The Casey Report
Volume V, Issue 10 / October 2012
Special Feature:
You Don’t Own What You Think You Own (Investor rights and protections in the US)
An Interview with Hedge Fund Manager David Webb . [So what year and day was this?]
David Webb is a Sweden-based hedge fund manager with an exceptional track record. Between September 1, 1998 and November 9, 2002 – the period leading up to and including the dot-com crash – he used his neutral long/short equity strategy to produce a cumulative return of 258%.
David spoke at our Navigating the Politicized Economy Summit in September, and he was quite a hit. In particular, when he spoke about the erosion of investor protections in the US – a topic few people understand – it was as if an electric shock had hit the room. David’s presentation was so popular that the audience vocally demanded an encore when his stage time expired.
Given the vital importance of this topic, we decided that David’s knowledge is far too valuable to keep among the 300 or so attendees of our summit. So we called up David in Sweden, and an edited transcript of our interview is below.
Dan Steinhart dan@caseyresearch.com
Managing Editor
The Casey Report: Hello David, thanks for talking with us today. [So what year and day was this?]
Do you want to start by telling us a bit about your background?
/* BEGIN LONG-WINDED INTRODUCTION
David [Webb]: Sure. I grew up in Cleveland. My grandfather, father and uncle were engineers, in the business of overhead materials handling – cranes, hoists, etc. I grew up in the sixties and seventies, when Cleveland really felt the brunt of the beginning of the industrial decline of the United States. My family certainly felt the impact.
In my formative years, I had an intense desire to understand what was happening in the world, what forces were at work. My dad wanted me to get an engineering degree, but instead I got a business degree and struck out for Wall Street in 1982. I arrived in August 1982, which was the beginning of the bull market.
I began working at CompuServe, one of the early computer services companies, in their Wall Street office. My clients were investment banks. After a year, I realized I was on the wrong side of the desk, so I managed to talk my way into a position as an analyst in the mergers and acquisitions group at Oppenheimer and Company.
I had a very intense experience in the M&A world for five years and then moved to the venture side of E.M. Warburg Pincus in 1987. At a young age, I ended up having complete responsibility for managing the acquisition of a regional telephone company called LCI Communications. This came about because the partner on the deal developed a bad back and stayed in bed for six months. So I handled everything: the sub-debt financing, the bank financing, the due-diligence work. It was very, very intense for the better part of a year.
That was a great experience, but it created a lot of stress for my family. I was sleeping on the floor in the office, getting maybe an hour of sleep a night, sometimes for days on end. When you’re managing a complex deal like that, you can never escape from it. I would wake up to phone calls on early Saturday morning, work until three in the morning and then repeat that every day of the week.
The deal turned out to be very successful – the largest capital gain in the history of Warburg Pincus – and I could have had a good future there. But it nearly destroyed my marriage. My wife told me that if she’d known our life was going to be like this, she wouldn’t have signed up for it.
So we decided to leave that kind of life and move back to Cleveland, and I eventually started as a partner in Shaker Investments. When I started, the company had three million dollars, which isn’t enough to pay for much of anything in that business. We grew that to about a two-billion-dollar business in less than ten years.
My heyday really began during the Asian financial crisis. I took responsibility for managing a hedge fund that had not been well managed up to that point. On the last day of August 1998, the market absolutely plunged, and I averted disaster by fully hedging the portfolio in the opening minutes of the day.
During that time, I learned that the S&P 500 is basically the world’s worst hedge. In a crisis, the Fed provides liquidity, and it goes straight into the S&P. So long/short managers who use the index to hedge get destroyed.
It’s the stuff outside the index that falls in a crisis, because it’s not receiving that liquidity. So I got the idea of developing an index to short based on the Russell 2000. I talked to Goldman and other firms about it, but the cost would have been more than five percent to have them hold the index for me.
So I decided to do it myself. I constructed my own index using hundreds of companies that I called “the cream of the crap.” Through the dot-com buildup, I ended up having a very unusual and powerful position of being short hundreds of tech stocks in the opening months of 2000.
Of course, first I had to get through the fourth quarter of 1999, when tech stocks were still rising, which was a living hell. But overall, I did very well through that whole process, from the Asian financial crisis through 2002.
