MF Global: Another Government-Funded Debacle

I just read about an article about UK hedge fund baby MF Global going bankrupt.  The filings were made back in October, and Congress has decided to investigate the whole thing, in light of the fact that $1.2 billion in client money has gone missing.  What a paltry sum, eh?  No worry.  Just add it to the pile of missing money in America.

If anyone thinks that issues like MF Global going tits-up are unrelated to the central banks and practices that closely mirror fractional reserve banking, they’re kidding themselves.  Unfortunately, central banks like the Fed and the ECB just feed the monsters.  Fractional reserve banking is nothing but a swindle, and this type of investment practice is the same thing: embezzlement.

Let’s start with fractional reserve banking made easy.  This will give you a fair idea of how the system works.  Let’s say I go to Bank A and deposit $100 in cash.  According to fractional reserve guidelines, the bank is required to keep 10% of my deposit on-hand at any given time.  They also make that promise to pay me back all of my deposit, should I ever wish to withdraw it.

We then move on to Mr. Jones, who either borrows $90 that Bank A lends him, or he receives it from another borrowing individual or entity, who pays him the money.  Mr. Jones then goes to Bank B, where he deposits that $90.  Bank B again loans out $81 to Mr. Smith, and the same story keeps repeating on down the line.  $90+$81+72.90+$65.61 = $309.51.  Thus, we can see that four transactions down the line, approximately $300 has been loaned out based upon the original $100 investment.  This is no problem, provided that there are many customers and none of them recall their deposits at the same time (a bank run).  It bears noting that, once the bank loans out a certain amount of money, they are no longer capable of paying back all of their depositors.

Why is this problematic?  Simple.  Banks are creating counterfeit claims to real wealth, which remains unchanged.  Yes, one can make the argument the banks, and therefore customers, are benefitting from interest paid on the loans, but this is a foolhardy notion.  Inflation will eat away whatever is gained through interest payments.  The creation of fake receipts doesn’t create more true wealth.  And if you hold claim to 10% of the real wealth before the loan goes out, you’ll claim even less later, after inflation is through with it.  You can make the argument that the banks are making life more convenient, but it always comes at a price – a cleverly disguised one, at that.

Why is this important to our discussion on MF Global?  Well, they were sort of doing the same thing.  They were putting up assets as collateral against bonds they were buying up – mostly European bonds, funnily enough.  According to Doug French of the Mises Institute, MF Global was using a neat little trick called a “repo,” which is basically putting up collateral that has the same maturity date as the loan. (The assets can be repurchased.)  Therefore, the transaction can be considered a “sale” and moved off of the balance sheet.  Ah, those off-balance-sheet transactions.  God love ’em.  The Fed sure does!

In any case, the customers were essentially taking the risk on the investments while MF Global sat back and collected the money.  French’s article states that the company moved something like $16.5 billion in assets off the balance sheet and went on to expose itself to debt that was worth more than five times the total value of the company.

The company also practices something called rehypothecation – pledging collateral for a loan, similar to a mortgage.  The company uses assets to secure its trading and borrowing.  In the US, companies can rehypothecate to the tune of 140% of the client’s liability to the broker.  This creates liquid capital, but there is nothing behind it, should the house of cards fall in on itself.  And the collateral ends up being promised to multiple creditors.  So what happens when four or five different creditors are fighting over the same piece of pie?

I highly recommend reading Doug French’s article for a clearer understanding of what’s really going.  I hope that MF Global isn’t the new Lehman Brothers, but with some economists predicting that rehypothecation is the newest and most dangerous credit bubble, it seems like that could be the case.  I suggest you look at the numbers in the article, because MF is the new Lehman Brothers, we are going to be in for a world of hurt – more so than we already are, financially speaking.

I think I’ll end this article with a nice little quote from Atlas Shrugged: “Look around you: what you have done to society, you have done it first within your soul; one is the image of the other.  This dismal wreckage, which is now your world, is the physical form of the treason you have committed to your values, to your friends, to your defenders, to your future, to your country, to yourself.”

Check out Doug French’s article “MF Global’s Fractional Reserves” at The Mises Institute online.

 

 

Predictable: European Leaders Calling for Further Integration

I am generally unsurprised by the European meltdown.  I mean, the way that their banking system is set up doesn’t exactly induce member states to live by their means.  In the wake of this meltdown, European leaders are calling for closer integration which, in my mind, is just about the last thing these folks need.  I’ve found two articles today where in Angela Merkel, the chancellor of Germany, and Jose Barroso, EU Commission President, claimed that Europe needs to be more closely bound in order for the Euro to survive.  I have no idea what logic they’ve used to arrive at this faulty conclusion, but they’re wrong.

