“Thus, it should be understood that when pro-US figures use the term, 'rules-based international order,' they are not referring to anything analogous to the rule of law. Quite the opposite, they are using Orwellian language to describe a system in which essentially no rules can be established and/or observed, given that the dominant state has the prerogative to violate and/or rewrite “rules” at its whim.” Aaron Good, American Exception
"Control frauds in the financial markets are by their very nature conspiratorial in that they involve the suborning of regulators, ratings agencies, exchanges, the media, and legislators to ignore and facilitate misrepresentation that enable white collar crime. They are difficult to prosecute because by their nature they involve twisting the legal into the extra-legal on a broad basis to achieve a particular financial effect, while limiting many specific aspects to the letter of the law, or at least the gray areas.
By and large they operate in the shadows, hiding behind secrecy and a general mindset towards short term greed and lapses in ethics. Investigations following the Crash of 1929 and the S&L crisis demonstrated that the existence of such pervasive lapses in stewardship do exist.
Light is a good disinfectant. Fraud cannot bear exposure. While some confidentiality must be maintained in trading, obsessive secrecy regarding significantly large positions and collateral matters is often an indication that something is not right, that it is hidden from the market participants view for a particular reason that is deleterious to market pricing and efficiency."
Jesse, 27 April 2010
"There is not a crime, there is not a dodge, there is not a trick, there is not a swindle, there is not a vice, that does not live by secrecy."
Joseph Pulitzer
"All frauds, like the wall daubed with untempered mortar, with which men think to buttress up an edifice, always tend to the decay of what they are devised to support."
Richard Whately
"Secrecy is completely inadequate for democracy, but totally appropriate for tyranny."
Malcolm Fraser
Stocks slumped today.
The precious metals rallied.
The Dollar moved up a bit.
VIX had a little bounce.
Wax on, wax off.
Bonuses on Wall Street this year are up on average by 27%.
In general, the oligarchy is increasingly audacious.
They have exerted their will and influence over corrupt enablers and the easily distracted very well.
"Control frauds are seemingly legitimate entities controlled by persons that use them as a fraud weapon. A single control fraud can cause greater losses than all other forms of property crime combined.
Financial control frauds’ primary weapon is accounting. Fraudulent lenders produce exceptional short-term “profits” through a four-part strategy: extreme growth (Ponzi), lending to uncreditworthy borrowers, extreme leverage, and minimal loss reserves.
These exceptional profits defeat regulatory restrictions and turn private market discipline perverse.
The finance sector is most criminogenic because of the absence of effective regulation and the ability to invest in assets that lack readily verifiable values. Unless regulators deal effectively with the initial frauds their record profits will produce imitators.
Mega bubbles produce financial crises."
William K. Black, Recurrent, Intensifying Bubbles and Crises
"Do not be deceived, God is not mocked; for whatever a man sows, that he will reap. For whoever sows to the flesh will from the flesh reap corruption, but whoever sows to the Spirit will from the Spirit reap everlasting life. And let us not grow weary while doing good, for in due time we shall reap if we do not lose heart."
Galatians 6:7-9
When we look back on this period in time with the perspective of
history, we will see markets dominated by control frauds and mispricing
of risk that will seem painfully obvious.
Why do we not see this now? Why did so few see it coming 2007, and in
2000?
Perhaps because the money is too good, and our societal
judgement is too corrupted, often willfully so.
Still, bubbles have a
surprising resiliency, as does evil in a hardened heart.
"What is most offensive is not their lying— one can always forgive lying— lying can be a delightful thing, for it leads to truth. What is offensive is that they lie, and worship their own lying."
Fyodor Dostoevsky, Crime and Punishment
“A true opium of [worldly] people is a belief in nothingness after death— the huge solace of thinking that for our betrayals, greed, cowardice, and murders that we are not going to be judged.”
Czesław Miłosz
Stocks continued selling today. What was particularly discouraging for the bulls is that there was no afternoon rally. In fact, the selling accelerated in the last hours of trading, and the major indices went out on the lows, and on heavier volume.
One might point to the new tariffs to come on China, and fears of a trade war. Earlier this week one would look to the Fed, and talk about the rising interest rates, probably the most carefully telegraphed monetary decision in history.
Perhaps it was the latest antics of Facebook, in the general growth of the abuse of privacy of the public by government and their corporations. One might also look to the dysfunction in Washington, and the misguided policies that have been crippling the middle and lower classes to the advantage of the one percent.
