NOVEMBER 2005

REFCO
Refco is a large foreign exchange and commodity broker providing clearing and execution services for global exchange-traded derivatives including futures, ...
.........the largest futures broker in the world ...
Commodities and futures broker Refco Inc., struggling with daily revelations in an accounting scandal, said yesterday it will freeze customers' accounts in one of its subsidiaries for 15 days because the unit may not have enough cash on hand to operate normally.

The news, a day after Refco's chief executive was indicted on federal securities fraud charges, prompted the New York Stock Exchange to halt trading in Refco's stock, which may become permanently delisted if the company doesn't give investors more details on its finances.

Refco sells off stock and bond holdings
By MICHAEL J. MARTINEZ
AP Business Writer

OCT. 14 11:51 A.M. ET Federal regulators have ordered subsidiaries of Refco Inc. to hold on to their assets, possibly preventing the company from moving money around to cope with a cash crunch prompted by the company's $545 million accounting scandal.

The move came as commodities futures brokerage Refco confirmed Friday that it was selling off its portfolio of stock, bond, credit and money-market holdings in its Refco Securities LLC subsidiary -- both its own holdings and those of its customers.

It remains to be seen, however, whether Refco could transfer money from Refco Securities to the rest of the company. The SEC, in an order dated Thursday, ordered Refco Securities and another subsidiary, Refco Clearing LLC, from moving more than 30 percent of its excess net capital to any shareholder, employee, partner or affiliate. An SEC spokesman did not immediately return a call seeking comment on whether the order would prevent Refco from taking liquidated assets from Refco Securities for use in other parts of the company. Refco Securities and Refco Clearing are considered separate companies by the SEC.

On Thursday, Refco froze accounts at its Refco Capital Markets subsidiary, an unregulated offshore stock and bond broker, for 15 days -- a move likely designed to prevent customers from fleeing the troubled firm. At the time, Refco asserted that Refco Securities and its other regulated subsidiaries remained "substantially unaffected" by the scandal. However, with the liquidation of a second subsidiary's holdings, it appears that the company's troubles have spread beyond the capital markets unit, which was allegedly used by former Chief Executive Phillip Bennett to hide up to $545 million in bad debts. Federal prosecutors claim Bennett hid the debts to inflate Refco's revenues ahead of its initial public stock offering in August. Bennett has been charged with securities fraud and is free on a $50 million bond. Bennett repaid $430 million to the company on Monday, right before he was placed on leave, but the crisis surrounding the company may have prompted numerous customers to withdraw their business from Refco, hastening a cash crisis. It was unclear how much money Refco would gain from selling off its securities subsidiary's holdings, or how much would go back to customers. It was also unclear whether the order from the Securities and Exchange Commission would prevent Refco from transferring money from the two subsidiaries.

Refco is the nation's largest independent futures broker, with a clientele consisting largely of hedge funds and Wall Street firms. The subsidiary which handles futures trading, Refco LLC, apparently remains unaffected thus far, and the Chicago Mercantile Exchange, the New York Mercantile Exchange and the New York Board of Trade each said Refco remained in good standing. However, all three said Refco would need their approval to move capital out of that subsidiary. Refco's stock remained halted on the New York Stock Exchange Friday as the exchange sought more information from the company and considered whether Refco should be delisted because of the scandal. Its corporate bonds fell precipitously for a second straight session after Standard & Poor's dropped Refco's credit rating deeper into "junk" status.

 PrudentBear.com
Commentary Archives

Signals of the End of the Dollar Standard
by Rob Lee©
October 5, 2005

I am an economist who worked for 25 years in large investment companies in South Africa. I “retired” to the UK a few years ago. For most of my career I lobbied for policies such as money supply targets and later inflation targets that were (implicitly) intended to substitute the role of gold as an independent anchor for the monetary system. I was never an advocate of any form of gold standard, unlike the current Fed Chairman, now ironically testing the fiat money system to destruction.

However, in recent years the scales have fallen from my eyes. As Voltaire said in 1729 “paper money eventually goes down to its intrinsic value – zero.” Every fiat paper currency before or since has confirmed to this prediction. A fiat paper currency that is also the global reserve currency becomes this problem writ large. A US Treasury official of old - Sam Cross - put it this way: “if you postulate a system that depends on one country always following the right policies, you will find that sooner or later no such country exists. The system is eventually going to break down”. In my view the Dollar Standard system is irretrievably breaking down, as signaled by four recent developments described below:

1. Chinahas ended its currency peg to the dollar. The new exchange rate system for the Yuan is admittedly not yet a dramatic break from the dollar fixed peg . That is not the Chinese way. It is nevertheless hugely symbolic. It serves notice that China will be increasingly reluctant to accumulate dollars they know will depreciate in value over time. Chinese economic spokesmen have made no secret in public of their alarm at US profligacy - what is said behind closed doors?

