Refco and Financial Derivatives Market Meltdown.

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ACCOUNTING SCANDAL
Wall Street braces for Refco fallout
Lawsuits loom, delisting sought as bankruptcy filing comes two months after broker's IPO
By SHAWN MCCARTHY
Globe and Mail - Wednesday, October 19, 2005 Page B12

NEW YORK -- Just two months after going public in a successful share offering, commodities and futures broker Refco Inc. has crashed to earth in Wall Street's latest corporate scandal.

With its former chairman charged with fraud and its underwriters facing the threat of lawsuits, Refco announced Monday night that it was seeking bankruptcy protection and had agreed to sell its core brokerage business for $768-million (U.S.)

The debacle poses significant financial risk to leading Wall Street firms that underwrote the initial public offering, as well as the Boston-based private equity firm, Thomas H. Lee Partners LP, which bought a controlling share of Refco last year for $507-million (U.S.).

In the deal announced late Monday, a group of investors, led by J.C. Flowers & Co. LLC, hope to salvage Refco's core brokerage operations, but will first have to gain court approval.
Christopher Flowers, a former Goldman Sachs Group partner who is leading the buyout, said Refco's main business operations remain viable, despite the damage to the corporate holding company.

…In August, Refco went public with a share offering that raised $583-million (U.S.) at a price of $22 a share. Within a few weeks, the company was trading at $30.55 a share, and its chairman, Phillip Bennett, was promising glory days to come.

Then, last Monday, Refco announced Mr. Bennett was suspended over allegations of dubious related-party transactions that were not disclosed to investors.

Two days later, the U.S. Attorney for Southern Manhattan charged Mr. Bennett with securities fraud, a charge that could land him in jail for up to 20 years. On Thursday, the New York Stock Exchange halted trading in Refco stock, which had plunged 72 per cent to $7.80 (U.S.), wiping out $1-billion in market value. Yesterday, the NYSE moved to delist the company.

According to federal prosecutors, Mr. Bennett hid from investors certain related-party transactions that were used to cover up a debt of more than $430-million owed to Refco by a company controlled by Mr. Bennett.

Refco entered a series of deals throughout 2004 and early 2005 that appeared to be timed to move the debt owed by Mr. Bennett off the company books for purposes of financial reporting.

The fallout from Refco's collapse is reverberating through the financial system. The Securities and Exchange Commission is investigating the collapse, and there were reports yesterday that it had broadened its inquiry to include other senior executives at the firms.

The SEC is also looking into the role of Refco auditor, Grant Thornton LLP of Chicago, which failed to report the quarterly financial deals between Refco and the related companies that led to the company's implosion.

Though its auditors did warn that Refco was lacking adequate financial controls, Grant Thornton has said it too was the victim of a fraud perpetrated by Refco, arguing that outside auditors cannot be expected to catch a well-planned, well-hidden fraud.


…Refco unravels

A week after its CEO was suspended in a financial scandal, commodities broker Refco Inc. files for bankruptcy protection and agrees to be bought.


Seven days at Refco

Oct. 10: Refco announces that CEO Phillip Bennett has been put on an indefinite leave of absence after the company discovered that an investment fund Mr. Bennett controlled owed Refco $430-million (U.S.). Refco says Mr. Bennett has since repaid the money but that its earnings reports dating to 2002 will have to be revisited. The company's shares drop 45 per cent.Oct. 11: The SEC launches an inquiry into the situation at Refco.

Oct. 12: Mr. Bennett is arrested and charged by federal prosecutors with securities fraud. Bail is set at $50-million, and Mr. Bennett faces up to 20 years in prison if convicted.

Oct. 13: Refco decides to temporarily shut down one of its key units, Refco Capital Markets Ltd., because of lack of liquidity. Refco's share price is halted on the NYSE at $7.90, and the price of the company's bonds plunges.

Oct. 17: Refco files for bankruptcy and agrees to sell its regulated futures brokerage business to a group of investors led by hedge fund J.C. Flowers & Co. The deal gives the brokerage firm the choice of an all-cash payment worth about $770-million, or the option of retaining a 20-per-cent interest in the business and also receiving a cash payment.


