The story broke from nowhere and caught many off guard. To others it was the manifestation of previously unspoken fears. It was, and is, by far the biggest story of 2013, the decade, and quite possibly the millennium. It was the crossing of another Rubicon. For years and decades, the financial piranhas had wandered around the edges, nibbling a little here and a little there. Inflation, bailouts, and other monetary mischief had already eroded the value of most currencies. But never before had they actually made the boldest of moves – to steal what were always considered to be the most liquid and secure of funds – bank deposits. In a weekend, the liquid became the illiquid and the secure became the repossessed. Hey, let’s not split hairs here, the money was stolen. The media dutifully came up with another new buzzword – the ‘bail-in’. Talk about putting a positive spin on outright theft.
We’ve already covered Cyprus in great detail. That story goes on and is largely ignored by the mainstream press corps; however, Cyprus was just a small prize. There are much bigger fish to fry – like you. This week’s column will cover the groundwork that has already been laid to turn America into the next Cyprus. I am not positing here that we will necessarily be the next in line chronologically, but it will happen eventually – and likely sooner than later. There are other pools of wealth in other parts of the world that may serve as additional beta tests prior and I claim no inside knowledge of the blueprint, but can only attest to the fact that it does in fact exist and more importantly, to make you aware of it now.
Spain, Canada, and New Zealand have already adopted specific measures using the ‘bail-in’ approach to guarantee the solvency of the ‘too big to fail and too big to jail’ banksters using depositor money. For simplicity’s sake, a bail-in is pretty much the opposite of a bailout. In a bailout, which we all know far too well, everyone shoulders the losses of the offensive, insolvent institution. Think of TARP. However, that ‘socialization’ of losses tends to annoy folks; especially those who had no prior pecuniary interest in the aforementioned offensive institution. And yes, I do mean offensive.
However, in a bail-in, instead of getting the funds from the general public, the strategy is to swipe (not write-down, not give a haircut, etc.) depositor assets. This is done by a bit of wordsmithing. Under previous customary definitions, depositor assets were also known as the bank’s liabilities. Obviously an insolvent bank has more liabilities than assets (in simple terms) and as such changing the status of account holders from ‘depositors’ to ‘unsecured creditors’ means the bank can ‘repatriate’ your money to pay off its bad debts. Truth told, this is nothing new; there is already the precedent of a series of frighteningly similar situations that are already part of America’s decaying reputation as an advocate for private property rights.
The Precursor – Sentinel Management Group
If all this is starting to sound a bit familiar, that is because in principle a variation of this has already happened in the case of the Sentinel Group. Late on Friday August 17, 2007 (always over a weekend, don’t EVER forget that), the company filed for Chapter 11 bankruptcy protection.
Blockage of the sale of firm assets to the hedge fund Citadel Investment Group caused lawsuits to be filed against Sentinel by two brokerages: Farr Financial and Velocity Futures. On August 20, 2007, the SEC filed a complaint in US District Court in Chicago alleging that Sentinel had used falsified statements to obtain a $321 million line of credit and had comingled $460 million of segregated client assets with assets in its proprietary ‘dealer’ or ‘house’ account. On June 1, 2012, the former CEO and head trader were indicted on federal fraud charges for defrauding more than 70 customers of over $500 million.
Here’s where it gets dicey. BNY Mellon is the firm that provided the $321 line of credit and it filed suit and the courts have ruled (in error and on the side of criminal behavior) that customer funds may be used by Sentinel to pay off BNY Mellon’s credit line. There have been two similar subsequent cases in the brokerage world – MFGlobal and Peregrine Financial Group. The Sentinel ruling is going to make it awfully difficult, if not impossible, for the clients of those firms to recoup lost funds. This is precisely the type of moral hazard that we need to be avoiding, not encouraging. To allow a few too big to fail – too big to jail firms to leverage the entire system is not only insanely foolish, but criminal as well.
Granted, Sentinel was a brokerage house that went belly up because it made bad bets, but allowing the firm to steal customer money to make good on its line of credit was little more than a precursor for a savings and loan entity to do the same thing. Or in the case of Cyprus, several savings and loan entities. However, given the incestuous relationship between commercial banks and brokerages thanks to the 1999 repeal of Glass-Steagall, there is ostensibly no difference between the situations at Sentinel, MFGlobal, and PFG and what happened in Cyprus. Can the brokerage arm of a big bank put the entire operation at risk? Absolutely. Are you protected if you happen to have deposits in such a bank? Absolutely not.
Of course in any case, the big insiders will be tipped off well in advance and have the opportunity to move their money elsewhere long before the hammer falls, leaving the Proletariat scrambling for ATMs after the banks close on a Friday afternoon.
Act Two – Canada, Spain, New Zealand, or America?
