The forthcoming irrelevance of the Australian consumer electronics retailers

This is a post aimed squarely at my hedge fund manager readers who regularly ask me what to short in Australia. The most obvious target (in my view) is retailers - and as a taster I start with the big-box consumer electronics retailers.

Australia still has two electronics chains doing big-box consumer electronics. These are JB HiFi which is well run, has a modern format, a short history and not much balance sheet and Harvey Norman which is a little more old fashioned (like Circuit City in the 1990s it still sells fridges on prime real estate) but has a better balance sheet (reflecting its once glorious history). Harvey Norman also has a franchise model - it does not own all of its stores.

In the US the debate is whether the country can support one or zero highly profitable big box chains. Best Buy - the bears argue - is the showroom for Amazon. In Australia as I said we still have two chains - its as if Circuit City were still around. Moreover because Harvey Norman has a balance sheet it can survive quite a long time and Gerry Harvey is prone to say it is the competitor that will go out of business. But Harvey Norman really is losing share to JB Hi Fi and ultimately both will lose share to the internet.

Gerry Harvey sounds somewhat desperate these days - firstly arguing that internet shopping is a con (nobody makes any money in it) and then arguing that there should be additional taxes on it. Then he sets up an internet company in Ireland.  It looks really bad except that because of the above-mentioned balance sheet he can stay around for a while and he might even be able to liquidate and be left with something valuable at the end. (I still believe liquidating a large retailer is scary-hard.)

The JB HiFi model

JB HiFi spends a lot of money to look cheap. Have a look at their website - it is almost a parody of old-style discounting pamphlets. The stores have false plywood floors to make them look like a discounting house. They have young staff wearing casual clothes and signs that are carefully printed on a computer so that they look hand-drawn. The shop is deliberately cluttered giving it a feeling of being (very) crowded. They don't do products that are not hip. There are no fridges, blenders, toasters but lots of pads, laptops, large screen TVs and computer games. The Apple products are given prime place not because selling them is profitable but because it makes the store look cool.

And for a long time JB HiFi really were cheap. The website flashes the slogan "cheapest prices - always". This was a company with the virtuous cycle of looking cheap and being cheap, selling fast, having high turnover and low inventory costs (important in electronics where obsolescence is quick) and just looking like a happening place. It was also a hot stock.

But it does not ring true any more. They are not the "cheapest prices always" - far from it. They match prices on large items where people price check and they will match prices if you really push them (trade practices law in Australia makes it hard to advertise the cheapest price if you don't have it) but I am noticing that on "convenience items" such as cables and SD cards they are pricing aggressively high. They spend money to look cheap but they aren't any more. It is the advertising tag-line of a decaying business.

They missed earnings expectations a while ago - the stock is having a rough time. But it is still fairly richly valued (do comparisons of price to sales if you want). The immediate question is how far further will it go and will Gerry Harvey keep throwing his good balance sheet at staying in the game and give them pricing pressure. Gerry Harvey it seems wants to be the survivor.

My Christmas Observation

I purchased a camcorder at Christmas and forgot to buy an SD card. These produce a lot of data so a big (ie 32gb) card was required.

Here is the only such card at the JB Hi Fi in the major shopping mall in Bondi Junction.

You see that price right: $299. It is the 45 mb/s version.

Here is the same product via an Amazon partner store at $128.

Gerry Harvey doesn't do better. Here is a 32 gb card at the Harvey Norman in the same shopping centre.

 The product is a Sandisk "ultra" at $190. Amazon will sell you an identical product for $39.

I am trying to work out the dynamics of this with regard to the stock. My best model is the decline of Radio Shack which did this before them. Radio Shack had a business model built on squeezing very fat margins out of customers that needed something now. They had 2400 stores over America so they were close enough to anyone who needed them pronto.

And proximity was useful. Remember the days you absolutely needed that Firewire cable and were prepared to drive to the local Radio Shack (or Dick Smith in Australia) and pay $10-20 for something that would cost 50c to purchase in China? As the Onion observed we do not need so many cables any more and Radio Shack has become irrelevant. These days it survives by selling mobile phone contracts.

