Money Isnít Safe in Any U.S. Financial Institution
Nestmann Group, Ltd.
by Mark Nestmann: Understand
the Rules Before You Transport Precious Metals Overseas
In August 2011,
encouraged by friends who I thought knew much more about these sorts
of things than I do, I opened a small account to trade options and
futures. The account was with MF Global.
know the rest of the story. Just two months later, on October 31 Halloween I
learned that MF Global had a shortfall in segregated funds of approximately
$900 million. Trick or treat, anyone? MF Global promptly filed for
bankruptcy protection. Later, the companys bankruptcy trustee
reported that the company had plundered $1.6 billion of customer
At the time
MF Global declared bankruptcy, the total value of my account came
to $19,452.22. Of that amount, $1,900 of that was in a highly leveraged
futures position (a bet against the euro). The balance of the account,
$17,552.22, was (I thought) in a segregated and firewalled account
to which no creditor of MF Global had access.
Boy, was I
wrong. I could close out my position what I thought was the high-risk
euro trade and pocket the cash immediately. But the supposedly segregated
balance of my account had disappeared. I later learned that it had
magically reappeared in MF Globals operating account.
the bankruptcy trustee succeeded in retrieving some of these funds.
On Dec. 15, 2011, it transferred 60% of the missing funds in
my case, $11,972.60 to my account at the futures firm that
took over my MF Global account. Then, just a few weeks ago, I received
a check for an additional $1,594.18. That brings the loss from my
segregated account with supposedly impenetrable legal protection
down to $3,985.44, or about 23% of the original loss.
What went wrong?
cause of the bankruptcy, it turned out, was that MF Globals
president, former New Jersey Senator and Goldman-Sachs chairman
Jon Corzine, had made a leveraged bet with MF Globals assets,
including segregated client funds, on euro zone sovereign debt.
When Corzines bet headed the wrong way in the closing days
of last October, it forced the company into bankruptcy.
Yes, it could.
The rules that allowed MF Global to convert $1.6 billion of segregated
customer funds into an ultra-leveraged investment that ultimately
bankrupted the company remain in place.
it could recur is due to a practice called re-hypothecation.
Hypothecation means to pledge something as collateral.
If you borrow money to trade securities on margin or if you
own highly leveraged investments such as futures contracts your
broker will ask you to sign a hypothecation agreement.
The agreement stipulates that your broker can borrow shares or other
securities in your account to other customers or to the broker,
up to the amount you have on margin.
occurs when a broker uses customer-pledged collateral to back the
brokers own trades and borrowings. Federal Reserve and SEC
rules permit a prime broker (such as MF Global) to re-hypothecate
an amount up to 140% of the customers liability to the broker.
For example, if you purchase $100,000 of securities in your U.S.
brokerage account, $50,000 of which is borrowed from the broker
on margin, the broker may re-hypothecate up to 140% of the underlying
collateral, or $70,000.
MF Global under
Jon Corzine ratcheted up the leverage to a much higher level by
playing regulatory arbitrage between the United States, the United
Kingdom, and other countries. For instance, under U.K. rules, theres
no limit to the amount of collateral that brokers can re-hypothecate.
U.K. brokers can, and apparently do, re-hypothecate 100% of the
securities in a customers margin account. To take advantage
of this arbitrage, MF Global apparently booked some of the trades
from U.S. customers in the United Kingdom. Much of its activity
took place off MF Globals balance sheet, resulting in a phenomenon
some call hyper-hypothecation.
All of this
is perfectly legal. My MF Global contact states:
To Loan Or Pledge You hereby grant us the right, in accordance with
Applicable Law, to borrow, pledge, re-pledge, transfer, hypothecate,
re-hypothecate, loan, or invest any of the Collateral, including,
without limitation, utilizing the Collateral to purchase or sell
securities pursuant to repurchase agreements [repos] or reverse
repurchase agreements with any party, in each case without notice
to you, and we shall have no obligation to retain a like amount
of similar Collateral in our possession and control.
of rules relate to funds in segregated futures and securities accounts.
