Now, ad one healthy dose of as-yet undefined impropriety. Mix together vigorously and what do you get? A big fat mess where the retail investor doesn't own his shares but does owe the lender and the lender faces receivership by HIS lenders. More below.

But first, the share market's worst fourth quarter in 20 years is probably going to end on one of the sourest notes yet, and also one of the most bizarre. The trouble with the last few years of the share market boom-as we are learning one failed firm at a time-is that it was based on borrowed money. Borrowed money has to be paid back. Or, in some cases, seized.

Take the case of Opes Prime, the Melbourne-based broker currently causing so much strife in the share market. The company was in the "equity financing and securities lending" business. On the retail end, Opes was basically a margin lender to clients, only instead of posting cash as collateral against the loan, the client puts up his entire portfolio as collateral.

When we say "puts up," however, we are not doing justice to what an Australian Master Securities Lending Agreement (AMSLA) actually stipulates. In exchange for the margin loan, the retail client actually surrenders legal title to his or her shares. The broker owns them, whether the client knows it or not.

With legal title to a diversity of shares on the Australian market, Opes then tuned around and lent those securities to professional borrowers. The borrowers might be, say, hedge funds looking to short the Australian market.

No one is quite sure how the whole thing went pear-shaped. But certainly it did. And now Opes secured creditors-ANZ and Merrill Lynch, the ones who financed the margin loans to retail clients-are seizing the collateral of its unsecured creditors (the share portfolios of its retail investors, put up as margin for loans) and ruthlessly selling them (sometimes at below market prices).

"ANZ and investment bank Merrill Lynch, which together provided Opes with $1 billion to fund its margin lending business, are selling shares held on behalf of Opes clients to recoup their money," according to today's Australian.

"ANZ, which is owed $650million, yesterday distanced itself from Friday's aggressive share selling, which forced stocks such as the Hedley pubs group sharply lower. Merrill Lynch, which last week held $500 million of shares as security for its $350million exposure to Opes, is believed to have already sold $300million of stock."

It gets worse. To bulk up its securities lending business, Opes had agreements with super funds. Why would a super fund surrender ownership of its shares to a securities lender? Good question.

The answer might be: to earn a fee or two on shares which would otherwise just sit in the fund's account for years, doing nothing. But now ANZ and Merrill Lynch own those shares.

"This raises the prospect of super funds and the custodian companies who hold shares on their behalf facing significant losses if they are unable to recover the shares loaned to the failed stock broking firm," according to Adele Ferguson and Michael Sainsbury in today's Australian.

Yes. That's bad. Opes 1,200 private clients face up to $300 million in losses. After the banks get their money back, whatever's left will go to unsecured creditors.

It sounds confusing. But it's almost like the business was designed to fail. Opes borrows from big banks based on the value of equity collateral from retail clients. But it then lends that collateral to short sellers, the very people who believe the collateral should be worth less, and sell it short to make it so.

Opes must have been hoping its business model was immune to fluctuations in the value of the equity collateral itself. It made money as a lender both ways, lending cash to retail clients and securities to institutional clients. ANZ and Merrill Lynch apparently didn't see the value in the model.

The flaw in the model is glaringly basic: too much leverage. Or, if you prefer to put it in common sense terms, the flaw is that you can get something for nothing. Opes thought it would take lazy equity-shares that were sitting around doing no work-and lend them out.

Like so much financial engineering of the past ten years, this kind of activity created no real economic value. All it did was encourage people to rack up big liabilities. You take on leverage because you think you can boost your return with borrowed money and use the gains to repay the loan. It stops working when asset prices fall. The trouble, after the whole affair goes kaboom!, is that the liability remains.

We were going to go in depth into the Reserve Bank's financial stability report last week. But gee, it's pretty obvious there's some major instability in Australia's financial markets. In the age of leverage (or deleveraging), it looks like it's going to be tough for banks and financial stocks to increase earnings.

But at least there's no subprime crisis in Australia, right? Or is there?

Dan Denning
The Daily Reckoning Australia

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