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Trevor Timm of the Electronic Frontier Foundation dug up a very interesting nugget. It was embedded in the heralded December 2013 White House task force report on spying and snooping.
Under Recommendations, #31, section 2, he found this:
“Governments should not use their offensive cyber capabilities to change the amounts held in financial accounts or otherwise manipulate financial systems.”
Timm quite rightly wondered: why were these warnings in the report?
Were the authors just anticipating a possible crime? Or were they reflecting the fact that the NSA had already been engaging in the crime?
Those systems would, of course, include the stock market, and all trading markets around the world.
Well, there is definite evidence of other NSA financial snooping. From Spiegel Online, 9/15/13:
“The National Security Agency (NSA) widely monitors international payments, banking and credit card transactions, according to documents seen by SPIEGEL.”
“The NSA’s Tracfin data bank also contained data from the Brussels-based Society for Worldwide Interbank Financial Telecommunication (SWIFT), a network used by thousands of banks to send transaction information securely…the NSA spied on the organization on several levels, involving, among others, the [NSA] agency’s ‘tailored access operations’ division…”
The NSA’s “tailored access operations” division uses roughly 1000 hackers and analysts in its spying efforts.
The next step in all this spying would naturally involve penetrating trading markets and, using the deep data obtained, manipulate the markets to the advantage of the NSA and preferred clients.
The amount of money siphoned off in such an ongoing operation would be enormous.
“Looking over the shoulder” of Wall St. insiders would be child’s play for NSA.
Ditto for predicting political events that would temporarily drive markets down and provide golden opportunities for highly profitable short selling.
Like drug traffickers and other mobsters, the NSA could invest their ill-gotten gains in legitimate enterprises and reap additional rewards.
And if the Pentagon, under which the NSA is organized, requires heavy amounts of money for off-the-books black budget ops, what better place to go than their own NSA?
All in all, when you operate the biggest spying and data-gathering operation in the world, the opportunities abound. Yes, knowledge is power, when the distinctions between legal and illegal are brushed off like like a few gnats on a summer day.
Jon Rappoport is the author of two explosive collections, The Matrix Revealed and Exit From the Matrix, Jon was a candidate for a US Congressional seat in the 29th District of California. Nominated for a Pulitzer Prize, he has worked as an investigative reporter for 30 years, writing articles on politics, medicine, and health for CBS Healthwatch, LA Weekly, Spin Magazine, Stern, and other newspapers and magazines in the US and Europe. Jon has delivered lectures and seminars on global politics, health, logic, and creative power to audiences around the world. You can sign up for his free emails at www.nomorefakenews.com
In what has to be the most disappointing denial of central bank manipulation of a market in recent history, and probably never, the Bank of England today announced that it “has seen no evidence to back media allegations that it condoned or was aware of manipulation of reference rates in the foreign exchange market.” As a reminder, last week we reported, that according to a Bloomberg, “Bank of England officials told currency traders it wasn’t improper to share impending customer orders with counterparts at other firms” or, in other words, the highest monetary authority in England, and the oldest modern central bank, explicitly condoned and encouraged manipulation. Fast forward to today when Andrew Bailey, the Bank’s deputy governor and chief executive of the Bank’s Prudential Regulation Authority, told parliament’s Treasury Select Committee on Tuesday it had no evidence to suggest that bank officials in any sense condoned the manipulation of the rate-setting process. In other words, it very well may have… but there just is no evidence – obviously in keeping with the bank’s very strict “smoking manipulation gun document retention policy.”
Then again, such evidence already was presented to UK regulators: “Bloomberg News said on February 7 that the Bank officials told currency traders at the April 2012 meeting that it wasn’t improper to share impending customer orders with counterparts at other firms. A senior trader gave his notes from the meeting to the Financial Conduct Authority, Bloomberg said.”
Hence, Mr Bailey had to modestly revise his statement:
“I should say that we have no evidence yet, and we have not seen the evidence that was in the Bloomberg report,” he added.
He added that the Bank of England review was in close cooperation with the Financial Conduct Authority (FCA), which is also investigating broader allegations of manipulation in the foreign exchange markets.
Which obviously means that should the BOE never be “confronted” with the evidence, and it mysteriously “disappears”, it simply means that one of Mark Carney’s henchmen pulled a few levers at the FCA, and made it disappear: of course, on national security grounds, because should it surface that a central bank is merely a criminal organization, then faith and confidence in the Ponzi system might falter. It would also mean confirm what most people who care about these things know: when it comes to UK governance, the buck stops with Threadneedle. And not only there, but everywhere else too.