The rules require firms like MF Global to set aside the amount it
would owe its customers if the accounts were liquidated. However,
theres an enormous loophole in the rules: they only apply
to domestic transactions. They dont apply to accounts traded
on foreign exchanges, or (as in my account at MF Global) that could
potentially be traded on foreign exchanges. Incredibly, under these
rules only options and futures positions themselves need to be segregated.
This is why the funds I had invested in my own risky bet on the
euro remained intact.
The rules dont
cover cash and securities. If thats all you hold in a U.S.
account that also trade on foreign exchanges, no segregation requirements
exist at all.
It gets worse.
In August 2012,
a federal appeals court upheld a ruling that gives the creditors
of failed futures brokerage Sentinel Management Group precedence
to the companys assets over its former customers. The court
confirmed a lower court ruling that Bank of New York Mellon had
first claim on these assets because it had a secured position on
a $312 million loan to Sentinel. The secured position, it turned
out, was the money customers had in Sentinels supposed segregated
accounts. The ruling makes it clear that U.S. financial institutions
can use segregated customer funds to pay off other creditors. It
certainly doesnt bode well for the remaining $3,985.44 I have
yet to receive back from the MF Global bankruptcy trustee.
In the meantime,
Jon Corzine, who led MF Global into bankruptcy hasnt been
charged with any crime. I doubt he will, because from what I can
see, what he did was 100% legal. Indeed, Mr. Corzine is now in the
process of forming a new hedge fund, although I hope you can understand
that I have no plans to invest in it.
terrified of the implications of hyper-hypothecation, combined with
the lax rules for segregated accounts. Not to mention that U.S.
courts have placed their stamp of approval on the practice of U.S.
financial institutions inter-mingling supposedly segregated client
funds with their own to make risky bets with borrowed money. It
means that your money isnt safe in any U.S. financial institution.
Nor am I confident that the situation offshore is any better, especially
in a country like the United Kingdom, which permits re-hypothecation
of 100% of collateral value placed in broker custody.
Both in the
United States and abroad, Im maintaining as small a position
as possible in segregated accounts, and maximizing actual market
positions in securities, futures, and options. These positions are
subject only to market risk not to financial chicanery. Ive
also closed all margin accounts. I keep the money I need for day-to-day
operation of my businesses and to pay personal expenses in the safest
banks possible. I use Veribanc to obtain quarterly statements of
these banks financial condition.
And no, Im
not counting on the Federal Deposit Insurance Commission (FDIC)
to bail me out if one of the banks I deal with goes under. The FDICs
Deposit Insurance Fund has a balance a little under $12 billion.
Thats a lot of money, but not when you consider that it must
cover about $10 trillion in customer deposits. That amounts to about
1.2% of funds on deposit.
Again, it gets
25 banks in the United States have total deposits of $8.3 trillion.
Not only does that sum exceed the amount of money on hand for the
FDIC by many times, it also doesnt include the enormous portfolios
of derivatives these banks hold. And U.S. courts have now ruled
that creditors of U.S. financial institutions, which surely include
counterparties holding the opposite side of these derivative contracts,
have the right to collect ahead of any obligation of financial institution
to its customers. The gross notional value of those
derivatives for these 25 banks comes to an almost unbelievable $249
reality, I think you can understand why Im trying to minimize
the money that I keep in segregated accounts or otherwise on someones
balance sheet. Instead, Im investing it in physical gold and
Nestmann [send him mail]
is a journalist with more than 20 years of investigative experience
and is a charter member of The
Sovereign Societyís Council of Experts. He has authored over
a dozen books and many additional reports on wealth preservation,
privacy and offshore investing. Mark serves as president of his
own international consulting firm, The
Nestmann Group, Ltd. The Nestmann Group provides international
wealth preservation services for high-net worth individuals. Mark
is an Associate Member of the American Bar Association (member of
subcommittee on Foreign Activities of U.S. Taxpayers, Committee
on Taxation) and member of the Society of Professional Journalists.
In 2005, he was awarded a Masters of Laws (LL.M) degree in international
tax law at the Vienna (Austria) University of Economics and Business
© 2012 Mark
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