Let's skip the usual bullshit exercise of identifying the reasons for this sell off for the moment shall we?
Certain financial assets, like the major stock indices, led narrowly by the FANG tech stocks and the financials, had been lifted to new heights by what certainly looked like the utter mispricing risks.
And as we have seen in the last two asset bubbles and subsequent financial crises, prices continued rising to even greater over-valuations. They were lifted on a cloud of misrepresentations and the purposeful weakening of transparency and regulation, from the purveyors of stocks and their many purveyors of the big lie designed to support the economic status quo.
As I have cautioned, when this mispricing of risk continued to expand,the 'trigger event' needed to knock the market off its blocks would decrease in required magnitude, until something incidental, or a cluster of rather minor incidents, would be enough to send prices down, and with a vengeance.
So far this latest market decline is what I would call a 'market break' and not a 'crash.' As a reminder, there was a disquieting market break in March 1929 that was quickly forgotten, until the market breaks of September, culminating in a bloody October.
The Father of Lies
It will not take much for some semi-official group to turn the markets around by buying the SP 500 futures at a key moment. There is not much fundamental stock picking in this market; it is all index ETFs and narrowing momentum.
Buying the futures to turn things around could be done by the Fed or some other NGO that is working with their compadres of the revolving door. One group wants to get rich, and the other wants to not be run out of town on a rail.
That has been a 'go to' solution since the mid-1990's. It is very possible that stocks will find a bottom, perhaps in a true selling capitulation, and then turn and run back up to perhaps a new high later this year, led by the usual suspects and their aficionados.
But if there is no financial reform, if there is no return to good governance and honesty in the major mechanisms of the financial system which, after all, is the capital allocation heart of any capitalist economy, there will once again be a crash, a staggering correction in prices, for the third time since the year 2000.
There was a very minor flight to safety today. The US Dollar managed to drift slightly higher within its recent trading range. And in the usual manner of the recent currency trading of the precious metals, gold and silver were off a bit in response.
And let us not forget that there will be an option expiration for gold and silver on Monday.
Government bonds caught a bid, which was a bit odd in this interest-raising environment needed because things are just that good in the real economy right? We certainly don't want any overheating, as in higher wages for working people.
Wall Street will be dropping another IPO into the markets tomorrow in Dropbox, unless they call it off for reason of market conditions. I suspect that they will try to stabilize the markets while Wall Street squeezes this latest creation out.
This is not going to end well. But if we get another rally, all of this gloom will be forgotten, and it will be bread and circuses and the latest scandals of the rich and frivolous all over again.
And when it really hits the wall, when the financial system is thoroughly knackered, we can always blame Trump, or Russia.
"It was a time of terrible suffering. The contradictions were so obvious that it didn’t take a very bright person to realize something was terribly wrong. And people blamed themselves, not the system. They felt they had been at fault. People who were independent, who thought they were masters and mistresses of their lives, were all of a sudden dependent on others. Relatives or relief. People of pride went into shock and sanitoriums. My mother was one.
What I learned during the Depression changed all that. I saw a blinding light like Saul on the road to Damascus. Up to this time, I had been a conformist, a Southern snob. I actually thought the only people who amounted to anything were the very small group which I belonged to.
The Depression affected people in two different ways. The great majority reacted by thinking money is the most important thing in the world. Get yours. And get it for your children. Nothing else matters.
And then there was a small number of people who felt the whole system was lousy. You have to change it. The kids come along and they want to change it, too. But they don’t seem to know what to put in its place. I’m not so sure I know, either. I do think it has to be responsive to people’s needs. And it has to be done by democratic means, if possible."
Virginia Durr, Recollection of 1933
"Having fallen from the eternal, the evil one's desires are endless, insatiable. Having fallen from pure Being, he is driven by the desire to possess, to fill his emptiness. But the problem is insoluble, always. He is compelled to have and to hold, to possess and consume, and nothing else. All he takes, he destroys. Certainly he rules the material, as he is called the Prince of this World in the gospels."
Denis de Rougemont
As you may have seen we had a rather stiff sell off today, on heavier volumes.
Stocks have pretty much given up all of their gains for 2018. I have included a year to date chart of the performance of a few financial assets below. Gold is outpacing most. Silver not so much.
You may have noted that I originally marked my stock charts with 'Blow Off Top In Progress?' and then a week or so ago dropped the question mark. There was no longer any question in my mind.
