More Refco Questions; NY Times Editorial Calls For SEC Investigation

Here's an example of the articles on Refco that have been appearing today, many of them in the NY press.

One, in the NY Times, which requires a subscription, describes Refco's meltdown and fraud-driven transactions in this way:

"As customers lost money in the 1990’s through 2005, Mr. Bennett would have the firm’s parent, Refco Group Holding Inc., assume those debts. Rather than write off those losses, Mr. Bennett then transferred them to Refco Group Holding. By all appearances, Refco appeared to be owed money by its parent.

From there, a series of loans among Refco Group Holding; another Refco unit, Refco Capital Markets; and several customers sought to keep the loans off the books. One of those customers, an Austrian bank, Bawag P.S.K., was ordered in June to pay at least $675 million for its role in the scheme."

But here's the funny part. The articles in the NY press actually don't get it right. They obfuscate, either deliberately or through incompetence/ignorance, what the actual wording of the indictment says, which is different than "as customers lost money."

Here's what it actually says:

"During this time, certain Refco customers to whom Refco had extended credit sustained hundreds of millions of dollars of market losses in their Refco accounts. When the customers were unable to make payments on the credit Refco had extended, Refco liquidated certain of the positions and assumed the resulting trading losses."

So, Refco had to take over the positions when customers were unable to cover the credit Refco had extended. And after liquidating the positions, Refco assumed the losses.

Huh.

Liquidated all the positions, I wonder? Or did they assume some of them, continuing to carry some in order to limit the actual losses?

The NY press spin is far less specific than the indictment. For all the words, there was precious little info being imparted. As I read the NY Times piece, I wondered aloud, "What do they mean by, as customers lost money? How did they lose the money, and why was Refco forced to assume the debts/losses? What kind of trading results in losses or debts which don't get collateralization on a marked-to-market basis, thus protecting the broker every evening?"

The most obvious one I can think of is naked short selling, wherein the miscreant manipulators NSS a company from $10 to $1, and due to the marked-to-market nature of the collateral they are required to keep to collateralize their position, their profits on the short from $10 - $1 are withdrawn and spent on jets and such. No problem, as long as the stock stays depressed - but if it rises, the broker (Refco) could well be in a situation where the collateral is woefully inadequate to cover the new obligation. A friend of mine described the math this way:

"Assume I am your broker, and you are short 10 million shares of some stock that today is at $10. That is 10 million X $10 = $100 million dollar short position. I insist you keep 102% (in this case, $102 million) in cash with me as collateral.

Thus your incentive is to keep shorting it: as the price collapses, you can suck more and more cash out of the sold shares and your collateral with me.

If another 10 million shares were able to drop the price to $4, then you now have to have collateral of 20 million X $4 X 102% = $81.6 million.

You have thus pulled out however much you sold those 10 million shares for (say, at an average price of $7, you would have gotten 10 million X $7 = $70 million) plus the $102 million - $81.6 million = $20.4 million, for a total of $70 million + $21.4 million = $91.4 million.

Now if the stock spikes to $15 some day. You are short 20 million shares, and should have $15 X 20 million X 102% = $306 million in collateral with me. So now, you have to pony up $306 million - $81.6 million = $224.4 million.

Ouch.

You cannot come up with $224.4 million. I might buy shares to cover as much of your short as I can, but I run through your $81.6 million pretty quickly and only get (assuming the price does not move) $81.6/$15 = 5+ million shares.

You crash and are gone. But there are still people out there who think
they own the 20 million - 5 million = 15 million shares that now become my obligation.

BTW, by "trading losses" I'll bet they mean "trading positions."

This is a pretty good description of the math, as well as the nature of the systemic risk caused by naked short selling. Imagine every prime broker with lots of big hedge fund customers, leveraged 10X or more, with a portfolio of these so-far-profitable nss positions, for which they have extracted the lion's share of the collateral. Each prime broker could easily be facing tens of billions of not hundreds of billions of liabilities if a few of these funds blew up, and they had to cover, say, NFI, OSTK, NFLX, TASR, HANS, NAVR, etc. As we have discussed before, just the legal short position in NFI alone could be a billion dollar hit - never mind the NSS, which could be many multiples of that.

Now imagine that multiplied out over hundreds and hundreds of stocks.

That's the systemic risk issue. And it also should tell you why the brokers work with their large hedge fund customers to make sure that any stock that has come down 50-70%, and is on the SHO list, stays depressed. The brokers' asses are on the line, right along with their hedge fund customers. Last year's big bonus was made allowing and aiding them in beating the stocks down - this year's survival of the brokerage could well be tied to ensuring the stocks don't go back up.

How many more Refcos are percolating on Wall Street? Quite a few, is my guess. And I bet the SEC, in its darkest and most frightened moments, understands precisely how out of control this is.

Which is my segue to this next bit - a NY Times editorial on the Aguirre investigation into Pequot, and the emerging apparent SEC cover-up.

While the Times is quick to insert the obligatory CYA language about the presumed innocence of Mack, it is interesting that the tone of it has begun shifting to, "I smell a rat."

Watergate actually comes to mind when I consider this sort of power-driven cover-up. The S&L scams also come to mind. Here are the last two paragraphs, which express the growing awareness of potential ugliness at the SEC pretty well:

"The Senate Finance and Judiciary Committees are pursuing the question of how the Pequot investigation proceeded and why Mr. Aguirre was fired. So far, there is hardly enough information available to jump to conclusions about the conduct of Mr. Mack or Mr. Samberg. The commission has informed both men that it is not seeking enforcement actions against them. What is more important to the public is not the specifics of the case as much as how easily the commission staff can be influenced, whether by reputation, connections or future job prospects.

Senator Charles Grassley, chairman of the Senate Finance Committee, said in a statement that additional questions had arisen because of conflicting statements and documents that had come to light over the course of the Senate panel’s inquiry. “My initial concerns haven’t been put to rest by what I’ve learned so far," Mr. Grassley said. Neither have ours. A full airing is in everyone’s interest."

Recall that about two years ago, Dave Patch was sounding the alarm as to the SEC's mendacity, with his site, InvestigatetheSEC.com. It's rather tragic that bloggers have had to be the ones investigating and breaking this story, even as the media studiously ignored it. Even now, the cover-up spin is pervasive from Wall Street's quisling media lapdogs - short sellers are American heroes, Reg SHO is working, our regulators are honest and good and true, and there is no massive systemic risk lurking just beneath the surface of an industry dependent upon secrecy for its dealings.

My sense is that this is starting to come apart on them. I am going to predict that my call for a special prosecutor, from months ago, is going to look prescient over the coming quarters.

Call it a hunch.

And the SEC's moves on Reg SHO will be glacial, even as the proof is incontrovertible that it has failed miserably, and more companies are being ripped off by miscreants while the media spins SHO as a success.

I don't expect anything to change for as long as they can manage - the evidence is mounting that the SEC is working for and with Wall Street, not policing it. Why would they want to cut into illegal manipulation when their future employers are dependent upon it to make their out-sized profits?

Quite a market we have. Even as IPOs abandon the US, and increasing interest is developing in foreign listings, the band plays on.