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Minimizing Systemic Risks:

 

In ECONOMICS, you can have one period for 50 years with one set of rules and then a very different period with another set of rules for the next period. Economics is not like Chemistry. With Chemistry...you add 2 parts hydrogen and 1 part oxygen you get water, and you get it immediately every time, and water...whether frozen, vapor or liquid, is still water (H2O).

The economic rules we grew up with have changed and are still changing, because of high levels of debt and unfunded promises accumulated globally. These changes are Financial Engineering.  So here is an important question...in our lifetime, are there limits to Financial Engineering?   The list below of 14 important and knowable facts, is meant to be a kind of a roadmap for conversations with clients and prospective clients who are interested in a systemic risk mitigation conversation. 

  1. The Federal Reserve has a mandate that includes the stable purchasing power of our currency, low unemployment, and what was most recently added was stability of our financial system (Macroprudential Supervision,  Systemic Risk Mitigation). Since the 2008 Lehman failure they have signaled a "whatever it takes" approach for financial stability. It is why the Federal Reserve has bought many Trillions of dollars of assets with money it created out of thin air. 

  2. In 2012, FDIC entered into an agreement with the Bank of England regarding how to solve the bankruptcy of banks. They agreed upon a system of Bail-Ins. This means using the customer's deposits, not government money, to solve a bankruptcy. Soon after it was adopted it was used in the Cypress banking crisis, where depositors took a large hair cut on their deposits. The New York FED put this out in 2014 on Bail-Ins. Are you potentially protected from Bail-Ins?

  3. Securities Investors Protection Corporation (SIPC) is a non-profit company with 39 employees, and 2.72 Billion capital at the end of 2016.  Many millions of investors with many trillions of Dollars are counting on SIPC. To me, this is a false safety valve. Are you exposed?

  4. Excess SIPC insurance (CAPCO). A Lloyds of London excess SIPC policy worth 1 Billion dollars sounds like a lot. But if divided up by 5 million accounts, may be worth 200 dollars for an individual account (Merrill Lynch Example).  Are you exposed?

  5. In 1996, Bob Flowers was the President of Bank of America Investments. Bob taught me that without Margin Lending (re-hypothocation) no major brokerage firms were profitable (Example Goldman Sachs). For example, Goldman Sachs is projected to get 41.5% of their future revenue from Re-hypothocation and Margin (Interest Income). Back in 2008, Goldman got 66.56% of their Revenue from Margin/Re-hypothocation. Here is an Merrill Lynch Margin Agreement, look at page 2, item 9 and 10. 

  6. Definition of Hypothecation: The pledging of securities or other property as collateral for loans. When securities are pledged for a loan the title to them is surrendered to the bank or other lender with which or whom they are pledged. On the London Stock Exchange stock pledged as collateral is said to be pawned. Hypothecation of securities typically occurs when you execute a margin agreement with a brokerage firm.  In some instances, you may be defaulted into a margin account when you open a new account with a brokerage firm.

  7. Re-hypothecation: Using collateral that secures one loan to secure a second loan. Rehypothecation significantly increases the original lender's risk because the collateral is pledged twice.

  8. SIPC used re-hypothication for priority of payouts with the Lehman failure.  

  9. Re-hypothication at Brokerage firms.  Is your brokerage account exposed to Re-hypothocation? 

  10. Securities Lending in investment products. Did you know that Fidelity Magellan mutual fund lends securities? Did you know that many ETFs, like the 40 Billion dollar IWM - Russell 2000 Index, lend a large portion of their portfolio?  In what ways are your individual investments exposed to securities lending?

  11. Are your investments titled in your name or your Brokerage Firms name? More than likely the answer is "they are not titled in your name".

  12. Since 2000, Government revenue has increased by 67%, and spending is up 126%. Government debt is over 20 Trillion. Medicare, Prescription Drug, National Healthcare, and the Social Security unfunded liabilities are over 123 Trillion. Structural Unemployment, Actual Inflation Rate.  This touches all of our lives.

  13. Assets look expensive: Stocks, Multi-Family low Cap Rates (OC homes at 9 Times Median Income, Ohio homes at 2.7 Times Median Income), Bonds

  14. Derivatives are bets that allow investors to speculate on the future price of commodities, currencies, credit default swaps, and a bunch of other things...without buying the underlying investment. Derivatives add tremendous risk to our financial system. They are what caused Lehman Brothers to fail and Merrill Lynch, Bear Sterns, and Wachovia to be merged. They caused Long-Term Capital Partners to fail in 1998. Part of the risk that is added to our financial system comes from the counter- party risks, which is the risks that the other side of a deal will not live up to their promise. Back in 2003, Warren Buffett called derivatives “financial weapons of mass destruction.” When Buffett said that, there were close to $85 trillion of notional value in derivatives. Today there are 14 times more than 2003...over $1.2 quadrillion (bets of 1,200 trillion).  If actual value is 1% of notional value, those bets have a current value of 12 Trillion Dollars. 

Our financial system, with all this Financial Engineering has become exceedingly complex, and complexity fails under pressure. We still have cycles, it has been over 7 years since our last recession, so in due course more pressure is coming.

Exploring this further could be for you...if you believe, the time to dig your back up well is before you're thirsty

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Risk Mitigation Report - identify your areas of exposure, with get a plan of action designed to reduce and mitigate your risks. To get started I will need a copy of all your statements that show your assets and a signed engagement agreement. After I review your assets and can get a sense of the complexity, I will get back to you with how many hours it will take me and my proposed fee (before I undertake the work). 

Comprehensive Risk Mitigation Report - identify the risk elements of each individual asset, and every account, and get a detailed plan of action designed to reduce and mitigate your risks. To get started I will need a copy of all your statements that show your assets and a signed engagement agreement. After I review your assets, I will get back to you with how many hours it will take me and my proposed fee (before I undertake the work). 

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I have been asked many times what percent of assets should be positioned in a way that mitigates systemic risks (resistant to problems if we have a financial convulsion).  My answer has been you can go one of two ways. Either All...100%, or weight it like an insurance company deals with potential risks. If you think there is a 1 in 4 chance of an outcome, place 25% of assets to hedge for hedge for outcome.  If you think it is a 3 in 4 chance, place 75% of assets to address risk (1 in 10 chance, place 10%). You get the idea.