Stocks were so frothily mispriced to risk that the trigger event did not take much: a better than expected Jobs Report, and not by much, was enough to shock the markets into the realization that the continuous flow of hot money from the Fed almost directly to the Wall St Banks and wiseguys could not continue forever.
Today and Friday were definite flights to safety. Today in particular both gold and the US Dollar were higher. Silver was up by held back a bit by its industrial component.
The VIX, a measure of risk and volatility, rocketed higher. It was greatly aided by a short squeeze. The short interest on the VIX was profoundly malinvested against risk. And today that was corrected.
This was not an ordinary 'Blue Monday' and it went out on the lows. This was more of a 'Bad Monday.'
And contrary to popular thinking that sets up a strong possibility for a proper bull capitulation, and a relief rally from the lows. So we will have to wait and see what unfolds in these times of exceptional greed and deception.
Tomorrow is going to give us a lot of data. We blew out the short term correction metrics, and I have removed it from the charts. We have now pretty much completed a solid retracement of the meltup from the trendline, when stock risks were thrown aside with abandon, along with all the gains for 2018 and then some.
IF we continue to go lower, the beginnings of the 'Trump Rally' will start peeking their noses back up. Notice that I have never taken them off my charts. But I am not counting anything down to there yet. It will take an additional trigger event to bring that sort of price drop into play I imagine.
I hope you did not lose any money the last couple of days. I do wish everyone well. But if you embrace foolishness, and give yourselves over to the advice and leadership of the wicked, a downfall is not to be expected.
So let's see if tomorrow brings a sign that today was a proper capitulation of the bulls, and a cleansing of the excessive mispricing of risks. Or perhaps we will get a marked capitulation tomorrow intraday. We will know it because the relief rally that kicks in from the low will not fail like it did today. Today was a bull trap, to skin the dip-buyers.
And let's keep an eye on that instrument of financial expansion and dominance and the willfulness, the Dollar, la douleur du monde..
One thing of which I am almost certain is that if stocks find a footing tomorrow and rally, all of our cautions and reckonings of the day will be forgotten once again, and it will be back to pride in our exceptionalism and superiority, and the mispricing of risks all over again.
Have a pleasant evening.
P.S. A little while ago I put some different measurements on the SP 500 and NDX charts. I did notice that there is an unfilled 'gap' on the NDX chart and have highlighted that. After hours the futures markets in stocks are taking the gas pipe. If this continues into tomorrow AND stocks don't find a footing that one can call a capitulation then it might get quite interesting.
"Inequality is a euphemism, a kind of shorthand, for all of the things that have gone to make the lives of the rich so much more delicious, year on year, for the last three decades. And also for the things that have made the lives of working people so wretched and so precarious in that same time.
This word inequality. It's visible in the ever rising costs of healthcare and college, in the coronation of Wall Street, and the slow blighting of wherever it is that you happen to live. And you catch a glimpse of inequality every time you hear about someone that had to declare bankruptcy because a child got sick, or you read about the lobbying industry that drives Washington DC, or the new political requirement, the new constitutional requirement that every presidential candidate has to be a billionaire's favorite, or a billionaire themselves.
Inequality is about the way in which speculators, and even criminals, get a helping hand from Uncle Sam, while the Vietnam Vet down the street from you loses his house. Inequality is the reason that some people find such incredible significance in the ceiling height of an entrance foyer, or the hop content of a beer, while other people will never believe in anything again."
Thomas Frank
"People of privilege will always risk their complete destruction rather than surrender any material part of their advantage. Intellectual myopia, often called stupidity, is no doubt a reason. But the privileged also feel that their privileges, however egregious they may seem to others, are a solemn, basic, God-given right. The sensitivity of the poor to injustice is a trivial thing compared with that of the rich."
John Kenneth Galbraith
"Capitalism is at risk of failing today not because we are running out of innovations, or because markets are failing to inspire private actions, but because we’ve lost sight of the operational failings of unfettered gluttony.
We are neglecting a torrent of market failures in infrastructure, finance, and the environment. We are turning our backs on a grotesque worsening of income inequality and willfully continuing to slash social benefits. We are destroying the Earth as if we are indeed the last generation."