The rest of the report is trivial fluff and generic spin:
“The Bank does not condone any form of market manipulation in any context whatsoever,” Bailey told the lawmakers on Tuesday.
“On the evidence we have currently, we have no evidence to substantiate the claim that bank officials in any sense condoned or were informed of price manipulation or the sharing of confidential client information,” Bailey added.
“We’ve released the minutes of that meeting, but obviously there are now allegations that there are different versions of what happened at that meeting,” Bailey said.
Bailey said the claims, which the central bank first heard about last October, were being taken “very seriously” and a full review was now underway, led by the Bank’s internal legal counsel with support from an external counsel.
Perhaps just to confirm how serious the “review” is, Bailey should also release a few photos of the internal and external counsels operating the paper shredders with the passion of 2nd year Arthur Andersen intern.
JPMorgan Sued For Crony Justice – Presenting “A Decade of Illegal Conduct by JP Morgan Chase” | Zero Hedge
Earlier today, the non-profit organization Better Markets did what so many others have only dreamed of doing – they sued JPMorgan.
Specifically, as they disclose in the fact sheet posted on their website, they are “challenging the historic and unprecedented $13 billion settlement agreement between the U.S. Department of Justice and JP Morgan Chase (“Agreement”). Better Markets alleges in its complaint that the DOJ violated the Constitution and laws of the United States by using a mere contractual agreement to resolve claims of historic importance without subjecting the Agreement to independent judicial review. In effect, the DOJ acted as investigator, prosecutor, judge, jury, sentencer, and collector, without any check on its authority or actions, even though the amount is the largest in the 237 year history of the United States. Because the DOJ has declared its intention to use the Agreement as a “template” in future similar cases, it is imperative that the DOJ’s unlawful and secretive approach in the settlement process be subjected to judicial review.”
We wish them the best of luck, as in a “crony jsutice” system as corrupt as this one – perhaps best described, paradoxically enough by the fictional movie The International – where the same DOJ previously implicitly admitted it will not prosecute “systemically important” firms like JPM to the full extent of the law and instead merely lob one after another wrist slap at them to placate the peasantry, any hope for obtaining true justice is impossible.
That said, the key aspects of the Better Markets lawsuit deserve attention. They are broken down as follows:
For years leading up to the financial crisis of 2008, JP Morgan Chase allegedly engaged in pervasive fraud in the packaging and sale of thousands of mortgage-backed securities to investors. Those securities were stuffed with subprime loans that failed to meet applicable underwriting criteria. Employees, managers, and potentially high-level executives of JP Morgan Chase knew that the securities were riddled with toxic loans, but they allegedly concealed the truth from investors when they marketed and sold the securities. Investors lost huge but still unknown sums of money as a result of the fraud, and the bank’s illegal conduct contributed directly to the biggest financial crash since 1929 and the worst economy since the Great Depression of the 1930s.
After negotiating the Agreement in complete secrecy, the DOJ announced the $13 billion deal on November 19, 2013, claiming that it was holding JP Morgan Chase accountable for its illegal activities. Under the Agreement, DOJ grants JP Morgan Chase broad civil immunity in exchange for a $2 billion civil penalty, along with $4 billion in “consumer relief” for the benefit of homeowners with problem mortgages. The Agreement also allocates $7 billion to eight other agencies or states to resolve their claims against JP Morgan Chase.
Key Allegations in the Complaint
The Agreement was struck under the most extraordinary circumstances. For example—
- THE HISTORIC CLAIMS: The Agreement resolved claims of pervasive fraud that contributed to the worst financial crash since 1929 and the worst economy since the Great Depression of the 1930s.
- THE LARGEST AMOUNT EVER: The settlement amount was the largest in U.S. history from any single entity by more than 300%.
- THE BIGGEST BANK: JP Morgan Chase is the largest, richest, and most well-connected Wall Street bank in the United States.
- THE HIGHEST-LEVEL NEGOTIATORS: The Attorney General and other senior DOJ political appointees negotiated directly and entirely in secret with the CEO of JP Morgan Chase, someone who was considered a possible Treasury Secretary just a few years ago.
- THE $10 BILLION PHONE CALL: The cellphone of DOJ’s third highest ranking official rang with the “familiar” phone number of JP Morgan Chase’s CEO, who called to offer billions of dollars to stop DOJ from holding a press conference and filing a lawsuit in just a few hours. The call worked, and the press conference and lawsuit were both called off.
- THE UNPRECEDENTED AGREEMENT: DOJ gave complete civil immunity to JP Morgan Chase for defrauding thousands in exchange for $13 billion, via a contract that was negotiated and finalized in secret without any review or approval by a federal court.
