Tuesday, October 14, 2008

The 1934 Securities Exchange Act and all that

When you sign up to a margin account in almost all cases you pledge your securities to the broker with the ability for them to repledge. 

The reason to broker-dealer must be able to repledge is that it needs to finance the loans to you – and to reduce the cost of that financing it needs to offer collateral. 

So, when I take my million dollars worth of securities to the broker and borrow 100K on my margin account it looks like I have pledged a million dollars to a broker who might be questionable in order to get 100 thousand worth of financing.

There is one word for this.  Dumb.  They can – on face of it – take your assets and pledge them to finance their risky business.

If you do not believe it is dumb have a look at my post on Opes Prime, a small broker-dealer that went down in Australia taking something near a billion in client assets with it.  It involved organised crime, guys that killed hitmen and all sorts of other colourful characters.  There ain’t no way I would want to lend my securities to these guys and wind up an unsecured creditor.

The US had huge problems with broker-dealers in the 1930s.  They folded and lots of people lost their entire fortune by not understanding their credit arrangements. 

Enter the US Securities Exchange Act of 1934.  This is one piece of depression era legislation that survives and thank the Good Lord for that.

What the broker dealer act does is (a) ring fence the US broker dealer and (b) limit the amount that the broker dealer can borrow against your securities and the amount of collateral it may take. 

I am hardly a lawyer – so take the bush lawyer caveat – but the way it works is that the broker dealer may not borrow against your securities to finance their own business, only client business.  So Lehman Brothers US broker dealer could take collateral of securities and if they had 100 million out on client margin loans the most that they could raise using client securities is 100 million and not a brass razoo more.   This is really important because it meant that client assets were not used to finance Lehman’s disastrous commercial real estate and other businesses. 

Moreover when you deposit a million dollars at the broker dealer and give them the right to repledge those securities they can only rehypothecate 140 percent of your outstanding balances.

If you have 1 million deposited and you have 100 thousand borrowed then only 140 thousand can be rehypothecated and the rest must sit in a segregated client account.  [If your broker wants to steal from the segregated client account there are precious few defences – but…]  You can not contract out of this requirement. 

So (provided the broker is not acting criminally) you should get the bulk of your money back if the broker dealer fails.  And provided the capital requirements are adequate (and they mostly are) the broker dealer won’t fail.  Even the Drexel Burnham Broker Dealer did not fail.

Goldman Sachs claims that they can determine the capital requirements of their broker dealer intra-day.  I have no proof of this claim – but in this age of computers that is plausible.

The result.  Whilst Lehman brothers went bust Lehman US broker dealer did not.  This pretty well saved the US hedge fund industry. 

Europe however was a different story.  Lehman Europe failed – and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman.  Many funds have folded.  Far more have been nicked.  Whilst the US hedge fund business is currently looking dazed, confused and a little problematic the UK business is on life support. 

In some sense this is the end of the City of London.

I am on record as saying the UK took Maggie Thatcher to heart and deregulated financial activity to such an extent that the whole UK market worked without capital.  That was of course inordinately attractive in a boom where having capital was just a cost.  That attractiveness was one of the reasons why the London market grew and grew – and why UK banks wound up being amongst the biggest in the world.

But now with the biggest bank in the world by balance sheet (Royal Bank of Scotland) effectively nationalised and the and a large part of the UK hedge fund community lying with open veins it looks a little stupid.

This puts in a different light the 8 billion dollars that Lehman London transferred to the US when it was failing.  I stand open to correction – but I would guess that the money was obtained from client accounts from the European/London broker dealer.  It is certainly being investigated by Lehman clients.   This is a scandal of the first order allowed by an insane lassis faire approach to financial regulation. 

So here is a plea for US Depression style financial regulation.  Some of it (such as the Broker Dealer regulation) was well thought out and should be duplicated.   (Some of it was less sensible…)  

If I have a plea to my home country (Australia) after the Opes Prime debacle – a copy of the US 1934 Act would be a good start. 

As for London – I am sorry, but it is a wreck.  Maggie Thatcher you stand condemned.

 

John Hempton

16 comments:

Blank Xavier said...

I have to say, I see this in a different light - the broker clients were not compelled to act as they did, they chose to do so and it is *their* responsibility to get it right. The State is not a nanny. It's up to *us* to live our lives. The contract was voluntary and well-understood - or rather, there was no reason why it *shouldn't* have been well-understood. It may have not been understood, in which case the clients were idiots and should learn from this, or it may have been understood but the risk dismissed, which is their mistake.

People can do what they like, completely, as long as both parties understand what they're doing and it's voluntary.

Of course, what Lehmen did was unethical - that money belonged to other people and they had first claim on it. But the contract that was signed permitted that behaviour. The clients should have known better, as well.

John Hempton said...

I have to disagree with you because the structure in the UK can result in systemic runs on brokers.

The contractual terms are NOT well understood - and can be hidden in fine print (as they were with Opes Prime).

In Australia Opes Prime caused a systematic run on brokers.

J

Anonymous said...

John, one question about Opes Prime and Australian securities law: if a client had a margin account but was not using any margin at the time (no shorts, no outstanding balance), were their shares also rehypothecated and subsequently lost or were those folks in the clear?

John Hempton said...

I gather the shares were lost whether you had a margin loan or not.

J

Blank Xavier said...

JH wrote:
> I have to disagree with you
> because the structure in the UK
> can result in systemic runs on
> brokers.

That's a good reason for brokers *not* to write their contracts in this way and it's a good reason for clients not to work with brokers who do this.

> The contractual terms are NOT
> well understood - and can be
> hidden in fine print (as they
> were with Opes Prime).