The stock

Refco went public on Aug. 11. Its stock surged 25 per cent to more than $27 on the first day. Before the shares were suspended last week, they traded at $7.90. Shares trade over the counter yesterday at 65¢.


The suspended CEO

The lawyer for Mr. Bennett, 57, says he will fight the criminal charges. Bennett is a U.K. native who played rugby at Cambridge. A banker -- not a trader -- by background, Mr. Bennett led Refco on a global acquisition spree that formed the biggest independent futures broker. Before joining Refco in 1981, he worked in Toronto, London and Brussels for Chase Manhattan Bank.


The allegations

A criminal complaint filed against Mr. Bennett, suspended as CEO last week, alleges he used Refco Capital Markets to hide $430-million in bad debt.


The company

Refco began trading agricultural commodities in 1969 and gradually diversified into foreign exchange, fixed- income products and asset management. It operates in 14 countries and 16 cities worldwide.
The future

Private buyout company J.C. Flowers & Co. is in talks to buy Refco's futures-commodities business, which operates through a handful of subsidiaries, for $768-million.
SOURCE: WALL STREET JOURNAL


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Quote from southamerica:

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October 17, 2005

SouthAmerica: Fortune magazine issue dated March 7, 1994 had an excellent article: "The Risk that Won't Go Away,” payments.
More...

from 1994? Oh well, a stopped clock is right at least twice a day.


My article from 2005: In year 3492 I predict oil will run out.
 
Refco may not be the domino that starts the avalanche but derivatives are scary indeed. Leeson destroyed Barings bank, Barings was the oldest merchant bank in the world, and they were big. It bothers me that hundreds of years of success could be wiped out by over leveraging and a trader that was too smart by half. Leverage is scary, it is definitely what made 1929 so bad, there was more $ lost in 1929 in the markets than all the money in circulation in the US. I really don't dwell on the negatives much but it seems inevitable that leverage leads to collapse eventually.
 
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Toronto Trder2: from 1994? Oh well, a stopped clock is right at least twice a day.
My article from 2005: In year 3492 I predict oil will run out.


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SouthAmerica: Yes, Carol Loomis wrote that article on Furtune magazine in 1994 to put the spotlight on an area of global investment that might become a problem in the future. Today, that potential problem might be 100 times bigger – if in 1994 that was a little problem today eleven years later the problem might be of a humongous scale.


*****


maxpi: Leverage is scary, it is definitely what made 1929 so bad, there was more $ lost in 1929 in the markets than all the money in circulation in the US. I really don't dwell on the negatives much but it seems inevitable that leverage leads to collapse eventually.


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SouthAmerica: I want to remind you of a major difference between 1929 and today - in 2005, it is estimated that we must be approaching a historical point in which 75 percent of the US dollars ever created circulates outside of the United States

In May 2003 I wrote the following on one of my published articles:

“The long-term US trade imbalances have created a large pool of US Dollars in the hands of relatively few central banks around the world. These nations continue to run large trade surpluses with the United States, and they continue to increase the pool of US Dollars held by their central banks.

Forbes Magazine's columnist/economist Steve Hanke estimates that today 70 % of US currency circulates outside the United States. The major holders of this currency are the Euro countries, Japan, China, Hong Kong, Taiwan, South Korea, Indonesia, and Singapore. Probably today, there is an oversupply of US Dollars outside of the United States.”

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This oversupply of US dollars in the hands of foreigners – not only it does put the US economy in a very vulnerable position, but it is a prescription for disaster in the future.

Today, Americans are in a position that probably: they are not masters of even their own currency.

When the “Derivatives Market” blow up the US Federal Reserve will be able to do very little because of the size of that international market today.

And just God knows what will happen to the value of the US dollar.


*******


SouthAmerica: On October 29, 2004 I posted this information on the “PBS” message board at the time of the 75 birthday of the stock market crash of 1929, and I noticed that there were very little mention of that event in any program on American television – on regular and on cable – and that says volumes since American television usually beat to death any minor event, and they make programs about any little thing.

But regarding the 75 birthday of the stock market crash of 1929, just to be in the safe side, the American media did not say much last year about the stock market crash of 1929. The American media are aware of the precarious situation of the entire American economic system, but nobody knows what will trigger the collapse of the house of cards.