?Notwithstanding the historic nature of the settlement, the Agreement was never subjected to judicial review, so there has been no independent evaluation of its terms. Furthermore, the vague settlement documents fail to disclose critically important information about every aspect of the deal. For example, the Agreement fails to identify or explain—
- THE LOSSES: How much did JP Morgan Chase’s clients, customers, counterparties, investors, and others lose as a result of its fraudulent conduct? $100 billion? $200 billion? More?
- THE PROFITS: How much revenue, profits, and other benefits did JP Morgan Chase receive as a result of its fraudulent conduct, and was it all disgorged? $10 billion? $20 billion? More?
- THE BONUSES: Who received what amount of bonuses for the illegal conduct?
- THE INVESTIGATION: What was the scope and thoroughness of the investigation that provided the basis for the Agreement?
- THE FRAUD: What are the material facts of the illegal conduct by JP Morgan Chase and the specific violations of law that were committed?
- THE CULPRITS: What exactly did the individual executives, officers, managers, and employees involved in the illegal conduct actually do to carry out the fraud, and do any of them still work for the bank?
- THE CORRECTIVE ACTION: Why did the contract fail to impose on JP Morgan Chase any obligation to change any of its business or compliance practices, which are standard conduct remedies that regulators routinely require? And how can the sanctions effectively punish and deter JP Morgan Chase, given its wealth and its extensive history of lawless conduct?
- THE LACK OF ADMISSIONS: Why are there no admissions of fact or law by JP Morgan Chase, and what, if any, are the concrete legal implications of their so-called “acknowledgment”?
By entering the Agreement without seeking any judicial review and approval, the DOJ violated the Constitution and laws of the United States.
- The Executive Branch, acting through the DOJ, violated the separation of powers doctrine by unilaterally striking a bargain with JP Morgan Chase to resolve unprecedented matters of historic importance, without seeking any judicial review and approval of the Agreement.
- The DOJ violated the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”) by failing to commence a civil action in federal court so that the court could, among other things, assess the civil penalty.
- The DOJ acted arbitrarily and capriciously by, among other things, entering the Agreement without seeking judicial review and approval.
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But perhaps the most informative aspect of the lawsuit fact sheet is simply stepping back and observing the relentless illegal transgressions by Jamie Dimon’s firm. Better Markets summarizes them best as follows:
Highlights From A Decade of Illegal Conduct by JP Morgan Chase
- United States v. JPMorgan Case Bank, NA, No-1:14-cr-7 (S.D.N.Y. Jan 8, 2014) ($1.7 billion criminal penalty); In re JPMorgan Chase Bank, N.A., OCC Admin. Proceeding No. AA-EC-13-109 (Jan. 7, 2014) ($350 million civil penalty); In re JPMorgan Chase Bank, N.A., Dept. of the Treasury Financial Crimes Enforcement Network Admin. Proceeding No. 2014-1 (Jan. 7, 2014) ($461 million civil penalty) (all for violations of law arising from the bank’s role in connection with Bernie Madoff’s Ponzi scheme, the largest in the history of the U.S.);
- In re JPMorgan Chase Bank, N.A., CFTC Admin. Proceeding No. 14-01 (Oct. 16, 2013) ($100 million civil penalty); In re JPMorgan Chase & Co., SEC Admin. Proceeding No. 3-15507 (Sept. 19, 2013) ($200 million civil penalty); In re JPMorgan Chase & Co., Federal Reserve Board Admin. Proceeding No. 13-031-CMP-HC (Sept. 18, 2013) ($200 million civil penalty); UK Financial Conduct Authority, Final Notice to JP Morgan Chase Bank, N.A. (Sept. 18, 2013) (£137.6 million ($221 million) penalty); In re JPMorgan Chase Bank, N.A., OCC Admin. Proceeding No. AA-EC-2013-75, #2013-140 (Sept. 17, 2013) ($300 million civil penalty) (all for violations of federal law in connection with the proprietary trading losses sustained by JP Morgan Chase in connection with the high risk derivatives bet referred to as the “London Whale”);