Well as my little SD card survey demonstrates the big-box electronics stores here have become Radioshack - albeit with a bigger footprint and the pretence of "lowest prices". But Radioshack didn't blow up - it just sort of drifted away. The stock was $70 in 2000 - the peak year in which everyone was connecting their computers to the net and needed all those cables. It is $9 now.

That I think is the future here too. The two stores won't deal either one a death-blow. Gerry Harvey will continue to lose share to JB Hi Fi (who look cheaper and cooler) but he and his company are rich and they can bleed for a very long time. JB Hi Fi will continue to charge "convenience prices" to the customers hiding behind their faux-cheap facade.

And we will wake up in a decade and realize these companies are just not important - or for that matter even relevant.



John

Disclosure: no position in the funds. For various tax reasons we have elected to have no Australian positions.

Sears Holdings liquidation sale

We have been short Sears Holdings, publicly, albeit in small quantity. Being summer in Australia I did not even look at the market for the last couple of days - but got into work for some congratulatory emails as Sears stock is off very hard on an announcement of truly awful sales, the closure of 100 to 120 stores and $1.6 to $2.4 billion of non-cash charges. (More about the charges later on.)

I look pretty smart putting a Sears short on in November - and kudos is gratefully accepted but undeserved. I was short Sears at my old firm when the Eddie Lambert controlled K-Mart took them out for considerably more than they were worth. It was not the only time that happened to me - but multiple stabs don't dull the pain. I would gladly swap kudos for a refund of my then clients' money.*

The premise for owning Sears was property liquidation. The company owned many of its sites - sometimes on book at low historic values reflecting the company's long and once glorious history. Eddie Lambert and his merry-men were going to extract that value through selective store closures and super-profitable liquidation. Sears was an awful retailer (there was little doubt about that) but it was - they thought - a good property play.

My view: owning Sears as a property play is a demonstration of the arrogance and breathtaking naivete of much that passes on Wall Street. Sears Holdings has over 300 thousand employees. I don't know how you successfully liquidate a business integrated with that many lives. I don't know of anyone who has ever successfully liquidated a business with that many employees.** I am not sure it can be done and it certainly can't be done by someone with my skill-set (highly analytical, ability to spy value or value traps but no people management skill and not much tact).

The idea that Sears was going to be managed/liquidated by a bunch of hedge fund guys (people like me) well - that was comical.

Just to stress the point for my fund manager friends who read accounts and have my skills (but like me are often disconnected from the businesses they invest in) I will state the obvious. The employees are living breathing people and as you pull the business apart the way you treat those people and how they think about you (and behave towards you) are critical to any value you extract in liquidation. Someone has to look these people in the eye and tell them they don't have a job. And someone has to pick-and-choose which people to fire and which to retain. And they have to do this without destroying much of the value extracted along the way. They have to liquidate the firm in such a way that the value accrues to the liquidators and not to the people who are being screwed.

I don't care what you think of the morality of that. The reality of that is that it was always going to be hard - possibly very hard.***

We are about to find out how hard. Sears is going to close 100 to 120 stores (it is vague about the number) and fire many employees. But they have not worked out which employees or even which stores. Not to sound ghoulish - but my guess is that this is going to be considerably harder than the "Sears spokesman" makes it sound. And if they can't do 120 stores without trouble then the original Sears liquidation premise was insane. This is a case of Wall Street fantasy meeting reality: eventually reality wins.

The charges and reality

The large (non-cash!) charges deserve mention. This is from the Sears release:

[We Sears] expect that we will record in the fourth quarter a non-cash charge related to a valuation allowance on certain deferred tax assets of $1.6 to $1.8 billion

You know what that means. It means that you should not expect to earn that profit in the future. It is the admission from the Eddie Lambert controlled Sears that the fantasy is over.

The reality is unchanged: when you think of the 1950s you think of Sears. Sears was (in Main Street reality) irrelevant a decade ago. The Wall Street fantasy took a little longer to end.