China is clearly intent on exchanging its paper assets (predominantly dollars) for real assets, notably commodities in general and energy products in particular. On gold the strategy focuses on encouraging private citizens to own gold- deregulation of the gold market has been rapid by Chinese standards. [Ironically it may now be easier for citizens of Chinato invest directly in gold than it is in many western democracies].

China is likely to prefer to remove dollar support only gradually. Bear in mind though that most of the smaller economies in Asia tend to follow China - Malaysiaannounced a similar change to its exchange rate system very soon after the Chinese. Other countries from outside the region - notably Russia and Saudi Arabia- have indicated an intention to downgrade the dollar in their currency arrangements. Iran is attempting to create an oil trading exchange that does not transact in dollars. These are ominous straws in the wind for a currency so dependent on foreign capital.

2. Deflation in Japanis coming to an end. Japanis the biggest foreign holder of US dollars. For example, Japan held $680bn in US Treasury Securities at the end of June - nearly 34% of total foreign holdings. This compares with $291bn held by China(including Hong Kong). Japan will therefore play a critical part in any changes to the world’s currency system.

US-Japan relations are far closer than those between the US and China. Japan also has literally more to lose from the demise of the dollar than China. Nevertheless the same logic that impels China’s move away from USpaper applies to Japan. As long as deflation remained the key economic concern in Japan supporting the dollar was the paramount objective of its exchange rate policy. However, there are clear signs of a self-sustaining recovery of domestic employment, investment, and consumption in Japan. The recent election victory of PM Koizumi should reinforce reform and recovery. These forces are simultaneously bringing an end to both the deflationary process and to dependence on exports for growth. The imperative to support the dollar will erode and interest rates in Japan will begin to normalize. Another straw in the wind - Japandid not increase its holdings of US Treasuries in the first half of 2005.

3. The US in effect now has to borrow abroad in order to service all its foreign debt. The remarkable down spiral in the US foreign financial position took another crucial but little noticed twist recently. In the second quarter of 2005 the US paid out more in income to foreigners on their US assets than it received in income on its foreign assets. Technically net foreign investment income went negative. No comfort should be taken from the fact the second quarter investment income deficit was a mere $0.5bn. The income deficit will deteriorate rapidly in coming years. The UShas net foreign debt (foreign liabilities minus foreign assets) of more than $ 2.5 trillion, and this debt will grow rapidly as the US continues to rack up huge current account deficits (now roughly $800bn annually). The income deficit on this debt has only just gone negative because the US receives a rate of return on its foreign assets roughly double that of overseas investors in the US - about 7% versus 3.4% between 2002 and 2004.

This differential return reflects the fact that Americans have invested largely in riskier assets abroad while foreigners have opted more for Treasury securities. A world economic downturn (likely in my view) would reduce returns on US overseas assets, while rising US interest rates will raise the return to foreigners. The longer term dynamics of this process are alarming. Within a short period of years the US will be borrowing hundreds of billions merely to service existing debt. Economists call this the “debt trap” - and the US economy is heading inexorably into it Can the US dollar sustain its position as the world reserve currency in the face of these fundamentals? As the saying goes, you only have to ask the question to know the answer.

4. The gold price is breaking out in all key currencies. Not all the world’s investors (or central bankers!) are blind to the scary developments sketched above. Gold in dollars has definitively been in a bull market for some time, but in recent weeks gold has decisively broken out all key currencies including the Euro, Yen, Swiss Franc and Sterling. Markets are recognizing that the failure of the Dollar Standard is one not only of US economic management but one inherent in the fiat money system itself. In the long term they may demand gold’s return as an anchor to the global monetary system.

The flight from paper assets (and especially dollars) towards hard assets is now underway in earnest. There is still time - this is a multi-year trend - for investors to switch from devaluing dollars to rising gold. Those ahead of the herd are moving but the herd itself is yet to stir.

Rob Lee is an economist who has been involved in investment markets for 30 years, the last few in nominal retirement.