- In re JPMorgan Chase Bank, N.A., CFPB Admin. Proceeding No. 2013-CFPB-0007 (Sept. 19, 2013) ($20 million civil penalty and $309 million refund to customers); In re JPMorgan Chase Bank, N.A., OCC Admin. Proceeding No. AA-EC-2013-46 (Sept. 18, 2013) ($60 million civil penalty) (both for violations in connection with JP Morgan Chase’s billing practices and fraudulent sale of so-called Identity Protection Products to customers);
- In Re Make-Whole Payments and Related Bidding Strategies, FERC Admin. Proceeding Nos. IN11-8-000, IN13-5-000 (July 30, 2013) (civil penalty of $285 million and disgorgement of $125 million for energy market manipulation);
- SEC v. J.P. Morgan Sec. LLC, No. 12-cv-1862 (D.D.C. Jan. 7, 2013) ($301 million in civil penalties and disgorgement for improper conduct related to offerings of mortgage-backed securities);
- In re JPMorgan Chase Bank, N.A., CFTC Admin. Proceeding No. 12-37 (Sept. 27, 2012) ($600,000 civil penalty for violations of the Commodities Exchange Act relating to trading in excess of position limits);
- In re JPMorgan Chase Bank, N.A., CFTC Admin. Proceeding No. 12-17 (Apr. 4, 2012) ($20 million civil penalty for the unlawful handling of customer segregated funds relating to the bankruptcy of Lehman Brothers Holdings, Inc.);
- United States v. Bank of America, No. 12-cv-00361 (D.D.C. 2012) (for foreclosure and mortgage-loan servicing abuses during the Financial Crisis, with JP Morgan Chase paying $5.3 billion in monetary and consumer relief);
- In re JPMorgan Chase & Co., Federal Reserve Board Admin. Proceeding No. 12-009-CMP-HC (Feb. 9, 2012) ($275 million in monetary relief for unsafe and unsound practices in residential mortgage loan servicing and foreclosure processing);
- SEC v. J.P. Morgan Sec. LLC, No. 11-cv-03877 (D.N.J. July 7, 2011) ($51.2 million in civil penalties and disgorgement); In re JPMorgan Chase & Co., Federal Reserve Board Admin. Proceeding No. 11-081-WA/RB-HC (July 6, 2011) (compliance plan and corrective action requirements); In re JPMorgan Chase Bank, N.A., OCC Admin. Proceeding No. AA-EC-11-63 (July 6, 2011) ($22 million civil penalty) (all for anticompetitive practices in connection with municipal securities transactions);
- SEC v. J.P. Morgan Sec., LLC, No. 11-cv-4206 (S.D.N.Y. June 21, 2011) ($153.6 million in civil penalties and disgorgement for violations of the securities laws relating to misleading investors in connection with synthetic collateralized debt obligations);
- In re JPMorgan Chase Bank, N.A., OCC Admin. Proceeding No. AA-EC-11-15, #2011-050 (Apr. 13, 2011) (consent order mandating compliance plan and other corrective action resulting from unsafe and unsound mortgage servicing practices);
- In re J.P. Morgan Sec. Inc., SEC Admin. Proceeding No. 3-13673 (Nov. 4, 2009) ($25 million civil penalty for violations of the securities laws relating to the Jefferson County derivatives trading and bribery scandal);
- In re JP Morgan Chase & Co, Attorney General of the State of NY Investor Protection Bureau, Assurance of Discontinuance Pursuant to Exec. Law §63(15) (June 2, 2009) ($25 million civil penalty for misrepresenting risks associated with auction rate securities);
- In re JPMorgan Chase & Co., SEC Admin. Proceeding No. 3-13000 (Mar. 27, 2008) ($1.3 million civil disgorgement for violations of the securities laws relating to JPM’s role as asset-backed indenture trustee to certain special purpose vehicles);
- In re J.P. Morgan Sec. Inc., SEC Admin. Proceeding No. 3-11828 (Feb. 14, 2005) ($2.1 million in civil fines and penalties for violations of Securities Act record-keeping requirements); and
- SEC v. J.P. Morgan Securities Inc., 03-cv-2939 (WHP) (S.D.N.Y. Apr. 28, 2003) ($50 million in civil penalties and disgorgements as part of a global settlement for research analyst conflict of interests).
Did we mention that nobody from JPM has gone to prison, and instead as of late last week, one of the biggest JPM culprits was set to become a member of the CFTC’s advisory panel before the people and not the regulators, were forced to step in? Why? #AskJPM
Every time a TBTF bank releases its 10-Q, we head straight for the section, usually well over 100 pages in, that discloses the bank’s total profitable trading days.