Here is why the coming depression is a sure bet. I like to quote some information from one of mine published books as follows: (Quoting from pg. 21 – “JBAS The Greatest Man in Brazilian History”)


"Unrealistic Expectations.

There is much evidence that human expectations tend to be linear. Most of the time, most people expect current conditions to continue for the indefinite future. It is almost an unnatural act for a man to leave home with an umbrella on a sunny day. Call it optimism, faith in the future, or just reluctance to see the party end, there is a presumption that the environment is stable. This is why cities are built on floodplains and fault lines. A similar presumption makes the gambler double his bet or the farmer plant additional crops on reclaimed land the year after a good harvest. Whenever prosperity exists, it is natural for people to expect prosperity to continue. For this reason, much of the history of human society is a record of astonishment. Time and again, people have marginalized their affairs, rendering themselves increasingly crisis-prone.

They have gone into debt, extending claims on resources to an extreme that could be supported only if current conditions were sustained uninterrupted into the future. Time and again these hopes have been disappointed. Whenever prosperity has seemed permanent, some apparently minute change could produce astonishingly large nonlinear shifts in the organization of human society. The failure to recognize or anticipate these nonlinear transformations has been a common characteristic of almost all societies.

…When the dynamic and nonlinear world adjusts itself to the linear thinking used daily by governments and other institutions such as corporations, banks, insurance companies, the church, and so on, the result can be sometimes catastrophic and can translate into unemployment, inflation, monetary devaluations, market crashes, world wars, civil wars, depressions, and even chaos.

…Change is a fact of life, yet many people don't want to think about it because they feel threatened by it. So when change comes, it takes them by surprise. By then they can only react to it, and unless they're lucky, they suffer losses."


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Quote from maxpi:

Refco may not be the domino that starts the avalanche but derivatives are scary indeed. Leeson destroyed Barings bank, Barings was the oldest merchant bank in the world, and they were big. It bothers me that hundreds of years of success could be wiped out by over leveraging and a trader that was too smart by half. Leverage is scary, it is definitely what made 1929 so bad, there was more $ lost in 1929 in the markets than all the money in circulation in the US. I really don't dwell on the negatives much but it seems inevitable that leverage leads to collapse eventually.
More...

with all due respect, the 2 are very different.

barings broke because they didnt understand the risk they were undertaking via leeson. they failed to understand derivatives v cash. ie ignorance.

refco busted because of the greed of a handful of people, thinking they could sneak this and that without getting caught. ie fraud.
 
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SouthAmerica: Carol Loomis wrote that article on “Fortune” magazine in 1994, and not Furtune magazine.


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FredBloggs: with all due respect, the 2 are very different.
Barings broke because they didn’t understand the risk they were undertaking via Leeson. they failed to understand derivatives v cash. ie ignorance.

Refco busted because of the greed of a handful of people, thinking they could sneak this and that without getting caught. ie fraud.


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SouthAmerica: It does not matter how a company or Banking House fails – Ignorance or Fraud – the result can be catastrophic to the parties in the other side of the deals when they are not able to collect moneys that are due to them. If they don’t get paid and they don’t have the capital to eat the loss they also become victims of the entire fiasco. They can start a chain reaction of defaults down the line.

Here is another example of a derivatives default.


Financial Times of London – December 3, 2004
Story from front page of the FT

Aviation oil group stake sold ‘to cover derivative losses.’

China Aviation and Oil (CAO)

…On Wednesday CAO, which imports nearly all of the jet fuel used by Chinese airlines, announced it had sought court protection after losing $ 550 million dollars on oil derivatives.

The scandal at CAO is the biggest to hit Singapore since $ 1.2 billion of losses incurred by Nick Laeson, the Singapore-based foreign currency trader, brought down Barings, the British bank, in 1995.



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August 13, 2007

SouthAmerica: The amount of money that Central Banks are throwing at the world markets to calm it down signals that the global financial problem is much bigger than most people are aware of right now.

The good news is that most people have no idea how the derivatives market operates and the size of that market.

By the amounts of money that central banks are throwing at the market right now it seems to me that probably the derivatives market must also be getting out of control.

If that is the case then there is one major strategy left for all the Central Banks from around the world – “just start praying and hope for the best.”