John



*(A note about Schadenfreude.) The take-over of the old Sears by the Eddie Lambert controlled K-Mart was the second worst day of my career. The worst day was when Fred Goodwin's Royal Bank of Scotland purchased Charter One Financial. When I started the blog one of the main goals was to spell out just how atrocious Sir Fred Goodwin (the then CEO of Royal Bank of Scotland) was. The fourth post on this blog was the beginning of my "Sir Fred Goodwin death watch". I enjoyed watching him and his bank come apart. But I should not have enjoyed it. Schadenfreude is not an attractive personality characteristic and the collapse of RBS has caused real pain to a lot of innocent parties. And a Schadenfreudegasm - well that just strikes me as unreasonably indulgent. After all my clients lost money - and I should and would but cannot swap any pleasure I had for a refund of their losses.

This time though I am just accepting the Schadenfreude. My client are making money and I have no reason to feel guilty about that. Moreover I don't have to fire those employees. Unlike Royal Bank of Scotland (which Sir Fred destroyed) Sears employees were doomed anyway.

**. It is worth mentioning the GM example. GM was salvaged through bankruptcy with a couple of hundred thousand employees. But those employees were particularly trapped, the shareholders were wiped out and the Government contributed considerable money. That is what a "successful" transition for a business with that many employees looks like.

***. (Politics, employees and realism). I am a bleeding heart left-winger and naturally feel a little paternalistic to the employees being fired. However you don't need to be a bleeding heart lefty to agree with my analysis. A realist will tell that when you have 300 thousand employees your relation to them is going to be critical in running your business. Employees are "stakeholders" even if your only (moral) criteria is "shareholder value". Realism over politics is a better basis for investment.

Future Joseph Jett traders get a Christmas card from Mario Draghi

Well the Euro fix is in. Whether it works - that is another question. But the fix is this: European banks can borrow unlimited amounts for three years to buy Euro government debt. The debt often yields 5 percent. The money costs 1 percent.

The Government debt has - at least for the moment - a very low (mostly zero) risk weighting for capital adequacy purposes so the return on regulatory equity is more than adequate.

Now of all the things you want to be - top of the list these days has got to be a trader at a dumb bank paid a percentage of income earned at bonus time. Massive return on equity. Unlimited funds to employ. Christmas. Indeed a lifetime of silly-seasons all at once courtesy Super Mario.

Of course your bank is not just going to sign over the 20 million check. You are going to have to bamboozle them for that. After all, the European Government Bond carry trade patently risks capital and the risk management department should charge you mega-bucks for that capital. Indeed the risk management department probably should do more than that and stop you.

At Goldman Sachs (where they are quite tight) the risk management department would stop it dead. Contra: at MF Global certain senior Goldies employees demonstrated how Goldies traders without Goldies risk management behave.

But even at MF Global the risk management department knew what was going on.

So dear traders seeking large bonuses: how do you complicate it beyond the feeble minds of your local back-office? You can do complex things with government bonds - strips, interest rate swaps and all sorts of high-fallutin maths that comes from them.

You might not believe me: remember Joseph Jett who misstated profits and risks at Kidder Peabody (then part of General Electric, now buried in UBS). He reported enormous profits and took home an $8.2 million bonus. Jett operated entirely in Government bonds and their derivatives.

So what are you waiting for? The complexity of the stuff you can trade - all dependent on the above ECB provided carry - is enormous. And surely you are smart enough to run rings around the kids in the risk management department.

Wall Street has proven that complexity and cheap money are the road to riches. Now, dear European traders, is your time.

Hop to it boys. You got a Christmas card to collect.


John

Peculiar goings on at Blogger

This post is a short apology. Somehow yesterday a post I part-wrote in September - left in draft and never finished - got circulated to my email list by blogger/feedburner. It had spelling mistakes in it (it was a draft) but nobody picked up that the email was dated several months ago. People did email me about the spelling mistakes.

It mentioned solar panel prices. They are much lower now.

Sorry for the inconvenience and the incorrectly dated and priced objects.

John

PS. About half the posts I write wind up never being sent - all sorts of reasons. I guess I got to be careful with the old ones.

J

Solar panel prices continue to fall

Guidance from Trina and other solar manufacturers was for a wholesale price to be above $1 per watt.