Without going into the reasons why, I left Shaker and started something called Verus Investments at the beginning of 2003 to do exactly the same thing. At that time, I was monitoring the rate of growth of the M3 money supply in order to navigate when the Fed was pushing harder. They are always growing the money supply, but some times faster than others.
TCR: So you used movements in M3 to help position your fund?
David: Yes, watching M3 gave me some lead time because the money would first show up in bank deposits.
This is before the Fed started directly injecting money into the financial markets, when they were still operating through loaning to the banking system. So it would show up in deposits first and make its way to the financial markets with some latency, and I used it as a signal to cut back on shorts.
This is when I started to realize that the amount of money that the Fed was creating was very large relative to the GDP of the US. In fact, we were getting to the point where the amount of money being created was perhaps larger than the GDP growth of the US.
Most people don’t realize that quantitative easing really started in 2003. I know that because beginning in 2003, the stimulus no longer showed up in M3, which was actually decelerating through the first half of 2003. That is when the Fed, in desperation, went to direct injection into the financial markets, and they did it secretly.
The market is normally a closed system, or at least it used to be. You could see day by day that if tech stocks were up, the old-line industrial stocks were down. If equities were up, bond prices were down. If you imagine looking at an equalizer for a sound system, where you see the frequency ranges bouncing up and down, that’s what the market was like. If money was going to flow into one area, it had to come out of another area.
But during that first half of 2003, bond prices rose because interest rates were driven down to one percent, and every segment of the equity market went straight up as well. So where was that money coming from? It was being created and injected, probably into the Treasury market at that point.
This was a challenging time for me because I knew that, under the surface, this was a crisis situation. But the public thought it was wonderful, because the market was going straight up.
So I anticipated a collapse and remained short for two years. But when George Bush was reelected in 2004, I realized things weren’t going to change. I decided that even if I were very well positioned for the collapse, the prime brokers themselves could fail.
And so I felt that it was not possible to run an entity to protect people in the US because we were looking at a monolithic collapse when it finally happened. We got that failure in 2008. Massive and escalating government intervention has provided stabilization for a period of time, but the problems were never resolved. The widespread insolvency is still being masked.
I apologize for this long-winded introduction – I have been watching and thinking about these things for a long time.
END LONG-WINDED INTRODUCTION */
TCR: Not a problem – you have an impressive and diverse financial background. There was one thing in particular that you spoke about in Carlsbad that really got the audience’s attention. It was your study of investor rights and protections in the US. You shared your findings, and they were not good. Can you tell us about that?
David [Webb]: Sure. I was looking for signs of the beginning of the financial collapse well before 2008. In the first half of 2008, I noticed mention of the failure of a little securities firm in Florida called North American Clearing. What got my attention was that all client assets were swept to the receiver.
I thought, how could client assets become involved in the bankruptcy of the broker? But they were. The way I explain it to my friends is, it’s as if you bought a car, you paid for it with cash, and when the auto dealer goes bankrupt, your car is repossessed.
TCR: So let’s say the average Joe buys Microsoft through his broker. You’re saying that that stock is not really his property if push comes to shove?
David: It’s not even when push comes to shove. Those stocks are legally no longer defined as property.
TCR: Can you expand on that?
David: It took me some years to uncover the basis for how this has changed. It all arises from a revision of the Uniform Commercial Code, Article 8, in 1994. This article governs securities “ownership.”
When they did this revision in 1994, they created a completely new legal concept called a “security entitlement,” which means that a security is now a contractual claim rather than property. That’s the key, and it’s hugely important because a contractual claim in a bankruptcy proceeding has very little standing.
So even though there are records that a particular security is your property, it’s really not. If your broker goes bankrupt, those securities, by law, become part of the bankruptcy estate. As a client, you cannot revindicate [to reclaim; to demand and take back] those securities in a bankruptcy.
Of course, secured creditors have a higher priority to the assets of the bankruptcy estate than you do. So you’re left with an inferior claim to what you thought was your own property.
TCR: Aren’t brokers required to segregate client assets?
David: That’s a separate issue, and it varies by country. In Britain, for instance, there is some legal requirement to segregate assets.