Jeffrey Sachs
"Over the last thirty years, the United States has been taken over by an amoral financial oligarchy, and the American dream of opportunity, education, and upward mobility is now largely confined to the top few percent of the population. Federal policy is increasingly dictated by the wealthy, by the financial sector, and by powerful (though sometimes badly mismanaged) industries such as telecommunications, health care, automobiles, and energy. These policies are implemented and praised by these groups’ willing servants, namely the increasingly bought-and-paid-for leadership of America’s political parties, academia, and lobbying industry.
If allowed to continue, this process will turn the United States into a declining, unfair society with an impoverished, angry, uneducated population under the control of a small, ultra-wealthy elite. Such a society would be not only immoral but also eventually unstable, dangerously ripe for religious and political extremism."
Charles Ferguson
“There are two visions of America a half century from now. One is of a society more divided between the haves and the have-nots, a country in which the rich live in gated communities, send their children to expensive schools, and have access to first-rate medical care. Meanwhile, the rest live in a world marked by insecurity, at best mediocre education, and in effect rationed health care―they hope and pray they don't get seriously sick.
At the bottom are millions of young people alienated and without hope. I have seen that picture in many developing countries; economists have given it a name, a dual economy, two societies living side by side, but hardly knowing each other, hardly imagining what life is like for the other.
Whether we will fall to the depths of some countries, where the gates grow higher and the societies split farther and farther apart, I do not know. It is, however, the nightmare towards which we are slowly marching.”
Joseph E. Stiglitz, The Price of Inequality
"Psychopaths have a grandiose self-structure which demands a scornful and detached devaluation of others, in order to ward off their envy toward the good perceived in other people."
Robert D. Hare, Without Conscience
"The worldly treasures you have hoarded will testify against you on the day of judgment. Listen! Hear the miseries of the workers whom you have cheated through fraud from fair payment."
James 5:4
"Two-thirds of the directors at the New York Fed are hand-picked by the same bankers that the Fed is in charge of regulating.
Today, the United States is No. 1 in corporate profits, No. 1 in CEO salaries, No. 1 in childhood poverty, and No. 1 in income and wealth inequality in the industrialized world.
Today, the top one-tenth of 1% owns nearly as much wealth as the bottom 90%. The economic game is rigged, and this level of inequality is unsustainable.
We need an economy that works for all, not just the powerful.
I think what the American people are saying is enough is enough. This country, this great country, belongs to all of us. It cannot continue to be controlled by a handful of billionaires who apparently want it all."
"The commercial world is very frequently put into confusion by the bankruptcy of merchants, that assumed the splendour of wealth only to obtain the privilege of trading with the stock of other men, and of contracting debts which nothing but lucky casualties could enable them to pay; till after having supported their appearance a while by tumultuary magnificence of boundless traffic, they sink at once, and drag down into poverty those whom their equipages had induced to trust them."
Samuel Johnson: The Rambler, January 7, 1752
The regulators are clueless and conflicted, the self-regulators are careless and complicit, the industry is enmeshed in cronyism, and fraud is broadly tolerated as way of doing business, a droit du seigneur of the elite over customer funds and assets, pricing and all other forms of news and information. It has every character of an advanced form of control fraud.
And as for the politicians, one might conclude as the Parliament had done with Mr. Bob Diamond, that they are either incompetent or indirectly complicit as well, in the manner of a credibility trap. It seems hard to explain it any other way.
The culture of privilege and corruption through the mispricing of risk and outright fraud in the Anglo-American financial system is pervasive, stuffed with phony paper. No outrage seems too extreme, too great, and therefore nothing can be said to be safe.
Reuters Exclusive: Iowa futures broker forged bank records for years - source
By Ann Saphir
Jul 10, 2012 7:23pm EDT
CHICAGO (Reuters) - Russell Wasendorf Sr., the sole owner and chairman of stricken futures broker Peregrine Financial Group, Inc., intercepted and forged bank documents for more than two years to cover up hundreds of millions of dollars in missing money, a person close to the situation told Reuters.
The National Futures Association on Monday froze the funds of the Iowa-based brokerage, which does business as PFGBest, after discovering an estimated $220 million shortfall in PFGBest's customer accounts. The NFA had said in an affidavit that Wasendorf "may have falsified bank records."
Wasendorf, 64, is reported to be in a coma after a suicide attempt Monday morning, according to a complaint filed by the Commodity Futures Trading Commission on Tuesday that accuses Wasendorf and Peregrine of fraud.
The source offered new details on how Wasendorf allegedly carried out the deceit, which involved the forging of confidential documents that the NFA uses to verify a broker's cash balance with its depository institution.