So I got this email from my local supplier today suggesting retail prices far below that:

Dear Client:

Just a quick note that Powerark Solar is promoting a Christmas sale on BLD solar panels, the brochure and specs are attached.

BLD panel pricelist:

190w: 95cents for 1 pallet (58pcs), 93cents for 2 pallets (116pcs)

250w (60cells): 99cent for 1 pallet (40pcs).

We are also supplying Alex Solar panel, and various brands of inverter including Ever-Solar, SMA, Afore (double MPP Trackers), JFY and APS Micro-Inverter, please feel free to contact us if interested.

Best Regards,

 

Will Li

 

Powerark Solar Pty Ltd

Add: 26 James Street, Lidcombe, NSW 2141

Tel: 1300 887 ***; (02) 9460 ***

Fax :(02) 9437 ***

Website: www.powerarksolar.com.au

Mob: 0422266***

Email: wil@pow***.com

The extent of Chinese solar subsidies and their implications

Chinese solar makers are facing a countervailing tariff case essentially arguing that the Chinese Government (through state controlled banks) are subsidizing them. The CEO of Trina Solar (Jifan Gao) was party to a statement (also made by three other solar CEOs) that:

China’s solar industry had to pay higher interest rates for bank loans than U.S. and European competitors, and paid market rates for loans. With the appreciation of the yuan, “the loan rate we are paying is probably equivalent to over 10 percent,”

Ok - lets see what the interest rate the market (as opposed to the Chinese banks are charging the solar makers):

(Unfortunately you need to click this image to see the axis)...

Suntech is at 78 percent. LDK is 53 percent. Trina is "only" at 22 percent - but the Trina debt piece is a convertible and was recently trading way above par as this bond price chart shows:

(Click the image to see the axis.)

Which shows the price of the Trina piece coming down from well over 100 as the "convertible" bit lost its value.

Trina has recently expanded its loans by several hundred million dollars at low rates. But Jifan Gao says those rates are not subsidized. He is wrong and the solar makers should and will lose their case. There is a robust market telling us what the "free market rate" is and it does not look like the subsidized rate the Chinese banks are providing.

The Solyandra case

The Chinese solar makers will - with righteous indignation - point at the subsidized loan that the US Government gave Solyandra - a loan that has now gone solidly into default. They have a point - but not a good one in a court. Their problem is that the WTO agreements have a specific exemption for government loans to develop new industries and new products. The most famous recipient of these loans is (of course) Airbus who gets subsidized loans to develop every new plane. Boeing can't win that trade case because the subsidy - like the Solyandra subsidy - is international trade law compliant. (If you want a decent history of that subsidy read John Newhouse's excellent book on Boeing versus Airbus.)

The reality for solar makers

The reality for the solar makers is bleak - maybe not for the solar business - but certainly for the shareholders and debt holders in the companies. The American solar makers will win the trade case. There will be a countervailing tariff. Europe will almost certainly follow. The products will have no markets at tariff included prices and the subsidized loans that the Chinese banks gave the solar companies will not be repaid.

The banks will wind up owning the companies anyway, selling products facing crippling countervailing tariffs. When the most potent argument that the Chinese solar CEOs can come up with is that their interest rates are high (almost 10 percent) but are really 30-60 percent below market their position is clearly weak.

There is an alternative. The alternative is for the Chinese to simply agree to provide no more subsidized loans and to roll all funding as it matures into long-dated non-subsidized loans. Then the whole countervailing tariff argument just evaporates.

Of course the solar companies - every single one of them - goes bust. And quite rapidly.

But it doesn't matter - after bankruptcy the Chinese government - through their banks - owns them. They become state owned enterprises and the Chinese Government can amalgamate them as they see fit. Indeed as SOEs they can seemingly subsidize them as they see fit too - because those subsidies are much harder to argue against in a trade case.

The losers are of course shareholders and western debt holders of the Chinese solar stocks. But I see no reason why should the Chinese government should give subsidies and enter into a crippling trade dispute to protect them.