We need to look at why Europe is in this trouble in the first place.  The European Central Bank operates in much the same way that the Fed does, except that it is a “produce money and lend” (PML) approach, while the Federal Reserve used the “produce money and purchase” (PMP) approach.  Although the process is similar, says Philipp Bagus via the Mises Institute, the results are the same: the money supply is expanded, which allows governments to keep living beyond their means.

I will admit that the article, while excellent, can be a bit, well, scholarly (i.e. boring for most people and hard to read in parts).  Nonetheless, it has diagrams that go along with it to show the reader exactly how the money supply is being inflated.  Let’s start with the Fed.  In a nutshell, the government issues bonds or, as they are commonly referred to, T-Bills.  The government must pay interest on these T-bills.  The Fed buys them in an open-market scenario which, according to Bagus, “monetizes the debt in a way that does not hurt politicians.”  Basically, politicians make a promise to pay at a later date for money they spend today.  The government pays interest to the bond’s new owner, the Fed.  At the end of the year, the Fed pays a bulk of its interest profit back to the government.  When the bonds mature and the principal must be paid in full, the government simply issues new bonds to pay the principal on the old ones and continues the cycle of monetizing the debt.

At the same time as the Fed is buying government bonds, it will also allow credit extensions to private banks, which operate on the fractional reserve system.  Fractional reserve banks loan out money at a rate of about 6:1, meaning that, at any point, they are unable to pay back all of their depositors’ cash.  Essentially, the Fed uses the interest money to expand the supply of credit to the banks.

In the case of the ECB, it receives the government bonds from banks, rather than directly from the government itself.  The banks use those government bonds as collateral against ECB money, which it then loans out at interest.  At this point, you can see how fractional reserve banks are inherently bankrupt, for they are always increasing the money supply at a greater rate than they would be able to pay back, were those loans ever recalled and the money supply contracted.

In any case, since the bonds are merely collateral held by the ECB, the bonds still belong to the private banks, and the governments pay interest to the banks, rather than to the ECB directly.  The banks then pay interest on their loans from the ECB, and the ECB provides a portion of its profits to the governments.  In one sense, the Fed is actually more up-front about its dealings, because we can see the bonds on its balance sheets, whereas the ECB doesn’t directly declare this, since the bonds are still property of the banks.  The effect is essentially the same, with the major difference that the profits are often distributed unequally between participating governments, and this is where we run into problems with the likes of Greece, Italy, Spain, Ireland, and anyone else who needs a bailout this week.

Basically, what has happened is that banks have been buying up Greek bonds when they should have been rejecting them outright.  The whole fiat/fractional reserve system avoids meltdown by being held in check by the behavior of other banks.  In truth, there is very little to prop up the system, once it begins to spiral out of control, which is exactly what we’re seeing now.

The problem with Europe is what is commonly referred to in economics as a “tragedy of the commons.”  Because of the misdeeds and irresponsibility of a few, everyone is going to suffer.  In this case, Greek bonds were being purchased for rates similar to German bonds, but the Greek government was spending at a furious rate.  Now that banks aren’t buying Greek bonds, the interest rates have gone up, and the Greeks have been left out in the cold, unable to monetize the debt.  That’s why the news media keeps bleating on about Greece raising taxes on everything – heretofore, they were able to avoid raising taxes by monetizing the debt via the ECB.  Now everyone is going to end up paying for the misdeeds of individual as well as the EU government.

I hardly see how closer integration is going to solve anything, as the EU government has been a vehicle in creating this catastrophe.  It seems more likely that countries like Germany and France will force out the economically impoverished ones such as Greece, although none of Europe is in a glowing situation right now.  The only reason I can figure for Merkel and others calling for closer integration is so that there will be more regulation on the banking sector.  Still, I don’t know how that’s going to solve the essential problem that is inherent to all banking systems such as these.  It seems a far better idea to let go of this half-baked idea about the Euro and go back to currencies that are printed by the governments themselves.  It might not be such a bad idea back home, either!

Note: I owe Philipp Bagus a debt, as I used some of his ideas and source material to help me write this article.  While I have some different ideas about intellectual property, I wouldn’t want to begrudge a true scholar the recognition he deserves.  Please head over to the Mises Institute and check out his articles.  He makes the mess in Europe seem crystal clear.

“The Bailout of Greece and the End of the Euro”
“The Fed and the ECB: Two Paths, One Goal”
“The Commons and the Tragedy of Banking”