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Without trust, the financial system cannot work. The regulators and Federal Reserve have done nothing to assuage these concerns. Instead they’ve shifted all trust onto their own shoulders: the defining bull argument for the market and economy is that “the Fed will save us”, or “don’t fight the Fed.”

As powerful as it may be, the Fed is not the market. And since the Fed failed to restore trust in the system by forcing all bad debts to light, the financial world has grown increasingly volatile and broken as investors grow increasingly distrustful of the system and begin to pull their money from it: investors have pulled $266 billion from stock-based mutual funds since January 2008.

Nowhere is the lack of trust more apparent than in the financial sector. Indeed, it was a lack of trust between banks (inter-bank lending) that caused the credit markets to jam up in 2008, which resulted in the Crash.

That lack of trust continues to this day. In the post-Lehman collapse, instead of forcing real derivative and credit risk out into the open, the Federal Reserve and regulators instead suspended accounting standards and allowed financial firms (and other corporate entities) to continue to lie about the true state of their balance sheets.

As a result of this, the financial sector remains rife with fraud and impossible to accurately value (how can you value a business that is lying about its balance sheet?).

Those times in which a company was forced to value its assets at market prices have always seen said values losing 80%+ value in short order: consider Washington Mutual, which sported a book value north of $70 billion right up until it was sold for… $2 billion.

This type of fraud is endemic in the system. Indeed, we got a taste of just how problematic a lack of transparency can be with MF Global’s bankruptcy, in which a firm with $42 billion in assets lost over 80% of its value since August only to reveal in bankruptcy that it had stolen over $700 million worth of clients’ money.

Report: MF Global Exec Admits to Using Client Money

MF Global, the futures brokerage that imploded this week after facing a run on the bank, reportedly admitted to regulators it used client money in an apparent violation of government rules and Wall Street practices.

According to The Associated Press, an unnamed executive from the New York-based firm that is led by former Goldman Sachs chief Jon Corzine made the admission Monday morning after regulators discovered some $700 million went missing.


That MF Global engaged in fraud and stole clients’ money is noteworthy. However, the far more important issue is: HOW did this company receive primary dealer status from the NY Fed this year?

The Primary Dealers are the banks that actively engage in day to day activities with the New York Fed regarding the Fed’s monetary policies. Primary Dealers also participate in US Treasury auctions.

Put another way, Primary Dealers are the most elite, well-connected financial firms in the world. They have unequal access to both the Fed and the US Treasury Dept. In order for MF Global to have attained this status it must have passed through a review by:

  1. The New York Fed
  2. The SEC

This is not a quick nor superficial process. According to the NY Fed’s own site:

Upon submission of a formal application, a prospective primary dealer can expect at least six months of formal consideration by the New York Fed. That consideration may include, among other things, on-site reviews of front, middle, and back office operations, review of compliance programs and discussions with compliance and credit risk management staff, discussions with senior management about business plans, financial condition, and the ability to meet FRBNY’s business needs, review of financial information, and consultation with primary supervisors and regulators.

MF Global passed through all of these reviews to became a primary dealer in February 2011. Today, a mere nine months later, the firm is in Chapter 11 and has admitted to stealing clients’ funds to maintain liquidity.

These developments reveal, beyond any doubt, that financial oversight in the US is virtually non-existent. This returns to my primary point: that trust has been lost in the system. And until it is restored, the system will remain broken.

A final note on this: the NY Fed is the single most powerful entity in charge of the Fed’s daily operations. How can any investor believe that the Fed can manage the system and restore trust when the NY Fed granted MF Global primary dealer status a mere nine months before the latter went bankrupt?

If the NY Fed cannot accurately audit a financial firm’s risks during a six month review, then there is no way an ordinary investor can do so.

With that in mind, the banking system remains at huge risk as no one, not even the Fed, knows the true exposure on financials’ balance sheets. The Fed couldn’t even accurately assess MF Global, a $40 BILLION company. How could it assess JP Morgan (NYSE:JPM) or the TBTFs?

The reality is that 2008 was just the warm-up. And we’re now heading into the Second Round of the Great Crisis: the Sovereign Default round in which entire countries will go bust. By the time this mess ends, we’re facing systemic failure, bank holidays, debt defaults, and more.

So if you have not already taken steps to prepare for systemic failure, you should to do so now. We’re literally at most a few months, and very likely just a few weeks from Europe’s banks imploding.

Source: What Other MF Globals Are Lurking In The System?