Let’s look at the blueprints and what we’ve got regarding Canada, Spain, New Zealand, and even from our ever quiet, perpetually underfunded friends at the FDIC. There has been a bevy of whitepapers released over the past few months that outline how various jurisdictions are going to deal with future crises. Note that the emphasis is on cleanup rather than prevention. Nobody is interested in preventing another disaster and that is precisely why we’re going to have one. I am going to link these whitepapers from our site so that you can look for yourself and draw your own conclusions. I challenge everyone reading this paper to do exactly that.
Exhibit One: “Resolving Globally Active, Systemically Important, Financial Institutions” – FDIC / Bank of England
They call them G-SIFIs; short speak for Globally Active, Systemically Important Financial Institutions. These are your Citigroup, JP Morgan, Lloyds of London, BNP Paribas, and Societe Generale folks. They’re intertwined in a web of deceit, corruption, and astronomical leverage and when one goes, they all go. That is why the paper refers to them as being ‘Systemically Important’. Like we need these characters for something. These aren’t even banks really; they’re casinos on steroids. Let’s take a look at some of the bankerspeak from the Bank of England and FDIC shall we?
“These strategies have been designed to enable large and complex cross-border firms to be resolved without threatening financial stability and without putting public funds at risk.” – Note the emphasis on ‘public funds’ ie: bailouts and the concomitant promise that bailouts will no longer be used.
“A process to ensure the equitable treatment of the creditors, depositors, counterparties and shareholders of group entities, regardless of the jurisdiction in which they are located, which would require careful assessment of the provision of intra-group financing;” – Note ‘equitable treatment’ clause.
Here’s the London Whale and the essence of the entire paper:
In the U.S., the strategy has been developed in the context of the powers provided by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Such a strategy would apply a single receivership at the top-tier holding company, assign losses to shareholders and unsecured creditors of the holding company, and transfer sound operating subsidiaries to a new solvent entity or entities. – Still no specific mention of where depositors fit in.
And a bit more on who ultimately takes the hit, but in vague terms:
Title II (of the Dodd-Frank Act) requires that the losses of any financial company placed into receivership will not be borne by taxpayers, but by common and preferred stockholders, debt holders, and other unsecured creditors, and that management responsible for the condition of the financial company will be replaced.
Note that depositors are not mentioned anywhere in this exchange. It only says that taxpayers won’t take the hit. So there will be no more bailouts. Allegedly. The portion of interest to depositors is the bit about ‘other unsecured creditors’. If only equity and debt holders are going to be held responsible for ‘making the firm whole’ in receivership, then what happens when a hundred dollar stock can’t get a bid at five bucks because the firm is insolvent? Look at Lehman. Confiscating every share and selling it wouldn’t have even come close to righting the ship. Double that for bonds. Besides, who would even want it? Even assuming there were buyers at par, thanks to leverage, the amount needed to effectively resolve the insolvent firm could easily be many times the proceeds of any sale. The ONLY liquid assets within reach for an insolvent bank are the deposits. Yet deposits and depositors aren’t even mentioned in the FDIC/BOE report. Follow along:
“An efficient path for returning the sound operations of the G-SIFI to the private sector would be provided by exchanging or converting a sufficient amount of the unsecured debt from the original creditors of the failed company into equity. In the U.S., the new equity would become capital in one or more newly formed operating entities.”
And this is where the noose closes around the necks of depositors. Pay close attention. Unsecured debt is money that is OWED by the now insolvent bank to creditors. That debt is unsecured, meaning that the creditors can’t repossess buildings, etc. to make good on the unpaid debt. So they’re going to take a bunch of people that are owed something and turn them into owners of the company by converting debt to equity. So what you have is the common and preferred stockholders wiped out and a bunch of creditors now owning the company. But where does the capital come from that is mentioned in the above paragraph? All we’ve done to this point is shuffled some deck chairs on the SS BrokenBank. We’ve wiped out the original capital/owner’s equity and replaced it with ‘unsecured debt’ holders. This resolution mechanism ONLY works if you assume that the deposits fall into the same category as ‘unsecured debt’ and as such are written-down along with unsecured debt (a la Cyprus). Otherwise you’d be in a situation where public money would be needed to re-liquefy the new firm and both Dodd-Frank and the FDIC/BOE report specifically state that public money will not be put at risk. Instead, depositor money will be at risk. Yet the FDIC/BOE report does not explicitly say that, and in fact does quite a bit of outstanding grammatical grandstanding to avoid even alluding to it.
It must also be noted that the FDIC/BOE report was dated 10-December-2012; well in advance of the Cypriot bank holiday. The blueprints for America and Europe were laid well ahead of the beta test.