This is what the most recent Bank of America 10-Q said on this topic:
The histogram below is a graphic depiction of trading volatility and illustrates the daily level of trading-related revenue for the three months ended September 30, 2013 compared to the three months ended June 30, 2013 and March 31, 2013. During the three months ended September 30, 2013, positive trading-related revenue was recorded for 97 percent, or 62 trading days, of which 69 percent (44 days) were daily trading gains of over $25 million and the largest loss was $21 million. These results can be compared to the three months ended June 30, 2013, where positive trading-related revenue was recorded for 89 percent, or 57 trading days, of which 67 percent (43 days) were daily trading gains of over $25 million and the largest loss was $54 million. During the three months ended March 31, 2013, positive trading-related revenue was recorded for 100 percent, or 60 trading days, of which 97 percent (58 days) were daily trading gains over $25 million.
In summary, so far in 2013, Bank of America lost money on 9 trading days out of a total 188.
Statistically, this result is absolutely ridiculous when one considers that the bulk of bank trading revenues are still in the form of prop positions disguised as “flow” trading to evade Volcker which means the only way a bank could make money with near uniform perfection is if it either i) consistently has inside information that it trades on or ii) it consistently front-runs its clients.
In related news, the only more absurd datapoint was JPMorgan’s announcement of how many trading day losses it had in the first nine months of 2013. For those who missed out succinct post on the matter, the answer was clear: zero. The absurdity becomes even clearer when one considers that in the pre-New Normal days, JPM had an almost normal profit/loss distribution in its trading days.
But back to Bank of America, where as we noted, the kind of trading result would only be possible if the bank was aggressively insider trading or just as aggressively frontrunning flow orders in its prop book (a topic we covered back in 2009 as relates to Goldman Sachs, and which the bank sternly rejected).
We now know that at least one of the two almost certainly happened after Reuters report from earlier today that it discovered on the FINRA BrokerCheck page of one of the bank’s former Managing Directors, Eric Beckwith, the following curious ongoing investigation:
WE UNDERSTAND THAT THE USAO (US Attorney Office) -WDNC IS INVESTIGATING WHETHER IT WAS PROPER FOR THE SWAPS DESK TO EXECUTE FUTURES TRADES PRIOR TO THE DESK’S EXECUTION OF BLOCK FUTURE TRADES ON BEHALF OF COUNTERPARTIES, AND WHETHER MR. BECKWITH PROVIDED ACCURATE INFORMATION TO THE CME IN CONNECTION WITH THE CME’S INVESTIGATION OF THE SWAPS DESK’S BLOCK FUTURES TRADING. WE ALSO UNDERSTAND THAT THE COMMODITY FUTURES TRADING COMMISSION IS CONDUCTING A PARALLEL INVESTIGATION INTO THE TRADING ISSUE.
More from Reuters:
The U.S. Department of Justice and the Commodity Futures Trading Commission have both held investigations into whether Bank of America engaged in improper trading by doing its own futures trades ahead of executing large orders for clients, according to a regulatory filing.
The June 2013 disclosure, which Reuters recently reviewed on a website run by the securities industry regulator FINRA, sheds light on the basis for a warning by the Federal Bureau of Investigation on January 8.
The warning, in the form of an intelligence bulletin to regulators and security officers at financial services firms, said that the FBI suspected swaps traders at an unnamed U.S. bank and an unnamed Canadian bank may have been involved in market manipulation and front running of orders from U.S. government-owned mortgage giants Fannie Mae and Freddie Mac.
Only this time it’s different, because a quick check on the background of Beckwith shows that his expertise is not trading MBS but a different product entirely.
First, it goes without saying that Eric would promptly scrap his LinkedIn Profile as the following URL shows.
What Eric, however, was unable to delete was the mention of his name as the Bank of America contact for an “innovative new product created [by the CME and the banks] based on client demand” –Deliverable Interest Rate Swaps Futures, or as some call them Deliverable Interest Rate Products.
What is this newly promoted product, and why is there demand for it? This is what the CME had to say about the benefits of “DIRPs” (even though the technical acronyms is DSFs):
- Capital efficient way to access interest rate swap exposure
- Flexible execution via CME Globex, Block trades, EFRPs and Open Outcry
- Allows participants to trade in an OTC manner:
- Ability to block calendar spreads
- Lower block thresholds and longer reporting times
- No block surcharges
But, as in the case of CDS, and all other novel products, the main reason for DIRPs is simple: an even lower margin requirement compared to Interest Rate Swaps and Treasury Futures (margined together), allowing one to express a position, or better, manipulate the market in Interest Rate products, using the least amount of margin (initial capital) possible.
The following chart explains just this:
Bottom line: if you want to manipulate Treasurys in a reflexive market, where the derivatve almost always drives the price of the underlying (as perhaps explained best by none other than the then-member of the Fed Dino Kos), this is the best product as you get even more firepower for your buck.
