Refco declares bankruptcy as regulators work to contain more widespread damage - 20-Oct-05 - Generational Dynamics

Generational Dynamics Web Log for 20-Oct-05

Refco declares bankruptcy as regulators work to contain more widespread damage

Fast intervention by regulators has prevented a panic or a chain reaction, but the danger is far from over.

Last week, it took only four days for Refco to go from the world's largest commodities and futures dealer to complete meltdown, with the CEO charged with securities fraud.

The SEC shut down trading operations on Friday evening, and on Tuesday, Refco filed the fourth largest bankruptcy in U.S. history. The collapse occurred just ten weeks after Refco went public with a spectacular IPO.

Refco consists of several different companies, and some are in more trouble than others. As is the case in any bankruptcy situation, various investors are looking to purchase different pieces of Refco at the cheapest possible prices. The leading bids are from little known hedge fund firm J. C. Flowers (which evidently has no web site), from the government of Dubai, and from over two dozen additional bidders. The complex negotiations over who will get which pieces will be overseen by the bankruptcy court, but Refco would like to sell its assets as quickly as possible, according to its lawyers in court on Wednesday.

The situation is greatly complicated by the danger to the rest of the rest of the market. Very quick work by regulators last week appears to have controlled the damage, but there are still many unknowns.

As happens in all bankruptcies, creditors often lose a great deal of money. Refco's biggest creditor is Austrian bank Bawag International Finance, which is owed $451.2 million by Refco. Wells Fargo Corporate Trust Services is owed $390 million, and VR Global Partners LP has $380.1 million in claims.

Those are the three largest creditors, but Refco had 200,000 clients, and possible losses may be far more widespread. Since many of Refco's trading operations have been frozen by the SEC, the full impact may not appear until the freeze is lifted.

There are two major dangers that concern regulators as they try to steer the Refco settlement into safe waters:

The danger that the Refco bankruptcy will cause a chain reaction: A Refco creditor loses hundreds of millions of dollars and also goes bankrupt, then a creditor to the second firm loses money and goes bankrupt, and so forth. This chain reaction will continue since most of the hedge fund firms are highly interlocked with each other, and with other kinds of businesses. Once this chain reaction gets started, there won't be enough money in the world to stop it from engulfing most of the major businesses in the world.

An emotional "panic" among investors, such as happened in 1987 and previously in 1929. At the time of the 1987 panic, the market was priced at about 102% of book value; the panic caused an immediate lost of 22% in market pricing, and so the market recovered quickly. But in 1929, the market was priced at well over 200% of book value, so the panic lasted many years. The market today is priced at about 215% of book value, so a panic would have the same effect as in 1929.

There's actually a third danger: A chain reaction of discoveries of securities fraud and embezzlement in other firms. How would that work? It would happen as follows:

The accounting firm Grant Thornton is receiving a lot of blame right now. It was Refco's auditing firm for the IPO, and it didn't catch the securities fraud that finally led to Refco's demise. As a result, Grant Thorton is facing potentially huge claims by people who lost money in the debacle and are looking for someone else to blame.

This will cause other auditing firms to become increasingly about their own potential exposure. (Recall that when the Enron scandal broke, its auditing firm, the venerable Arthur Andersen, was forced out of business.)

The increased scrutiny from auditing firms will uncover other crimes at other financial firms, crimes that wouldn't otherwise have been discovered, at least for a while.

This is not a far-fetched concept, because this is exactly what happened after the 1929 crash. All sorts of financial irregularities and crimes that had slid by unnoticed before the crash suddenly came to light after the crash.

John Kenneth Galbraith described this phenomenon in his 1954 book, The Great Crash - 1929, as follows:

"[Before the crash], to the normal needs for money, for home, family and dissipation, was added, during the boom, the new and overwhelming requirement for funds to play the market or to meet margin calls. Money was exceptionally plentiful. People were also exceptionally trusting. A bank president [was] unlikely to suspect his lifelong friend the cashier. In the late twenties the bezzle grew apace.

Just as the boom accelerated the rate of growth, so the crash enormously advanced the rate of discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed. ...

Each week during the autumn more such unfortunates were reveled in their misery. Most of them were small men who had taken a flier in the market and then become more deeply involved. Later they had more impressive companions. It was the crash, and the subsequent ruthless contraction of values which, in the end, exposed the speculation by [financial firms] with the money of other people. Should the American economy ever achieve permanent full employment and prosperity, firms should look well to their auditors. One of the uses of depression is the exposure of what auditors fail to find. Bagehot once observed: "Every great crisis reveals the excessive speculations of many houses which no one before suspected."" [pp. 133-35]

In 1929, these crimes were rampant before the crash, but were not discovered until after the crash, as Galbraith describes. What I'm suggesting is that these crimes are just as rampant today, but instead of waiting for a crash to be uncovered, Grant Thorton's problem may cause some of them to be exposed soon, and it's those very discoveries that might trigger the crash.

In fact, the Panic of 1857, which was the major generational crash that preceded the crash of 1929, was triggered by the embezzlement of a cashier at a bank in New York.

From the point of view of Generational Dynamics, we're entering a new 1930s style Great Depression, as I've been predicting since 2002. At that time, I indicated that Generational Dynamics predicts a stock market crash to the Dow 3000-4000 range, most likely by the 2006-2007 time frame.

The current troubles at Refco may or may not be the trigger that leads to this financial crisis, but one way or another, a financial crisis of this type is going to occur, with absolute certainty. (20-Oct-05) Permanent Link
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Generational Dynamics Web Log for 20-Oct-05 Refco declares bankruptcy as regulators work to contain more widespread damage

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Generational Dynamics Web Log for 20-Oct-05
Refco declares bankruptcy as regulators work to contain more widespread damage