thereby serving as an object lesson for others who would do the same?

More recently, on July 10, 2012, the Commodity Futures Trading Commission (CFTC) filed a complaint against Peregrine Financial Group (PFG) and its founder and chairman, Russell Wasendorf Sr., for the misappropriation of over $200 million in customer funds for more than two years. The bank account which PFG had reported as holding $225M in 1,845 customer accounts actually contained only $5M. Several of these clients actually sustained losses in accounts at MF Global months before. To be fair, regulatory agencies did their jobs here and an indictment of Wasendorf seems likely. This case more closely seems to resemble the $65B ponzi scheme of Bernie Madoff who at least was sentenced to 150 years imprisonment and forfeiture of $17.179B. Where this differs, however, is with the complete failure of oversight by the SEC over a period of almost 2 decades, despite multiple warnings by financial analysts going back to 1999. Question: Despite the CFTCs complaint against PFG, has the regulatory or enforcement Agencies improved their performance or increased investor confidence since Madoff? Other recent examples abound but the point of this essay is not simply to enumerate financial scandals.

Trust continues to break down in many other aspects of the financial World which will have very real consequences on our daily lives. The Federal Government under the current administration cast aside well-established bankruptcy laws during the Chrysler intervention in 2009 by ignoring the priority that should be granted to secured bondholders and gifted 55 per cent interest ($4.5B) to the United Auto Workers (UAW) Group who had no interest in the ailing auto-manufacturer. These bond holders had trusted that their status over unsecured creditors would protect them from the worst aspects of bankruptcy. Instead, preference was given to the UAW, which had been largely responsible for the bankruptcy of the corporation in the first place. A few remnants of the corporation were given back to the secured bondholders only after the Government kept a sizeable slice for itself and gave a free 20 per cent interest to Fiat. Question: How does an investor calculate the risk of loss when buying bonds if an overpowering third party (Federal Government) can arbitrarily cast aside contract law for expediency or political gain?

To avoid bankruptcy, banks and financial institutions have been granted permission of not having to value assets (debt, equity, Treasuries, derivatives and securitized loans) based on their fair current value or mark-to-market. Instead, these institutions can state the value of such assets based on historical cost accounting, which is based on past transactions. While this may be more stable, it does not reflect current market pricing. Losses are only recorded once asset sales are realized. This is standard current practice. Question: How can investors have faith in the earnings numbers of publicly traded companies when their balance sheets are suspect?

As I mentioned in my last column, Sins of Proportion, Government has now assumed the role of shielding its citizens from reality, thereby hiding its own role in the financial crises through excess spending, unsustainable social programs, and centralized banking (i.e. The Federal Reserve). Through verbal complexity, The Federal Reserve Chairman Ben Bernanke prevaricates every time he speaks before Congress. Question : Based on his and Alan Greenspan’s track record, how can an investor have any confidence they are either (a) competent, or (b) honest about predicting the future of financial markets?

Taken together, these are all symptoms of the overall violations of trust occurring with increasing regularity throughout the financial system. Where does this all lead? There are potential similarities with the economies of the Third World. In his analysis of Western Capitalism, “The Mystery of Capital”, the incisive Hernando de Soto noted that there was significant wealth locked up and immobile in Third World Cities such a Cairo and Lima due to excessive bureaucracy, poor contract law, and a basic lack of trust that businesses and governments would honor contracts. As a result, would be investors or people willing to start a business simply keep their capital locked up in properties they could not or would not sell and avoid all risk taking.

Confidence can vanish in a flash once collective realization emerges that nothing in the paper world of finance or investing is believable. Until now, much of the rot in the system has remained hidden from view, but the recurrence of financial lies and misdeeds are slowly eating away at the core of trust that is the backbone of Western Economies.After all, it is becoming increasingly apparent that if one cannot see it, touch it, and have it in his possession, it may not be real or safe (i.e. stocks, bonds, ETFs, money market accounts).

Question: How to restore faith in the System? I do not believe this will be possible until a sufficient number of public hangings (figurative) occur and a new monetary system based on something of tangible value (probably gold) replaces the current fiat order.Better (not necessarily more) regulation such as a reinstatement of Glass-Steagall and a resulting breakup of large financial institutions would also be a must. Only changes as wide-sweeping and profound as these let us know that the World Economy could potentially be on the mend. Additional bailouts and emergency funding only signify that everything is still business as usual. Trust will continue to erode until it breaks. As long as the current system remains in place, my actionable advice is to view tangibles as the only trustworthy financial assets (i.e. gold, silver, land, oil) one can invest in. All else is wild speculation and risk that cannot be accurately quantified.

Full Disclosure: I am not a financial advisor and I would strongly encourage everyone to perform their own research on these important personal decisions.

 

Last modified on Sunday, 19 August 2012 14:02
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