Only in this case, anyone trading with the Bank of America DIRPs desk was apparently also being frontrun on a consistent basis.
We are relatively comfortable with alleging that BofA did indeed allow this to happen (whether it neither admits nor denies guilt at the end of the day), because a few weeks after the notice appears in Beckwith’s Brokercheck profile on June 14,2013, he promptly “left” Bank of America in July as Reuters reports: not exactly the course of action an innocent man would take.
In other words, while Reuters is focused on the Fannie and Freddie frontrunning angle, it appears the frontrunning activity spread substantially to involve the entire Treasury curve as well!
So while HFTs frontrun all equity retail trades in open markets, major banks frontrun all institutional block equity orders in their own dark pools, we find out that bankers also just happen to frontrun clients in “you name it” over the counter product, where the only reason to be involved is to take advantage of the low margin – something JPM’s CIO did quite aggressively and quite well until it blew up of course.
But the best news: we finally know how it is possible that every bank reports quarter after quarter of near uniform trading perfection and close to zero trading day losses.
Finally, our question for the regulators: in a Volcker world in which banks are supposedly not allowed to trade ahead of their clients, why are banks, well, trading ahead of their clients!?
* * *
Appendix 1 – the CMEs overview of Deliverable IR Swap Futures
Appendix 2 – Eric Beckwith’s Brokercheck profile
Last week we were the first to raise the very real and imminent threat of a default for a Chinese wealth management product (WMP) default – specifically China Credit Trust’s Credit Equals Gold #1 (CEQ1) – and its potential contagion concerns. It seems BofAML is now beginning to get concerned, noting that over 60% of market participants expects repo rates to rise if a trust product defaults and based on the analysis below, they think there is a high probability for CEQ1 to default on 31 January, i.e. no full redemption of principal and back-coupon on the day. Crucially, with the stratospheric leverage ratios now engaged in such products, BofAML warns trust companies must answer some serious questions: will they stand back behind every trust investment or will they have to default on some or potentially many of them? BofAML believes the question needs an answer because investors and Trusts can’t have their cake and eat it too. The potential first default, even if it’s not CEQ1 on 1/31, would be important based on the experience of what happened to the US and Europe; the market has tended to underestimate the initial event.
For those who have forgotten, below is a quick schematic of what a WMP looks like:
And as we previously noted,
…borrowers are facing rising pressures for loan repayments in an environment of overcapacity and unprofitable investments. Unable to generate cash to service their loans, they have to turn to the shadow-banking sector for credit and avoid default. The result is an explosive growth of the size of the shadow-banking sector (now conservatively estimated to account for 20-30 percent of GDP).
Understandably, the PBOC does not look upon the shadow banking sector favorably. Since shadow-banking sector gets its short-term liquidity mainly through interbanking loans, the PBOC thought that it could put a painful squeeze on this sector through reducing liquidity. Apparently, the PBOC underestimated the effects of its measure. Largely because Chinese borrowers tend to cross-guarantee each other’s debt, squeezing even a relatively small number of borrowers could produce a cascade of default. The reaction in the credit market was thus almost instant and frightening. Borrowers facing imminent default are willing to borrow at any rate while banks with money are unwilling to loan it out no matter how attractive the terms are.
Should this situation continue, China’s real economy would suffer a nasty shock. Chain default would produce a paralyzing effect on economic activities even though there is no run on the banks. Clearly, this is not a prospect the CCP’s top leadership relishes.
So the PBOC’s efforts are merely exacerbating the situation for the worst companies… and as BofAML notes below, this is a major problem…
The 3bn CNY Beast Knocking
via BofAML’s Bin Gao
CNY stands for the currency, and also a beast
CNY represents China’s official currency. It also stands for Chinese New Year, the biggest holiday for the country and the occasion for family reunions and celebration. But less familiar for many, however, the Year (?) itself actually stood for a beast which comes out every 365 days and eats everything along the way from bugs to humans. The holiday tradition started as a way for people to fend off the beast by getting together and lighting up the firecrackers.
At the same time, custom dictated that people also to paid their due to avoid becoming the beast’s target. In particular, it has been a tradition to settle all debt before the New Year. From the perspective of such folk culture, the trust product Credit Equals Gold #1, referred as CEQ1 hereafter, by China Credit Trust planned poorly for having the maturing date on the New Year, leaving a 3bn CNY beast running wild.
High probability for the trust product to default
Though the term default is used quite frequently, there are actually confusions on what constitutes a default in this case when talking to investors and especially onshore investment professionals. To simplify the issue, we define a default as failing to pay the promised contractual amount on time.
