How To Avoid Brokerage Firm Failures

I first wrote in this post November, 2011 about a problem with brokerage firm failures. I think during times when there is no news like this is a good time to rethink the quality of one’s brokerage. Just how good is SIPC insurance? How good are the private insurance contracts that brokers also use? Remember the Enron crisis was facilitated by a brand name big four CPA auditor. Many of the monoline private mortgage insurance companies that insured mortgages went bankrupt during the great 2008-09 crash making guarantees useless. The question about how can one be certain of anything reminds me of the quote in Nasim Taleb’s book “Fooled by Randomness” he asked “how does anyone one know anything?”. What he meant was how can one find a reliable benchmark by which to judge the truthfulness of something.

It is tempting to think perhaps all one can trust is using a shovel to bury gold in the backyard but that is absurd. Instead one must try and study what caused catastrophic failures in financial companies and what are the fingerprints that are evidence of a new hidden risk. Perhaps the more conservative a vendor is in making claims about their service or rate of return the greater the probability that the vendor is honest.

People are asking “how to protect yourself from what happened to MF Global?” What are the implications of MF Global bankruptcy? MF Global had a $650 million dollar bank account that “disappeared” in an industry that has six overlapping regulators and which requires strict application of accounting rules. People want to know regarding MF Global bankruptcy how does it affect a margin account? What about bank accounting gimmicks?

Bank accounting gimmicks are where a bank can elect to mark the value of bad loan assets at the original purchase price and thus refuse to recognize the drop in value. This was authorized by a change in the law in 2009 in the hopes that if banks could pretend that bad loans had not gone bad then somehow the economy would get better. This is like a financial planner hypnotizing a client who has too much debt into believing that somehow the debt has magically gone away in the hope that having a positive attitude will somehow make a physical reality fade away. It is important to mark down the value of a bad loan asset because banks are leveraged 12 to 1 which is a lot more leverage than a hedge fund. Also banks don’t use Put options on loans but hedge funds are supposed to, so banks are really overleveraged hedge funds. The proper way to loan money to hedge fund is to monitor the assets in real time and demand margin calls when the assets go down. However with the bank’s getting a special la passed that allows them to elect to “mark to model” instead of “mark to market” banks can avoid booking a loss and thus pretend to stay solvent.

There is a conflict of interest that corrupts the judgment of some people. That is that the government would have such huge bailout costs that they have a conflict of interest that makes them want to cover up bank losses with legislative approval of unjust mark to model accounting. Brokerage firms have set up a bank subsidiary and funneled their bad loans into it and then used its special legal privileges to hide the bad loans in a mark to model accounting system.

The financial industries have so much leverage that can offer huge profits that this corrupts them into wanting to gamble with client’s money using 40 to 1 leverage, even though they might only allow a hedge fund to borrow from them at 4 to 1 leverage. To smooth out the fluctuations these companies need to hide asset price declines with clever bookkeeping.

The problem is the corporate culture of risk taking, extreme leverage, financial engineering and lobbying with regulators means that there is too much hidden risk in financial companies. So avoid leverage in your own investments, avoid working with or investing in, or holding assets inside of excessively leveraged companies. Check the rating agencies’ ratings of the financial companies that you want to work with. Read the financial companies financial statements and see what financial companies are consistently profitable, have low debts, etc. A corporate culture of low leverage is a hint that they are cautious with their assets and fear risk. A corporate culture with high leverage (Bears Stearns and Lehman had 30:1, MF Global 40:1, Long Term Capital Management had 100:1) is accompany that will have higher probability of failure.

About the author

Don Martin, CFP®

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