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Why you probably might not have what you think you have

The November 2011 bankruptcy of MF Global and the subsequent global search for the million $1+ billion in customer deposits is looking increasingly like the tip of the iceberg. There is a much larger risk scenario that is beginning to unfold.  Pay attention now or suffer the consequences later.

Hypothecation is far more prevalent than you might think
At first blush, you might think that the bankruptcy of MF Global was an isolated situation where a rogue company acted outside of the boundaries of their contracted fiduciary duties to customers.  And you would be wrong. The reason why Corzine will almost certainly not get the Madoff treatment — at least in the judicial sense — is because his customer agreements have authorized the company to hypothecate and re-hypothecate anything on deposit.

So, earlier today I took a look at my TD Ameritrade account agreement and low and behold we have the following on page 6 of the customer agreement, apparently last modified in November 2011:

In other words, property on deposit — including cash — is not required to be segregated. It can be pledged, re-pledged, hypothecated and re-hypothecated at their sole description, without notice and without recourse.  If those hypothecated trades go great, the house keeps 100% of the upside. If those house trades fail catastrophically, the depositors have been exposed to the potential risk that they will suffer without recourse if the company were to become insolvent or bankrupt.  This is counter-party risk.  Is it legal? Apparently yes. Is it ethical? Personally, I don’t think so.  Will it end happily? I fear possibly not. That is why I don’t invest in hedge funds, fund of funds, or derivatives.  The opportunity of obfuscation of ownership just too great.  I would rather own something outright — like investment-grade domain names.

For more perspective on the issue of hypothecation of custodial assets, I strongly encourage you to read the excellent piece from earlier today on Zerohedge, which you can find here.  It was one of the most useful things I read during 2011.  If nothing else, it should serve to make any investor more highly conscious of the true counter-party risk for any investment.  Otherwise you just might end up with the proverbial:

 


Comments (4)

  • owen frager

    December 9, 2011, 6:50 am

    I follow this stuff and zh and the situation is dire. Investors will be blind sighted and won’t know what hit them. Mainstream spin creates an illusion of opportunity. Many investors are into funds they have no idea of the holdings. Much of this is overseas and susceptible to Euro collapse. Fed makes a press release and people follow like sheep. Meanwhile AA is 20 cents, BA $5 and Citigroup laying off 5K people. That doesn’t convey much confidence.

    The time-proven trusted 10% dividend that drove acquisitions and gave investors confidence that dividends on a million dollar portfolio would fund their retirement, are getting just 3% and their portfolio is now probably 70K.

    That’s an expectation of 100K a year and a reality of $20K.

    They need a solution but the3dscanner.com for 50K isn’t going to make it.

    I think that language you highlighted above could just as well apply to parked domains. You have no control, no transparency or stability.

    And that’s the roadblock to pitching domains as investment grade. Example: a guy bought a house down the street on a short sale for 99K. The owners foreclosed owing over 400K. The guy can put up a sign and rent the house within days because so many foreclosed people are seeking rentals. He is guaranteed a 10% net annual return. You can’t promise that from a domain. In a perfect world you could by dishwashers.net for $20K and there would be an agency that would offer it to GE and others for rental like real property investing. I always believed it would be an ideal product expansion and new revenue stream for Google, After all they have reps calling on companies and selling million dollar ad words placements. Imagine they had an inventory of domains to offer as well. It would be a slam dunk.

    The other barrier to investment domains is inability to liquidate if you need to. You end up selling for pennies on your dollar. Investors in this space must be financially secure and able to hold the asset until the market matures and demand is created.

    Let’s say an elderly couple decide to go into assisted living. They sell their condo for $600K which is a $400K taxable gain unless they reinvest it in another home. If domains qualified as real property and buy investing in the domain they could avoid the tax and not have to buy a home they don’t need an worry about renting it- then you could argue that a $400K domain investment has already made them $200K in tax savings. There also could be trust strategies where they could pass the domain to children and spare them an inheritance tax. Those are the kinds of elevator pitches that would connect with investors who would never comprehend what a domain was and be terrified of the costs and liabilities of running it as a business.

    Reply
  • owen frager

    December 9, 2011, 6:53 am

    btw, the house buying guy put both sale and rental signs on the property. After 3 weeks he put a big sign “Price Reduced.” He ended up flipping and netting $70K on $99K. If domains could do that.. then you could command attention

    Reply
  • Scott Alliy

    December 9, 2011, 8:33 am

    Owen

    I like your house rental reference. I know somebody who has lots of foreclosure rental domain names :-)

    BTW

    To be fair about the home owner chances you did leave out the parts about the renters stiffing him and the potential 6% tax being considered on home sales.

    For my money good domains still have most upside with limited downside and to paraphrase the line from CaddyShack if the buyer doesn’t have the money they aren’t getting the name.

    As a domain name investor you are spared the eviction process BS

    SA

    Reply
  • Rob Monster - Epik

    December 28, 2011, 1:13 am

    Two followup thoughts here:

    1. Counter-party risk: The SOPA legislation is actually not all that different from what happened at MF Global. SOPA adds counter-party risk. A registrar can now seize a domain and be exonerated for doing so if that action is cloaked under the banner of SOPA compliance. There is a lot of room for interpretation. It is one thing to seize a domain that a client failed to renew despite multiple notifications. It is quite another to put an operating business out of business because of policy compliance. All of a sudden who your registrar is matters a whole lot more.

    2. Liquidity: The liquidity topic that Owen raises is an important one. It is frankly unsolved. As domain investors, most owners are “arbitraging time”, i.e. they have to have the means to sustain the carrying costs until a logical end-client comes along to take the domain to the next level. This was easy to do in the heady days of parking but became harder to do in recent years when some level of development was often needed for turning a domain into a cashflowing property.

    At the end of the day, the economics of buy-and-hold for development-grade domains remains pretty attractive. I would not suggest to anyone to go all-in on domains but for sure it is mighty attractive as a % of any balanced portfolio.

    Reply

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