The product, CEQ1, is straightforward. It is CNY3.03bn financing with senior tranches of CNY3bn and junior tranche of CNY30mn. In principle, the senior tranches are also equity investment, but the junior tranche holder pledged assets for repurchasing senior investment at a premium. The promised rate was indexed to PBoC’s deposit rate with a floor for three classes of senior tranches at 9.5%, 10% and 11%, paid annually (detailed structure is illustrated below).
In a sense, the product is in technical default already. The last coupon payment in December, with nearly all the money (CNY80mn) left in the trust account, came in at only 2.7%, falling far short of the promised yield. The bigger trouble is the CNY3bn principal payment, along with the delinquent coupon, on 31 January.
We see high probability of default on 31 January
Political or economic consideration: ultimately, given the government’s strong grip on financial institutions, default may be a political decision as much as an economic decision. From that perspective, CEQ1 would be a good candidate for default. The minimum investment in CEQ1 is CNY3mn, much more than the typical amount required for other trust investment and 75 times of per capita GDP in China. If defaults were to be used to send a warning signal to shadow banking investors, this group of rich investors may have been a good target because the government does not need to worry too much of them demonstrating in front of government offices.
Timing: there is never a good timing for deleverage because of risks involved. But the current job market situation provides a solid buffer should defaults and subsequent credit contraction slow down the economy growth. The government planned 9mn jobs last year; instead it has created more than 12mn by November. So the system could withstand a potential shock.
Financial capability: China Credit Trust has a bit over CNY10bn net assets, which some analysts cite as evidence of the trust company’s capability to fully redeem the product first and recover from the collateral asset later. However, the assets might not be liquid enough, so the net asset is not the best measure. Based on its 2012 annual report, the company has liquid asset of CNY3bn and short-term liability of CNY1.35bn, leaving liquid accessible fund of CNY1.65bn at most. ICBC for certain has much deeper pocket, but it has declared that it won’t be taking major responsibility.
Career concern: To certain extent, the timing was unfavorable for another reason, the ongoing anti-corruption campaign. It is reported that there are around 700 investors involved. On CNY3bn senior tranche investment, it averages CNY4.3mn per investor. We do not know the exact identity but with CNY3mn entry point, we know no one is a small-scale investor. Legally unjustified, if either China Credit Trust or ICBC decided to pay 100% with their capital, the decision maker would have to ensure that he does not have any business deals with any of the 700. Because if he does, his career or even his freedom could be in jeopardy in the current environment of ongoing anti-corruption campaign and strict scrutiny of shady deals/personal favors.
Questionable asset quality and uncertain contingent claim: There are cases in the past of near default, but most of them involved collateral of real estate assets, which have at least appreciated over the years. The appreciation of collateral assets makes it easier for the third party to step in by paying back investors and taking over the collateral assets. This particular product involves coal-mining assets whose value has been decreasing over the last couple of years. Moreover, there have been multiple claimants on these assets, as exemplified by the sale of Yangjiagu coal mine. Although the mine was 51% pledged through two levels of ownership structure, only 20% of the sales proceed accrued to trust investors (Exhibit 1 above). Such a low percentage would be a deterrence and concern to whoever contemplating a takeover of the collateral assets.
Other cases less relevant: In the past, one way to deal with the issue was for banks to lend to shareholders of the existing collateral asset owners for them to payback investors, with explicit or implicit local government guarantees. Shangdong Hailong’s potential default on bond was avoided this way last year. However, in the current case, the owner has been arrested for illegal fund raising, making the past precedence less applicable.
Putting all the above reasons together, we think there is a high probability for CEQ1 to default on 31 January, i.e. no full redemption of principal and backcoupon on the day.
Immediate impact would be for China rates curve to flatten
The case has been widely covered in the media. However, many still believe one way or the other the involved parties will find a last minute solution to fully redeem the maturing debt. So if the trust is not paid, we believe it will be a big shock to the market.
China rates market reaction, however, might not be straightforward. On the one hand, default would likely lead to risk-averse behavior, arguing for lower rates. On the other hand, market players would likely hoard cash in such an event, leading to tighter liquidity condition and pushing money rates higher.
We think that both movements are likely to ensue initially, meaning higher repo/SHIBOR rates and lower CGB yield if default were to realize. We suggest positioning likewise by paying 1y IRS and long 5y CGB. On the swap curve itself, we think the immediate reflection will be a bear flattening move.