Exhibit II – “Report and Recommendations of the Cross-Border Bank Resolution Group” – Bank for International Settlements – 2010
This report pre-dated the combined FDIC/BOE report by nearly 2 years and was one of the first whitepapers released by a major banking ‘authority’ after the demise of Lehman Brothers and several other firms in 2008. Again, the ambiguity of the language must be noted and the not-so –subtle grouping of depositors with ‘other creditors’. See below:
“The operation of national regulatory, corporate and insolvency regimes in home/host jurisdictions including the scope of potential ring fencing measures, the treatment of intra-group claims, safe harbour provisions for financial contracts, the treatment of depositors and other creditors under the relevant resolution frameworks, and market, regulatory and legal constraints that may require early disclosure of an impending crisis;”
Note again as in the FDIC/BOE report the lumping together of depositors and ‘other creditors’. Formerly, depositors were NOT considered creditors and had separate and distinct rights under the law. For US bank account holders, the biggest ‘right’ is FDIC protection afforded depositors. That protection is not afforded to creditors.
Below is another example of where depositors are amalgamated with creditors. What obligations do depositors have to a bank anyway? And even further, what obligations do they have when a bank goes bust other than to safeguard their assets? Follow along as the BIS report begins to shift the definition of and mindset concerning depositors:
A commitment of national jurisdictions to undertake the necessary legal reforms, which may require a harmonization of national rules governing cross-border crisis management and resolutions, including rules on core issues such as a common definition for bank insolvency, avoidance powers, minimum rights and obligations of creditors including depositors, treatment of intra-group claims, ranking of claims, rights to set-off and netting, and the treatment of certain financial contracts, submission and admission of claims, and distributions to creditors;
Also, and perhaps ironically, the BIS paper and the FDIC/BOE paper differed dramatically with regards to the possibility of public bailouts for compromised firms such as Lehman. Banks shoot their own wounded. When one gets in trouble, credit lines are withdrawn, loans refused, and the failing institution is isolated. That is what caused the need for tremendous publicly funded bailouts in 2008. Obviously such actions are politically unfavorable, especially when you have a Treasury Secy who blatantly lies about how the money will be used.
Making a note of the change in tenor from 2010 to 2012 is critical. The emphasis shifted from taxpayer-funded bailouts to the model of swiping depositor money to sustain broken firms. Of course nobody was really sure how that would work out. Hence the perfect test in Cyprus. Physically isolated, the Cypriots never had a chance. And, right on schedule, the biggies were forewarned and made their quiet exit before D-Day. This part always comes out later and is released very quietly.
In Conclusion – Some Pointers
In America, the segment of folks who are actually awake are pretty upset about all this and have noticed the change in tone from the bailout to bail-in model. Understandably, they’re not too happy about it and seek insight. There are a couple of signposts and points to remember about these types of events:
1) Beware of Friday afternoons after market close. This is when the big actions occur. Bankruptcy filings are made and these crises are whipped up to a frenzy state. This is done for a reason. It gives the powers that be the entire weekend to plot behind closed doors while nobody can do a thing. In Cyprus they closed the banks and when the ATMs were empty, that was it. The crisis was on. Lehman happened over a weekend. That is no guarantee, but that has been the modus operandi in the past.
2) We’re one headline from an identical crisis here. The same applies to the EU and the rest of the world. This is the nature of the game that is played. It is literally impossible for any person to fully comprehend the amount of leverage that is being employed in terms of the OTC derivative market alone. The exposure is tremendous and systemic. The BIS and the rest can write all the whitepapers and talk about orderly this and that all they want. The truth is when (not if) that mountain starts shaking, all bets are off. And again, the focus of the banking ‘authorities’ has been on cleanup rather than prevention. Understanding this is key to grasping the concept that these folks realize they can’t control these markets or events. It’s a financial Frankenstein and nobody really knows what it is going to do.
3) Follow the blueprints – and the money. The BIS paper, and more importantly, the FDIC/BOE paper, lay the blueprints on how these crises will be dealt with moving forward. I find it hilarious that the papers cite a public distaste for bailouts. I guess they figure that swiping bank accounts is going to be more palatable. Of course it won’t be packaged that way. We’ll be told that the ‘haircut’ will only be for the ‘rich’. However, by the time it is over, everyone will be cleaned out to some extent. Just look at the end result in Cyprus. They knew all along the Proletariat was going to take a beating. Class warfare is the oldest weapon in the book when it comes to getting people to subscribe to draconian social measures. Yep, nail the other guy, just leave me alone. It works every time.
There are many analysts who believe these events are imminent. I tend to disagree. Don’t forget that this is, in many ways, a psychological warfare operation. There is always the potential of a black swan event, however, I would think that there would be some time separation between Cyprus and the next event(s) to allow the public to go back to sleep. That said, those who adequately prepare now should be prepared to maintain those preparations – perhaps indefinitely. This is not a one or two month, then back to the party type situation. Our world has changed many times in the last decade. This is just another step in that progression away from liberty.
The FDIC/BOE report may be found by clicking here.
The BIS report may be found by clicking here.
Andrew W. Sutton, MBA
Chief Market Strategist
Sutton & Associates, LLC