But in the US, I like to cite an article and presentation about the MF Global bankruptcy by two securities law experts, one of which is a former commissioner of the FCC. They say point blank that there is no legal requirement to segregate client assets.
TCR: Which means firms probably don’t do it.
David: Exactly. So realistically, the assets are rarely segregated.
But it gets worse. All of the securities are pooled – there is no specific identification of who owns what. By law, in a bankruptcy, the losses must be shared pro rata across the client pool. So even if a client somehow manages to get a legal assurance that their securities are not being hypothecated, they are still in a pool where other clients have margin accounts and their securities are being hypothecated.
TCR: Can you explain hypothecation?
David: Hypothecation is when a firm pledges a clients’ assets as collateral to another party. The securities firm is allowed to use the client assets as collateral for its own proprietary trading. In my book, that’s fraud. But it is perfectly legal.
So the securities firm borrows the security on the assumption that it will return like securities to the pool.
But, of course, when an insolvency occurs, the music stops and those securities are not returned.
The firm that received those securities as collateral is a secured creditor, and if there is a bankruptcy, they take those assets – the assets you thought you owned – and immediately sell them. They are gone. And you’re left as an unsecured creditor, which means you get what’s left over at the end, if anything. [Why couldn’t a new kind of secured-creditor-client be created, secured by his “security entitlement”s – the shares the broker ‘holds’ for him in street name and shows on his monthly statement?!]
Further, in 2005, the Bush administration rewrote the bankruptcy law.
There used to be a concept of “fraudulent conveyance,” which meant that if a firm transferred assets to a secured creditor within six months before its bankruptcy filing, the receiver was required by law to give those assets back. It’s called a clawback.
But this revision of the bankruptcy law changed that. The law now specifically says that the receiver is not to claw back the assets. So what was considered a fraudulent conveyance prior to 2005 is now legal.
This is very similar to what happened with MF Global and their transfer of client assets to JPMorgan. But it was not considered fraud. Everything was done according to the law.
TCR: Knowing this, it’s amazing that the financial system still functions at all.
David: Yes, it is a very precarious situation. Now here’s how it ties into the macro-picture.
One set of assets can be used as collateral multiple times, which is called rehypothecation. So a securities firm gives client assets to a secured creditor as collateral for proprietary trading. The secured creditor can then turn around and use those same assets as collateral for their own proprietary trading. So those assets are passed on to another firm as collateral, and so on. This is the chain of hypothecation and rehypothecation; the same assets are used as collateral over and over again.
I can’t stress this next part enough – it’s very, very important. There are about $700 trillion of derivatives worldwide in a $70 trillion economy. It’s pretty easy to see that there cannot possibly be enough collateral backing. The entire financial asset base of the public is being used as collateral.
This is a huge risk that everyone bears, whether they know it or not. If we have a major failure anywhere in that collateral chain, the collateral is pulled out and cannot be returned to the pool.
People often ask me when this crisis going to hit, and I have two answers. The first is, it’s not going to be one event. It’s going to be a series of events over many years. And the second answer is that it’s already happened. We’ve been in the collapse for fifteen years. Since the Asian financial crisis, we’ve seen many failures.
TCR: And a number of those failures were not bailed out.
David: True. People tend to think that the government will bail out everyone and stabilize everything if a serious problem arises. To that, I reply: what about MF Global? MF Global was headed by John Corzine,
who was a co-chief executive of Goldman Sachs, a governor and a senator. Who could be more connected than John Corzine?
Yet he wasn’t bailed out. It’s clear to me that if a firm run by someone like that is allowed to fail, we shouldn’t count on the government being able to bail everyone out and prop everyone up.
TCR: Because it can’t.
David: Exactly.
TCR: Is there any way to keep your assets safe, or at least safer? How about taking physical possession of paper securities certificates? Or getting the securities registered directly under your name using the Direct Registration System?
David: First of all, I think that there is a drive to eliminate all paper certificates. Not many companies will issue paper certificates anymore. They’re almost impossible to get in the fixed-income world. But if you are able to get a paper certificate, do it and keep it in a fireproof safe.
As for the Direct Registration System: as the financial crisis was heating up in 2008, the Depository Trust Company mentioned that they would publish on their website a list of securities eligible for DRS.