That's properly tantamount to fraud. If you arrange your contract such that important information is obscured, you're attempting to make someone else agree to a contract under false pretences. That's a good reason for judicial penalty.

Peter Phan said...

What good is a judicial penalty to account holders who has loss all their shares and face years of uncertain litigation? Fraud is not easy to prove, and as far as I know, the Opes documentations consists of more than one piece of paper with fine print, and some of these documentations represented to account holders that they retain ownership and control of their shares, whereas the fine print says otherwise. Oversight or fraud? This is not so much about freedom to contract, which is what is advocated, but rather, legislative policy to ensure that risks in transactions are properly allocated.

Roger Bigod said...

For markets to work, there's some conditions that have to be fulfulled, like having informed parties, no monopoly, no side effects, etc.

They clearly aren't fulfilled in this case. If brokers went out of business frequently, swallowing up client assets, and if some brokers offered contractual protection against this, the customer could make an intelligent decision about the cost of taking the risk. But in the real world, there are lots of naive customers and brokerages have several features, like government permission to operate, that encourage trust. Moreover, failure of a brokerage with loss of client assets damages the economy far beyond one business mishap and is certainly a matter for public concern.

If you view freedom of contract as a sacred right, the Chicago School is wonderful. If you compare the results of the regulatory regime and the current catastrophe under the Chicago intellectual regime, it's a cargo cult.

Blank Xavier said...

peter wrote:
> What good is a judicial penalty
> to account holders who has loss
> all their shares and face years
> of uncertain litigation?

There are two issues here.

Firstly, the good it does is that it prevents people from doing the same thing in the future, because they know what will happen.

Secondly, if it is hard to obtain a right through the judicial system, then the judicial system is in need of repair.

> Fraud is not easy to prove, and
> as far as I know, the Opes
> documentations consists of more
> than one piece of paper with
> fine print, and some of these
> documentations represented to
> account holders that they retain
> ownership and control of their
> shares, whereas the fine print
> says otherwise.

Anyone who signs such a complex agreement does so knowing that they probably do not fully understand it. It is wrong - judicially wrong - the agreement was so framed, but the people who signed up did so of their own free will. They bear the consequences of their foolishness.

Blank Xavier said...

roger wrote:
> If you view freedom of contract as
> a sacred right, the Chicago School
> is wonderful. If you compare the
> results of the regulatory regime
> and the current catastrophe under
> the Chicago intellectual regime,
> it's a cargo cult.

Do I read you right? are you saying the current catastrophe occurred under the auspices of a Chicago school view?

If you are, that's an outrageous slander - this whole problem came up because Congress intervened in the market and forced banks to lend to high risk borrowers.

Roger Bigod said...

No, it occurred because Wall Street discovered securitization of mortgages, generating paper that could be sold to Europeans and Arabs. They demanded more mortgages to securitize, regardless of credit quality, and pressure was brought to bear on ratings agencies, appraisers, etc. to generate product.

Programs to help the downtrodden were just grist for the mill. CRA had been there for decades without blowing up the financial system. It's kind of Dickensian that minorities were first encouraged to take out big loans, then evicted, and now blamed for all the troubles of the bankers.

Anonymous said...

I hate to say this, but the reason the London Lehman vehicle is in such trouble was that right at the end, it sent funds back to the U.S., something whose legality is questionable. See http://ca.news.finance.yahoo.com/s/21092008/2/biz-finance-send-8b-lehman-brothers-europe-tells-parent.html

bronte fan said...

Most of the funds referenced in the link within that story as having lost money at Lehman are American. Indeed I read elsewhere that Lehman's Ldn prime offered more leverage than its NY prime, and was actively marketed to NY hedge funds for that reason. So why is this story suggesting the episode is a death blow to Ldn funds in particular ?

John Hempton said...

The US funds listed are the London ends of the US funds. They all had London operations.

--------

My theory is that the UK operation was busily hocking client assets in the UK to provide funding for the US operation in a way that they would not be allowed to in the US.

The UK funds (and Harbinger) have filed with the US bankruptcy court to force Lehman to open up the books on these transactions. Lehman has requested that the US bankruptcy court deny the request.

The info in that Harbinger request is the core info needed to prove (or disprove) my point.

I am pretty sure I am right.

J

Distressed Volatility said...

great post, very informative, thanks.

-dvolatility

MW said...

May be of interest:
Hedge funds urge intervention on Lehman - A group of the largest US hedge funds has called on the Bank of England to intervene to
free an estimated $65bn in assets frozen in London in the collapse of Lehman Brothers, warning that delays “could be disastrous for UK
plc”. The funds, through the Managed Funds Association, said the scale of the problem was so great it could undermine bank rescue plans
as tens of billions of dollars would be kept out of the market. It was also likely lead to the failure of some fund managers, said Richard
Baker, chief executive of the MFA. The warnings come as hedge funds have been quietly shifting billions of dollars of assets out of London
to the US, claiming the US legal system provides greater protection. Administrators at PwC running Lehman’s UK business have won court
approval for a process to work out how much they hold in protected assets but have warned it could take years to finalise. (FT)

andy said...

i wonder what's your personal opinion on this. i'm looking to open a side account (passive retirement) with a european broker and found these guys

http://www2.saxobank.com/Documents/financial_documents/Saxo-Bank-Annual-Report-2008-EN.pdf

they're not public but publish their annual reports anyway. i know they've been around for a while, and have no reason to suspect anything BUT
i can't get my mind around that balance sheet. it's not like a regular broker dealer's. could it be because they mainly make markets in forex?

also point 27.3 of this

http://www2.saxobank.com/Documents/legal_documents/General_Business_Terms_ENG.pdf

makes me wary. and the fact that you can't opt for cash/margin account. i guess everyone is on margin.

what think you?

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