It is time for Jifan Gao and the other CEOs to have their subsidies - and their businesses - removed from them just as the CEO of Solyandra had his business removed from him. The Chinese banks will learn - as people have been learning since the advent of capitalism - that when you lend a business too much you either own it or are going to spend a lot of time collecting.




John

PS. I do not wish to enter into the morality of the trade dispute. For instance I don't wish to argue that the loans to Solyandra were moral and the loans to the Chinese companies were immoral. I just want to argue what is - and why it is from an investment perspective. The loans to Solyandra were legal. The loans to the Chinese makers are not legal. Morality does not enter into it.

Moreover a countervailing tariff will hurt some people in the US (eg residential solar installers). That is a fact - but it won't enter into the legality of the dispute.


J

The Sino Forest Independent Committee Report - Part 3.

Sino Forest had a simple enough business model. It held forest and then sold the standing trees to Authorized Intermediaries. AIs (and parties related to them) often sold them the cutting rights.

Sino Forest did not own trucks, chainsaws or employ huge numbers of people because the AIs did all that. All the things needed to run a 17 million tonne per year forestry operation were done by the AIs.

So the AIs you would expect are fairly substantial organizations - bigger than Sino Forest anyway - because the AIs do all the work.

This makes the Sino Forest meeting with the AIs the critical part of the Sino Forest investigation. This was the backbone of Sino Forest. If the AIs were phony then Sino Forest is unambiguously fraudulent.

You can find the full summary of the meetings with AIs here. I am just going to quote the first page. This is not a selective quote (check the original if you want).

Terms Not Herein Defined Shall Have The Meaning As Ascribed In The Second Interim Report Of The Independent Committee Of The Board Of Directors Of Sino-Forest Corporation.
Supplier #1 (OSC Supplier #1)
Location 1
Hunan City #3
(Source:  Provided by SinoForest)
 Site did not have signs or any other indication that Supplier #1 occupied
the location.
 According to an individual from the neighbouring office, Supplier #1’s
office is located on 2/F of the building.  They were unsure whether or not
people worked in the office there.
 Encountered individuals who introduced themselves as Supplier #1 staff,
including one who introduced herself as the Financial Controller.
 Neighbouring occupants stated the office was no longer used and Supplier
#1’s office had moved to a new site located on 6/F of the (redacted)
building in Hunan Location 5.
 Went to new address and confirmed that Supplier #1 shared the 6/F with
Hunan City #3's Government Land Acquisition and Demolition
Remediation Department.
Location 2
Hunan City #3
(Source: SAIC filings)
 This was a factory site previously occupied by Supplier #1.
 The factory is now operated by Other Co #11, a company owned by Other
Co #12.
 According to a factory worker and neighbouring occupants, Supplier #1
moved out in 2009.
 Neighbouring occupants referred to Supplier #1 as "Sino-Forest's Supplier
#1" (嘉漢的供應商#1).
Location 3
Hunan City #3
(Source: Mailing address
provided by Sino-Forest)
 Individuals identifying themselves as Supplier #1 personnel stated that
Location 3 should, in fact, be the same as Location 1 as there was only one
insurance office building on the road.  The address should be (redacted)
instead of (redacted).
Location 4
Hunan City #3
(Source: Mailing address
provided by Sino-Forest)
 This location is the same as Supplier #10 Location 1 and is now a bank
with the office above occupied by the bank itself.
 The security guard for the bank had not heard of Supplier #1.

It goes on:

Supplier #10 (OSC Supplier #10)
Location 1
Hunan City #3
(Source:  Provided by SinoForest)
 This location is the same as Supplier #1 Location 4 and is now a bank with
the office above occupied by the bank itself.
 The security guard for the bank had not heard of Supplier #10.
Location 2
Hunan City #3
 We could not locate Supplier #10 from the address provided.
 Neighbouring occupants had not heard of Supplier #10.

Monty Python could have written this.



Remarkable company Sino Forest: beautiful plumage.



John

Sometimes I am glad I host this blog at Google (Muddy Waters edition)

Muddy Waters Research (of Sino Forest fame) published a negative piece on Focus Media (the American listed stock of a real Chinese outdoor advertising company).