Interestingly, nothing has been published on the topic since April of 2009. It’s a completely cold trail. . [??? As of October 2012, a brokerage was actively trying to get a client not to use direct registration!!]
Now, I’m not saying it’s impossible to get direct registration on some things. If you can do it, great. But the industry is not making it easy. I suspect that the reason there’s been no discussion of it since April of 2009 is that the securities industry realized that it would take a lot of the collateral out of the system, and they can’t have that. . [This statement is confirmed by the brokerage mentioned just above attempting to get the client to bring back the large block of stock removed from the broker and directly registered!!]
So now it’s being downplayed, because the securities industry does not want to let go of that collateral.
TCR: So if by some miracle you could get a couple of your stocks directly registered, would that provide an extra layer of protection?
David: Yes, you should do it if you can. It takes the securities out of the collateral chain. I suspect that as more disasters occur and outrage escalates, the authorities will say, well, we created this system, but you people weren’t using it.
TCR: So it’s just to cover their behinds.
David: Perhaps. Or maybe they made the system preemptively, because they realize that when a catastrophic collapse does come, it will be necessary in order to restore any kind of confidence.
TCR: What about cash held at brokers? Is that in as much danger as securities?
David: Absolutely. There is no legal requirement to segregate cash, either. Although some brokers offer cash accounts that are covered by FDIC insurance, which adds a layer of protection.
TCR: Good to know. So here’s the million-dollar question: if someone wants to invest in the US, how do they ensure they’re as protected as possible?
David: For one, it’s imperative not to have everything in one place.
Diversifying between types of assets and sectors is no longer adequate. Having all of those diversified assets with one broker could be disastrous. There are such epic risks today that investors need to diversify in ways that they have never considered. Use multiple brokers.
It’s also smart to own some physical gold, which is outside the financial system. It makes sense to own land as well, as long as you have no debt against it. The advantage of land is that you can have real title to it, and if you own it debt free, you are at no great risk during a catastrophe.
That’s one thing that got my family through the recession during the early ‘70s in Cleveland, which felt a lot like a depression to us. My dad built our house for cash. He saved until he could build it without a mortgage. At one point in the early ‘70s, revenues of my dad’s business went to zero; we survived because we had no debt.
To me, it doesn’t make sense to have debt against things, including your home, so that you can have money invested in the stock market. Paying down debt is the lowest-risk adjusted return you can get.
Finally, effective international diversification is very important. Americans are not used to thinking about this. It is possible to diversify currency, custody and systemic risk by opening accounts in other countries.
Consider Canada, which has one of the soundest financial systems in the world.
But there is a considerable burden associated with that. You must report foreign financial accounts annually on FBAR forms to the Treasury and possibly also with your tax return on the new form 8938. You have to be careful with this because there are severe penalties for not meeting the reporting requirements.
TCR: To summarize, your advice is no debt, physical assets like land and gold, securities held in a variety of places and international diversification with the appropriate compliance. Any other investment tips?
David: Individuals should use insured time deposits with banks in various places. You might not think that yields on time deposits are attractive, but they are much higher than a government bond of comparable maturity, with essentially the same risk. That is one advantage individuals have over institutions, and it’s an important way to protect your assets from insolvencies.
TCR: Great. Thank you very much for talking with us today.
David: Thanks for listening. This is important stuff. Few people know anything about it, and even fewer have put the pieces together.
David Webb is the founder of Origin Investments AB, which has applied to the Swedish Financial Supervisory Authority (Finansinspektionen) for permission to manage a market neutral long/short equity strategy designed to serve as a core holding for institutional investors. Mr. Webb was the founder of Verus Investments, where he managed long/short equity hedge funds with AUM in excess of $600 million. Previously, Mr. Webb was a senior managing member of Shaker Investments where he was the sole manager of long/short equity hedge funds with AUM in excess of $1.3 billion. Mr. Webb has served as an associate with the venture investment arm of E.M. Warburg, Pincus & Co., Inc., and as an associate with the Mergers and Acquisitions Department of Oppenheimer & Co., Inc.
While with E.M. Warburg, Pincus, David managed the acquisition of Litel Communications, Inc., and served as a director and officer of LCI Communications Holdings Co.