Wasendorf intercepted these documents after they were mailed by the NFA, the broker's first-line regulator, to U.S. Bank, where PFGBest had said it had well over $200 million on deposit, the person said. The NFA has said the account actually held just $5 million this week.
Wasendorf had set up a post office box in Cedar Falls, Iowa, according to a second person involved in the matter. It was to that post office box that NFA sent the documents, which were addressed to the bank.
The post office box was neither in Wasendorf's name nor registered to the bank, the second person said. (That is, it was a 'blind PO box, something that would not be acceptable to even eBay. - Jesse)
Wasendorf then forged signatures and fabricated bank balances on the documents and simply mailed them back to the Chicago-based NFA, the person said.
Calls to spokespeople for PFGBest and NFA were not returned. A woman who answered the phone at the home of Wasendorf declined to comment...
"Price discovery is not a sexy function of markets, but it is critical to the efficient allocation of scarce capital and resources, and to the preservation of the long term wealth of investors and the economy as a whole. If price discovery is compromised by manipulation, then we will all be gradually impoverished and the economy will be imbalanced and unstable."
The blogger London Banker writes an extraordinarily insightful piece today that perfectly captures what I have said for some time now, and probably phrased more elegantly and persuasively than I have been able in my own efforts.
Fraud is the mispricing of risk and misreprenting the value of transactions for private benefit. And the fraud we are seeing exposed in the Anglo-American financial system is not incidental, it is not a lapse in safeguards, it is not a rogue operation, not a one-off, but rather it is a 'feature' of the system itself.
The financial system has become, through misplaced ideology and regulatory capture, and most importantly the corrupting influence of easy money on the morally weak and ambivalent, a gigantic con game run for the benefit of a few elite insiders who have been systemically looting the real economy for the past twenty years.
July 14 is Bastille Day. This might be a good time to resolve to do something peaceful but firm to let those around us know that this will not be tolerated any further, that it has gone on long enough, and that people are aware of it and care about it.
Write a letter, forward an article to friends, make comments on sites, stop doing business with bad actors, take your money out of Wall Street and the City of London, make some quiet gesture, and that little action will combine with other actions to form a swell of opinion that cannot be ignored.
If you don't like your choice in politicians, don't take it quietly. Boot them all out if you have to. Let them know that second rate is not good enough. Refuse to be used. Refuse to do business with them. What they cannot take away from you is your refusal.
If you act like a sheep or a cockroach, then they will treat you like a sheep and a cockroach.
The most important thing is to do something, if only for yourself, so that you will not feel powerless and disconnected from your fellows, many of whom feel the same as you do. Then no one can you have done nothing. And if you can, get into the habit of doing something little every chance you get, every day, to assert your humanity as a small act of defiance. Sometimes its the little things that make life worth living.
And above all, stop passing the lies around, and listening to those who put them out there to trick and confuse you. You can spot them by their ugliness and mean-spiritedness. Do not be a part of the problem. Reject the naysayers, the cynics, and those who sap the life and energy from you with their negativity and fatalism. They may be dead to life, but you do not have to join them.
'Thou shalt not be a victim, thou shalt not be a perpetrator, but, above all, thou shalt not be a bystander.'
The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained growth and recovery.
I've been hesitant to write about the LIBOR scandal because what I want to say goes so much further. We now know that Barclays and other major global banks have been manipulating the calculation of LIBOR through the quotation data they provided to the British Bankers Association. What I suspect is that this is not a flaw but a feature of modern financial markets. And if it was happening in LIBOR for between 5 and 15 years, then the business model has been profitably replicated to many other quotation-based reference prices.
Price discovery is not a sexy function of markets, but it is critical to the efficient allocation of scarce capital and resources, and to the preservation of the long term wealth of investors and the economy as a whole.If price discovery is compromised by manipulation, then we will all be gradually impoverished and the economy will be imbalanced and unstable.
Over the past 25 years the forces of regulatory liberalisation and demutualisation of markets have allowed the largest global banks to set the rules, processes and infrastructure of global markets to their own self-interested requirements. Regulatory complexity and harmonisation benefit the biggest banks disproportionately, eroding the competitive stance of smaller, local banks and market participants. This has led to a very high degree of concentration in a very few banks in most markets that determine global reference rates for interest rates, currencies, commodities and investments. If those few collude with each other - as Adam Smith warned was always the result - then they impoverish us all.