A day later Muddy Waters website is down - albeit with a short message:

MW regrets that our site has been hacked. We will bring it up as soon as possible.  

FMCN is still a Strong Sell. 

Happy Thanksgiving,  

MW

Google does not have a flawless record at keeping Chinese criminals (ahem the Chinese Government) from hacking them - but I suspect they could beat any attempt by an outdoor advertising company.



John

To be successful

I am reading Jason Manolopoulos's Greece's Odious Debt - an accessible successor to Mark Mazower - and one that reminds you that attitudes to things like tax collectors depend on history. (In Greece for instance Manolopolulos argues that under Ottoman rule not paying taxes - essentially poll taxes on Christians was highly honorable. This still influences Greek tradition.)

Chapter Two however starts with one of the best quotes I have ever seen:

To be successful, keep looking tanned, live in an elegant building (even if you're in the cellar), be seen in smart restaurants (even if you nurse one drink) and if you borrow, borrow big. 

-Aristotle Onassis

Seldom have I seen a business/political philosophy so diametrically opposed to mine stated so clearly. And exemplars abound - think Angelo Mozilo in American finance or Andrew Peacock in Australian politics.

Just a fabulous quote and a world view that seems to work for the people who hold it if not for the rest of us...


J

Oversimplification and financial crime (Felix Salmon edition)

I sometimes joke that straight accounts like virginity refer to one state only - whereas financial crime - as does sin - refers to a multitude.

This blog aims to provide - in part - a morphology of sin - and alas like the loss-of-virginity and relationships that ensue - it is complicated.

Not everybody always sees it that way. Felix Salmon posted about "The Return of Obvious Graft" which is about three financial crimes and how simply he sees them. I quote:

It’s almost comforting to find a spate of financial scandals which involve simple, easy-to-understand illegal and unethical behavior, after all these years rummaging around in synthetic mezzanine collateralized debt obligations and the like. Three have particular salience right now: 

(i) The Congressional insider-trading scandal. Spencer Bachus is the poster boy here: one minute he was getting highly confidential briefings from Hank Paulson and Ben Bernanke on the parlous state of the economy; the next he was loading up on contract options on Proshares Ultra-Short QQQ, a synthetic ETF designed to maximize profits when the stock market falls, and which is emphatically for day traders only. 

(ii) Olympus, which now seems to have channeled more than $2.5 billion to yakuza crime syndicates, including the country’s largest, the Yamaguchi Gumi. 

(iii) MF Global, which increasingly looks as though it stole money in customer accounts.

I am surprised that Felix - who is a bit of an aficionado of this sort of stuff - should boldly state that these three involve "involve simple, easy-to-understand illegal and unethical behavior". Felix is - I think - wrong about all three. In the second case I think Felix's error is important because it has investment implications.

Congressional trading scandals

The congressional trading scandal is simple enough - I can't think of any way in which is ethical for someone like Spencer Bachus - who is elected to represent a broad electorate - to use information that he gains as a representative to trade against the same people. Conflict of interest springs to mind. The problem is - as the article Felix links indicates - that the behavior probably isn't illegal. It should be. I don't disagree with Felix's sentiment here - just the fact of illegality is not clear.

Olympus

The Olympus scandal is alas much harder. I spent about eighteen (almost continuous) hours recently looking at Olympus. I wish the story was as simple as Felix indicates because you would buy the stock with your ears pinned back. If the story was that $2.5 billion were simply stolen then you would have a business that could generate $2.5 billion (which makes it a very valuable business) and the looting would  likely stop now. If the story was as simple as Felix says you would buy the stock as the business will continue to be highly profitable and the stock has cratered.

But Felix's story isn't even the official story now. The official story is that Olympus made some very large (albeit genuine) trading losses over a decade ago. It hid them. And hid them. And hid them. And its books did not balance so the hiding involved many senior staff. Then after many years (and towards the end of the careers of the malefactors) they sought to bring the books back into balance. So they jigged up some large fake acquisitions and paid a couple of billion for them. The money however was not looted - it was recirculated to fill the hole in the balance sheet from the trading losses.