Interestingly, an informal survey conducted on WeChat among finance professionals suggests the same kind of repo rate reaction (Chart 1). We think this survey is important because we believe these investment professionals will likely behave accordingly because the default event is not priced in and hard to hedge a priori.
Trust company can’t have their cake and eat it too
Of course, we can’t rule out that the involved parties do find a solution to avoid default. However, with a case as clear cut to us as this one favoring default, we believe such outcome would send a strong signal to investors that the best investment is to buy the worst credit.
Thus, we believe the near term market reaction with no default would be for the AA credit to shine brightly since this segment has been under pressure for quite some time. Trust investment would be met with enthusiasm and trust assets would likely expand further.
However, we see a fundamental problem in the industry; the leverage ratio has gone to a level which requires investors and trust companies to answer some serious questions: will trust company stand back behind every trust investment or will trust company have to default on some or potentially many of them? We believe the question needs an answer because the trust companies can’t have their cake and eat it too.
For the industry, the AUM/equity ratio has nearly doubled from 23 to 43 in less than three years during the period of 4Q2010 to 3Q2013 (Chart 2). Some in the industry has argued that one should only count the collective trusts since other trusts are originated by non-trust players like banks. Thus, trust companies have no responsibility for paying investors other than collective trusts.
We see two problems.
Even if we accept the trust companies’ argument, it is still questionable whether trust companies would be able to pay even a reasonable amount of default. The growth of leverage on collective trusts was much more aggressive. Collective trust AUM/equity ratio was 2.7 in 1Q2010 and 4.7 in 4Q2010 (Chart 2). It rose to 10 by 3Q2013, more than doubled in less than three years and more than tripled in less than four years. Along the way, the average provision has dropped from 84bp to 34bp when measured against collective AUM.
As the case of CEQ1 illustrates, as long as full redemption is on the table, no involved party could walk away totally clean. CEQ1 is a case of collective trust, but the ICBC still faces the pressure to pay. If the bank is being pressured to pay in the case of collective trust default, trust companies will likely be pressured to pay as well should some non-collective trusts get into trouble. If trust companies are on the line for the total AUM, their financial condition is even shakier, with average provision covering barely 7bp of total AUM as of 3Q2013.
On longer term market trend
Based on the analysis in the above section, we see a possibility for trust companies to have to let some trust products default with such high leverage and so few provisions. This is especially likely the case given that there will be more and more trust redemption this year and next year as a result of the fast expansion of this industry over the last couple of years and short duration of such products.
The heaviest redemption in collective trusts this year will arrive in the 2Q (Chart 3). Given that the financial system is stretched thin and there were more cases of near defaults on smaller amount of redemption last year (three cases in December alone), we believe some form of default is almost inevitable in the near term.
The potential first default, even if it’s not CEQ1 on 31 JANUARY, would be important based on the experience of what happened to the US and Europe; the market has tended to underestimate the initial event. Over the last year, China appeared to be mirroring what happened in the US during 2007, the spike of money rate (much higher repo/SHIBOR), the steepening of money curve (14d money much more expensive than overnight and 7d), and small accidents here and there (junior tranches of a few wealth management products offered by Haitong Securities losing more than 60%, a few small trusts and now CEQ1’s redemption difficulty).
Theoretically, China’s risk is best expressed using a China related instrument, but we also think the more liquid expression of China goes through the south pacific. The following points list our longer views on China and Australia rates.
- We have liked using Australia rates lower as a way to express our China concern and we continue recommending doing so as a theme.
- We recommend long CGB and underweight credit product. The risk for such positioning in the near term is no CEQ1 default. But we believe any pain suffered due to overt market manipulation to avoid default will be short lived since it has become much harder to keep the debt-heavy system in balance and the credit spread is bound to widen.
- After a brief flattening on CEQ1 default, we see swap curve steepening as being more likely on more default threatening growth leading to easy monetary policy and more issuance going to the bond market.
- We look for higher CCS rates due to the fact that the currency forward will more likely start expressing the risk.
“There is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.”
The “eerie resemblances” – as Soros previously noted – to the US in 2008 have profound consequences for China and the world – nowhere is that more dangerously exposed (just as in the US) than in the Chinese shadow banking sector.
- More Market Manipulation: Wall Street Out of Control (senseoncents.com)
- JPMorgan Accused obstructing regulators -Market Manipulation (12160.info)
- EU Accuses 13 Investment Banks of Hampering CDS Competition (bloomberg.com)
- Barclays, traders fined US$488M amid U.S. energy probe (business.financialpost.com)
- Is Libor Now Beyond Manipulation? (blogs.wsj.com)