We have allowed markets to evolve in ways that make supervision of markets almost impossible. Many instruments trade off-exchange or in multiple venues, making it nearly impossible for any single investor or regulator to supervise trading to prevent or detect manipulation or abuse. Many financial instruments are now synthetic compilations of underlying assets and derivatives, with multiple pricing components determined by reference to other prices or rates. Demutualisation and regualtory reforms stripped exchanges of the self-regulating interest in preventing manipulation and abuse by their members as mergers, profits and market share came to dominate governance objectives.
Off-exchange trading has been allowed to proliferate, creating massive ill-transparent and largely illiquid markets in almost every sector of finance. Pricing in these markets is based around calculated reference rates which, like LIBOR, are open to abusive quotation and data input practices. Many OTC derivatives are priced and margined using reference rates calculated against quotations unrelated to actual reported transactions. Synthetic securities such as ETFs are another example of an instrument that prices off a reference rate rather than the actual contents of an underlying asset portfolio. These instruments are open to consistent abusive pricing as a means of incrementally impoverishing those market participants who are the krill on which the global banks thrive.
How has it been possible for banks to grow from less than 4 per cent of the global economy to more than 12 per cent of the global economy without impoverishing others? How has it been possible for profits in the financial sector to be consistently higher than profits from other human endeavors with more tangible products or impacts on our daily lives - such as agriculture, transport, health care or utilities? How has it been possible that banks derive their profits not from the protected and regulated activities of deposit-taking and lending, but from the unsupervised and often unknowable escalation of off-balance sheet assets and liabilities? How has it been possible that pension savings have increased while pension returns have declined to the point where only bankers can expect a comfortable old age? Global banks have built the casinos and tilted the odds in the house's favour by rigging the data that determines the outcomes of most of the bets on the table. Every one of us that sits at the table long enough - whether saver, investor, borrower, taxpayer or pensioner - will be a loser. It is not a flaw; it is feature...
It is the introduction of synthetic derivatives in place of actual holdings, and the abuse of counterparty exposure with one's own organization thereby concentrating risk, that start to make these financial creatures look even more deadly, and more like control frauds, than one might have previously imagined.
I think that when one of these constructions fails, as one must almost surely do, we will then have either an MF Global moment, wherein one institution goes down and quite a few customers find that they are holding worthless paper instead of assets, or even worse, an enmeshed counterparty risk triggers another Lehman-like freeze in the credit markets and, as the dominos fall, a new financial crisis even worse than the last.
The nastier version would almost certainly occur if the failure and subsequent disclosure of fraud occurs in some commodity ETF. Why?
In that instance it is more difficult and much more noticeable, although not impossible, for the Congress and the Fed to throw loads public money, and subvert justice, to make the problem and full disclosure of fraud to go away.
Stocks and bonds are relatively easy to counterfeit; physical commodities take a little more energy, boldness, and imagination, the challenge of the shell game rather than the relatively mechanical process of inflating the world's reserve currency on behalf of financial friends with benefits.
So before you short stocks in your trading account, with abandon and quite possibly into insolvency, keep in mind that the Fed is perfectly capable of fomenting another bubble to save the status quo, as they did in 2002-2007. To underestimate the corruptibility of the Fed and the government in partnership with the banks and their corporations can be a costly lesson indeed.
So far so vanilla. Now lets look at how, as the ETF market has grown, the clever boys and girls of finance have found ‘innovative’ ways of pumping those ETFs up a bit, just like they did to Securities. Use of Derivatives in ‘Synthetic’ ETFs
The main innovation in ETFs has been the creation of what are called ‘synthetic’ ETFs which instead of actually buying or even borrowing a basket of shares, use derivatives to track the value of the underlying market without the need to match its composition. Instead the Synthetic ETF enters into an asset swap agreement with a counterparty using an over-the-counter (OTC) Derivative. Before explaining what the heck that means let’s just look at how quickly the Synthetic market has grown.
Synthetic ETFs have grown very rapidly in Europe and in Asia. In Europe Synthetic ETFs are now 45% of the over all ETF market. Synthetics doubled their market share between 08 and 09.
The key to Synthetics is the Counterparty.