If that story were true you would still probably buy the stock because that is still a story about a very profitable underlying business that will probably retain its profitability and a stock that has cratered.

Alas I am not sure even that story is true. At the core of Olympus is an amazingly profitable medical devices business. It makes gastrointestinal endoscopes - devices you stick you know where - and look for colorectal cancer. These devices are also used in operations. Stated revenue for this segment was 355 billion yen and operating profit was 69 billion yen. Put this in dollars because I don't think in yen - that is $4.6 billion in revenue and $890 million in operating profit. That is a lot of profit and a lot of revenue from peering where the sun don't shine.

My fear was that was too much profit. I could not convince myself that this business should be as profitable as all that. An alternative hypothesis occurred to me - which was that Olympus was sharply overstating the profit of its core medical devices business. Over time their accounts would then shift from reality - possibly by cumulatively more than a billion dollars. So some day they would chose to fill the hole (just as they supposedly filled the hole on the hidden trading losses). And then they did the fake acquisitions.

If my alternative hypothesis is correct then the case for buying Olympus stock evaporates. What you have is a cratered stock and a business that had been fraudulently overstating profits for years. And it has a lot of debt.

The underlying low-level-of-profitability hypothesis is more consistent with the debt load.

Olympus just isn't as simple as Felix makes out - and the differences have investment implications. If only it were simply looted.

MF Global

What happened at MFGlobal is not clear. There is no question that client cash is missing - but there is some doubt as to whether it was "stolen" or whether something else happened to it.

A US based broker-dealer (though not broker-dealers in other jurisdictions) is obliged to keep client assets (usually securities) separate from firm assets. Usually this means that client assets which are not required to be pledged to support client balances are kept in a client segregated account. Client assets are allowed to be pledged but only to a low multiple (usually 1.4 times) the client balance and then only to support client obligations. In other words client assets can be pledged if the clients are leveraged.

Client cash is also meant to be segregated under similar terms. The problem is that client cash is not kept as cash - that is it is not bits of paper sitting in vaults. Client cash is kept as people usually keep cash - in bank deposits when it is small in volume and maybe in short dated government securities when it is large in volume. Brokers have always been allowed to buy government securities as a use of client cash.

If they held Euro cash then they would presumably be allowed to buy Euro government securities (and in Europe now that means German Bunds).

Robert Lenzer in Forbes suggested (and possibly with good evidence) that the cash was held as Italian, Greek and Spanish government bonds - possibly longer dated. These are Euro government bonds held against Euro cash - which would be OK if it were US Government bonds against US cash. But in Europe its a problem: European governments can't print the Euro so they are not riskless and the assets were long dated. In which case MF Global may have legally speculated with client money. This is not the simple, easy-to-understand illegal and unethical behavior of Felix's blog post - rather a glaring policy loophole. Moreover Lenzer suggests that MF Global actively lobbied to keep the loophole open.

Still I am not even sure of the Lenzer story. There is a story doing the rounds in Asia (meaning I have heard it from multiple sources) that Deutsch Bank and/or Goldman Sachs got the client assets - the client assets were posted as collateral maybe for client positions and maybe for MF Global's own positions. And the bulge-bracket guys snitched it.

Now if it were clearly marked as client collateral and DB or GS snitched it then the big-boys would be involved in theft. But if were not clearly marked as or somehow DB and GS were not informed that it was client collateral then DB and GS would be entitled to grab it. And if they grabbed client collateral then alas it is not there for the clients.

So it is a real question as to what collateral was posted to whom and who snatched it. That will be litigated for a long time - and a malicious - or for that matter a not-guilty party at MF Global is likely to tell the jury that they posted the collateral to Goldman Sachs and clearly told Goldies it was client collateral and that Goldman Sachs pinched it anyway. It may be a simple crime - but a simple defense - and one that many people would find intuitively appealing - is that Goldman Sachs et al, not MF Global, stole the money.

Summary

All I am saying is that Felix has picked yet another three which do not meet Felix's criteria of "simple, easy-to-understand illegal and unethical behavior". Financial crime - like any morphology of sin - is complicated. Almost always.



John