We discussed the derivatives market on this thread and also on the following thread:

Derivatives Market - Warren Buffett has the right idea.
http://www.elitetrader.com/vb/showthread.php?s=&threadid=61266


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September 17, 2008

SouthAmerica: About 3 years ago I wrote the following on this forum about the derivatives market:

Financial Derivatives Market Meltdown
http://www.elitetrader.com/vb/showthread.php?s=&threadid=57218


I guess right now the big monster is spinning completely out of control and it is too late to stop the financial system from a massive implosion and creating out of sight financial losses throughout the financial system.

The good news is that nobody has a clue on how to stop this massive derivatives market meltdown since this 63 trillion dollars global market is unregulated and has been in automatic-pilot for many years.

Now let Wall Street commemorate the lack of regulation on the derivatives market by letting them eat their losses or even go out of business because of their lack of good judgment.


*******


Here is some more info about the derivatives market and also about another subject the end of the road for the US dollar.


Derivatives Market - Warren Buffett has the right idea
http://www.elitetrader.com/vb/showthread.php?s=&threadid=61266


Derivatives Meltdown
http://www.elitetrader.com/vb/showthread.php?s=&threadid=54638


The Big Meltdown - Column on NYT By Paul Krugman
http://www.elitetrader.com/vb/showthread.php?s=&threadid=88707


The New United States Currency - The New US Dollar
http://www.elitetrader.com/vb/showthread.php?s=&threadid=86842


The "New Asian Currency" - similar to the Euro
http://www.elitetrader.com/vb/showthread.php?s=&threadid=68758

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October 6, 2008

SouthAmerica: On 10-17-05 I posted the following on this forum:

“The point of my posting is that I would like to see Fortune magazine’s Carol J. Loomis write an article updating her article from 11 years ago.

Most people it doesn’t realize, but the global derivatives market is on automatic pilot – the plane is flying very fast but to where?

Ms. Loomis has the understanding necessary to be able to write a very interesting article on that subject.

If it is not Refco, maybe will be something else that can trigger that derivatives meltdown.

Remember, the next stock market meltdown similar to the one in 1929, will start with a meltdown in the derivatives market, this time around – this is a market that is probably approaching the $ 150 trillion dollar mark today.”

http://www.elitetrader.com/vb/showthread.php?s=&threadid=57218&perpage=6&pagenumber=2


*****


I sent an email to Fortune magazine’s Carol J. Loomis exactly 3 years ago and she sent me a note saying: "thank you for the encouragement about writing a follow up article about the derivatives market on Fortune Magazine."

It took exactly 3 years, but finally the current issue of Fortune Magazine dated October 13, 2008 one of the feature stories on this issue is “The $ 55 Trillion Time Bomb” Will credit swaps blow up?

Quoting from this article: “The financial crisis has put a spotlight on the obscure world of credit default swaps – which trade in a vast, unregulated market that most people haven’t heard of and even fewer understand. Will this be the next disaster?

The article has a chart with a label “Is That Trillion With a “T”?”

The chart says: “the amount at stake in the CDS market is greater than the world’s annual economic output.”

1) Credit default swaps (CDS) outstanding is $ 54.6 trillion

2) World GDP is $ 54.3 trillion

3) Value of all stocks on the NYSE + U.S. GDP + U.S. National debt = $ 50.5 trillion

…CDS are no mere artist’s fancy. In just over a decade these privately traded derivatives contracts ballooned from nothing into a $ 54. 6 trillion market. CDS are the fastest- growing major type of financial derivatives. More important, they’ve played a critical role in the unfolding financial crisis. First, by ostensibly providing “insurance” on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble.”If CDS had been taken out of play, companies would’ve said, ‘I can’t get this [risk] off my books,’ “says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Commission. “If they couldn’t keep passing the risk down the line, those guys would’ve been stopped in their tracks. The ultimate assurance for issuing all this stuff was, ‘It’s insured.’”

Second, terror at the potential for a financial Ebola virus radiating out from a failing institution and infecting dozens or hundreds of other companies – all linked to one another by CDS and other instruments – was a major reason that regulators stepped in to bail out Bear Stearns and buy out AIG, whose calamitous descent itself was triggered by losses on its CDS contracts.