What happens is the ETF Sponsor designs the deal, the AP (Apporved Participant. Usually one of the big banks or brokers) buys the basket of assets to make it, but then swaps that basket with the Counterparty for a different basket of assets in a derivative swap deal. However it turns out that rather too often for comfort, not only will the Sponsor and the AP be the same bank, but more often than not it will be the Asset Management branch of the same bank who will be the Swap Counter-party as well. It is quite common for the same bank to play all three roles. So a single bank creates the ETF, appoints itself as AP so it can fund it and then its Asset Management desk becomes the derivative counterparty in order to mutate the whole thing into a synthetic ETF. Think about what this does to the risk. What was market risk, where the risk was spread out across all the different shares, is now a single counterparty risk. The bank has effectively put all the ETF’s risk in one basket – itself.
But even if it is a different bank acting as the derivative counterparty the situation is only very slightly less incestuous because it is nearly always the case that the Sponsor, AP and Counter-party will all be from the same small group of big banks, brokers and Asset Managers. And it is also a statistical fact that all of them will be counterparties with each other many, many times over, via the over $1.2 Quadrillion of other repo, rehypothecation and derivative deals. This, as the Financial Stability Board’s report on instabilities in the ETF market rather laconically puts it,
…may also generate new types of risks, linked to the complexity and relative opacity of the newest breed of ETFs. The impact of such innovations on market liquidity and on financial institutions servicing the management of the fund is not yet fully understood by market participants, especially during episodes of acute market stress.
Not fully understood? I think we may not have understood what such entanglements of reciprocal risk meant before the first period of ‘acute market stress’, but I think now it is nutty to imagine the banks don’t know how risky such risk incest really is. The FSB report itself concludes,
Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults. Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.(P.4)
Please step forward Deutsche Bank and Soc Gen!
A “powerful source of contagion and systemic risk”. Sounds really good for you and me. So why are the banks doing it anyway? The official answer is that using Derivatives means the ETF can track the value of the market more closely. Though few have complained that Vanilla ETFs don’t track closely enough. And as the BIS report points out,
…the lower tracking error risk comes at the cost of increased counterparty risk to the swap provider. (P.8)
But this doesn’t answer why a bank would enter into a swap with itself as the counterparty. The whole idea of counterparties, once upon a time, was to hedge some of the risk in the original deal by passing it off to someone else. Using yourself as counterparty keeps the risk in-house. So once again why?
The answer is, according to the BIS report on ETFs,
…that this structure exploits synergies between banks’ collateral management practices and the funding of their warehoused securities. (P.5)
‘Synergies’ sounds like it should be good. Sadly it may not be. As the BIS goes on to explain,
…synergies arise from the market-making activities of investment banking, which usually require maintaining a large inventory of stocks and bonds …. When these stocks and bonds are less liquid, they will have to be funded either in the unsecured markets or in repo markets with deep haircuts. (P.8)
In essence it costs the banks money to have illiquid assets on their books. The repo markets won’t accept them as collateral unless they come with a deep haircut. So the banks can do little with them except sit on them. Basically it costs the bank to have the illiquid, hard to sell or Repo, stocks on its books. But.. .if they happen to have created a handy synthetic ETF, then everything changes because,
For example, there could be incentives to post illiquid securities as collateral assets [in the ETF Swap]…. By posting them as collateral assets to the ETF sponsor in a swap transaction, the investment bank division can effectively fund these assets at zero cost….
Handy isn’t it? Assets they can’t repo without hefty haircuts can be posted as collateral to their own ETF with the approval of the ETF Sponsor of course – who will just happen to be… the same bank – without those pesky, hurtful haircuts. In fact,
The cost savings accruing to the investment banking activities can be directly linked to the quality of the collateral assets transferred to the ETF sponsor.
The worse they are, the more illiquid, the more the bank saves/makes by choosing to put them in an ETF rather than having them loiter on its books.
…the synthetic ETF creation process may be driven by the possibility for the bank to raise funding against an illiquid portfolio that cannot otherwise be financed in the repo market. (FSB report P.4)
This is surely financial innovation at its shining best.
Now of course the banks will say they would never consider slipping some old tat into their ETF under cover of opacity. Except that they did, every one of them, do exactly that when they systematically and grossly lied about every single aspect of hundreds of billions worth of shabby mortgages which they intentionally stuffed into CDOs in order to shaft and rob those they sold them to. This is a matter of public record...."
William K. Black is one of the US' leading experts on financial fraud in general, and on banking fraud in particular.
This is why you will rarely see him interviewed or even quoted in the mainstream media. And why he gains so little traction with the Congress and this Administration. He is an informed and honest voice, at a time when the status quo just does not want to hear it. They are caught in a credibility trap in which they can admit nothing, investigate nothing, without risking themselves and their 'good thing.'
