Depositors Flee as Trust Evaporates on Wall Street

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Published on Tuesday, 08 November 2011 07:00

Written by Justice Litle, Editor, Inside Investing Daily

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Thanks to MF Global, Bank of America and the like, trust is evaporating on Wall Street.

The stories out of MF Global, the futures brokerage gone bankrupt, are getting darker by the day.

Not only did MF Global saddle itself with 40-to-1 leverage (in the hope of copying Goldman Sachs). Not only did it "misplace" more than $600 million worth of customer funds. It also sent out millions of dollars in bad checks.

When a customer wants to withdraw cash, the normal way to get it is via wire transfer. This is standard practice for brokerage and clearing house operations. The customer submits the request, verifies it and typically has the money in 48 hours or less.

In its final days before bankruptcy, however, MF Global pulled a fast one.

As rumors swirled in late October, a flood of redemption requests came in. MF Global customers smelled trouble, and were acting to protect their capital. They wanted their money out, and asked for it.

"But instead of simply wiring that money back to their customers," Reuters reports, "it seems MF Global tried to buy some time for itself by sending that money back via snail mail in the form of an old-fashioned check."

The difference between a wire transfer and a check comes down to precious time. With a wire, the funds are instantly moved. A check, by contrast, has to make its way through the United States Postal Service -- which can take days -- and is only then deposited and cleared (which takes yet more time).

For some MF Global customers, those last few days made a terrible difference. Once the firm filed for bankruptcy on Oct. 31, the mailed checks started getting rejected. The cause of rejection: Insufficient Funds.

MF Global clients who withdrew funds in late October would likely have gotten their money, had payment been made by wire. Instead, the checks turned to rubber even as Uncle Sam delivered them.

Some futures traders have reportedly lost millions. Many hedging clients of MF Global, like Midwestern grain farmers and cattle ranchers, have also been left high and dry. That old saying, "the check is in the mail," turned out to be a destroyer of fortunes.

Why is this alarming, besides the huge reach of MF Global in the futures clearing business? Because Wall Street's complex network of trading transactions is built on trust. Markets can be rough, but the underling network is solid.

Or at least, that's the way it is supposed to be. Trust is the only way multimillion-dollar deals can be done on the strength of a phone call (or an electronic transaction). You have to know your counterparty is good for it.

That is why banks and brokerages run on confidence. An investment house can handle messy, high volume financial transactions -- because the stability of the house is trusted. As soon as talk catches hold that a major player is insolvent, or even just cash strapped, the spiral begins. Confidence itself is the asset to protect no matter what.

The MF Global story is troubling because, now, another layer of trust has been evaporated. Horrified observers can see what happened to MF Global clients who did too little too late. Even though they acted prior to the bankruptcy -- days before even -- thanks to a slight delay, their money was gone.

So now traders and investors get to add "MF Global risk" onto the pile... the risk of having funds tied up in bankruptcy court when an institution suddenly fails.

As a result, rumors will spread faster. "Shoot first, ask questions later" will become even more of an established practice. This increases the odds of another 2008-style shock.

In other news, Nov. 5 was dubbed "Bank Transfer Day," as a result of unhappiness with the new Bank of America debit card fee.

B of A finally caved on the fee, but depositors are headed for the exits anyway. A reported 47,000 Texans have gone to credit unions as of Nov. 2. In North Carolina, the Charlotte Metro Federal Credit Union saw four times its normal weekend signup traffic. Credit union interest is ramping up nationwide.

The big banks are trying to play down the credit union movement. The switchers tend to have puny account sizes, the banks say, and were not that profitable to serve in the first place.

And yet, as with the "occupy" movement, there is a snowball building here. Both investors and depositors have their eyes open to the darker side of Wall Street... and are voting with their feet. As a result of this, we can expect more volatility and turbulence ahead.