And the fear of a CDS catastrophe still haunts the markets. For starters, nobody knows how federal intervention might ripple through this chain of contracts. And meanwhile, as we’ll see, two fundamental aspects of the CDS market – that is unregulated, and that almost nothing is disclosed publicly – may be about to change. That adds even more uncertainty to the equation. “The big problem is that here are all these public companies – banks and corporations – and no one really knows what exposure they’ve got from the CDS contracts, “ says Frank Partnoy, a law professor at the University of San Diego and a former Morgan Stanley derivatives salesman who has been writing about the danger of CDS and their ilk for a decade. “The really scary part is that we don’t have a clue.”

…A CDS is just a contract: The “buyer” plunks down something that resembles a premium, and the “seller” agrees to make a specific payment if a particular event, such as a bond default, occurs.

…Because they’re contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you’ve got yourself a $ 5 million – or a $ 100 million – contract.

…There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation.

..There’s another big difference between trading CDS and casino gambling. When you put $ 10 on black 22, you’re pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off a lot of CDS, it will simply go out of business.

…This is not an academic concern. Wachovia and Citigroup are wrangling in court with a $ 50 million hedge fund located in the Channel Islands. The reason: A dispute over two $ 10 million credit default swaps covering some CDOs. The specifics of the spat aren’t important. What’s most revealing is that these massive banks put their faith in a Lilliputian fund (in an inaccessible jurisdiction) that was risking 40 % of its capital for just two CDS. Can anyone imagine that Citi would,say, insure its headquarters building with a thinly capitalized, unregulated, offshore entity?

That’s one element of what’s known as “counterparty risk.” Here’s another: In many cases, you don’t even know who has the other side of your bet. Parties to the contract can, and do, transfer their side of the contract to third parties.

…Settlement has been sloppy, confirms Jamie Cawley of IDX Capital, a firm that brokers trades between big banks…But even as recently as a year ago, Cawley says, so many trades were sitting around unfulfilled that “there were $ 1 trillion worth of swaps that were unsettled among counterparts.”


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September 29, 2008

SouthAmerica: I knew all along that this $ 700 billion dollar Wall Street bailout was a massive fraud inflicted on the American taxpayer and nothing else.

These scam artists are selling this bailout to rescue the real estate market when in fact it is a case of bait and switch these scoundrels are going to use the bailout money in an effort to stop the derivatives market from a nuclear explosion – now that this financial weapon of financial destruction has blown into pieces people want to clean up the mushroom financial cloud with a $ 700 billion dollar bailout.

The only problem is that just God knows how many trillions of US dollars are going to be necessary to clean up the mess from this derivatives nuclear explosion.

The $ 3 trillion dollars Hedge Funds market is in the middle of this derivatives nuclear explosion.

The right question that people should be asking right now is the following:

The explosion on the derivatives market is going to be contained as the explosions in Hiroshima and Nagasaki or this derivatives nuclear explosion was the new version of the H-bomb that is 1,000 times more powerful.

I believe that they are going to find out that the explosion of the derivatives market is the latest version of the nuclear device.

http://www.elitetrader.com/vb/showthread.php?s=&postid=2096076&highlight=hedge+funds#post2096076


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October 2, 2008

SouthAmerica: After watching Warren Buffett being interviewed on the Charlie Rose Show - I posted the following in the comments section of that TV show.

I just watched Charlie Rose interview Warren Buffet the richest man in the United States and he almost begged that Congress pass the Wall Street bailout.

Warren Buffet looked desperate about this Wall Street bailout, and he even suggested that Congress should give Treasure Secretary Paulson a blank check probably for him to use it trying to stop a meltdown in the derivatives market related to the tsunami of redemptions that is affecting the $ 3 trillion dollar Hedge Fund industry and these guys are loaded with all kinds of derivatives instruments – that is why Secretary Paulson want the authority to buy any type of financial instruments since he already placed the orders to buy $ 700 billion dollars of toxic derivatives that just God knows if these instruments are already completely worthless at this point – and the derivatives market an unregulated $ 62 trillion dollar financial weapon of mass destruction that has exploded – and nobody knows what kind of toxic fallout is underway that is going to infect the entire global financial system.

http://www.elitetrader.com/vb/showthread.php?s=&postid=2100864&highlight=fallout#post2100864

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