He has done an impressive but somewhat lengthy interview with Russ Roberts of EconTalk. It is very informative, but would have benefited tremendously from some judicious editing.
I have to caution you in advance that it is somewhat lengthy, so it is best listened to when you have an extended quiet moment. Russ Roberts is a bright fellow, but in the first half he tends to interject himself quite a bit into the narrative, sometimes it seems not really listening well to what Wm. Black is saying. Perhaps he was having an ideaphoric day as do we all. I found it to be a little annoying at times. But he seems to calm down after a while.
But the interview is really a gem, because it explodes so many economic myths and urban legends about the financial crisis. Efficient markets hypothesis and the virtues of self-regulation are a joke. I think most of us who are not wedded to some ideological belief already know that, but Mr. Black puts a stake in that theory's vampiric heart.
Professional economists tend to make lousy public policy, because they have learned to think in theoretical models that only touch reality at statistical intervals. And those models often suppress and crush the significance out of crucial variables of problems that resist adequate measurement for the sake of mathematical expediency, whether it is the propensity of market participants to cheat and do foolish things, or in gravely underestimating fully priced risk and its dynamic consequences.
So we too often see economists in the media saying foolish things with a straight face, sometimes alas for pay in the manner of what they unfortunately are, but sometimes because, although they may be highly regarded and even esteemed, when it comes to the rough world of hard ball business and greed, they really are, as the kids are often wont to say, 'pwned noobs.'
Economics is a profession currently gasping in autoerotic asphyxiation, choking on intricately useless models and obfuscating jargon. I do not wish to dwell on their problems and challenges facing the hard-working and honest economists in reforming their profession because it plays a more supportive than primary role in the problems facing the world today. The economists, politicians, spokesmodels, and strategic analysts are merely the hired help, the servants, collaborators; the root of the problem is with the money masters themselves. If you wish to know who they are, then follow the money, if you can.
I think it is important to hear the clear voice of experience and reason in this matter, whether you like it or not, whether it suits your self-interest or political biases or not.
Why is this important? Because there is another financial crisis coming, and the monied interests and their banks will be serving up the same set of propaganda and demands, writ larger. So it now be a good time to unplug yourself from whatever media bubble machine you follow, so you may have at a least a slim chance of coming out of this intact.
"So, it's, I think, really naive to believe that any lender made loans because they thought it made politicians happy. Lenders made loans because it made individual lenders--I don't mean companies, I mean people--much, much wealthier. And they created those incentive structures not because they could care less about people...
...we think this actually is a story, driven overwhelmingly by what we call accounting control fraud; and we think no one much doubts that about the Enron era. And we think there is pretty good consensus on the Savings and Loan crisis as well, because of all the factual record. We had to go up against the best criminal defense lawyers in the world, and we got a 90% conviction rate.
Plus, we satisfied the economists that looked. I quoted from the National Commission, which was run by economists, that concluded that at the typical large failure, fraud was invariably present.
But if you go and read the economic literature on this crisis, you will find that Akerlof and Romer are cited for example in maybe, generously, 1 out of 100 articles that purport to discuss the causes of the crisis.
And you will see that fraud is virtually never discussed as even a potential major contributor. And that is poor; and that is really the tribal taboo that still exists in economics against any serious consideration of the word fraud."
Wm. K. Black
Daniel 5:25 מנא ,מנא, תקל, ופרסין Mene, Mene, Tekel u'Pharsin
"...A baited banker thus desponds,
From his own hand foresees his fall,
They have his soul, who have his bonds;
'Tis like the writing on the wall.
How will the caitiff wretch be scared,
When first he finds himself awake
At the last trumpet, unprepared,
And all his grand account to make!
For in that universal call,
Few bankers will to heaven be mounters;
They'll cry, 'Ye shops, upon us fall!
Conceal and cover us, ye counters!'
When other hands the scales shall hold,
And they, in men's and angels' sight
Produced with all their bills and gold,
'Weigh'd in the balance and found light!'"
Let us pray for those whose hearts are hardened against His grace and loving kindness by greed, fear, and pride, and the seductive illusion and crushing isolation of evil.
We pray that we all may experience the three great gifts of our Lord's suffering and triumph: repentance, forgiveness, and thankfulness. And in so doing, may we obtain abundant life, and with it the peace that surpasses all understanding.
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