Tuesday, November 22, 2011

MF Global Collapse Shows Wall Street Needs Tougher Rules

MF Global declared bankruptcy this month. The once trusted brokerage with roots dating back to the 1700s filed the eighth-largest ever U.S. bankruptcy after a wrong-way $6.3 billion trade on its own behalf on bonds of some of Europe's most indebted nations. "While most people would have never heard of MF Global, its bankruptcy may be seen as the first shoe dropping in the European financial crisis and as a clear indicator that the regulatory infrastructure of 2011 may not be sufficiently more solid than the structure that failed so miserably in 2008."

MF Global's CEO Jon Corzine, former CEO of Goldman Sachs as well as former governor and Senator from New Jersey, expanded the companies reach in recent years from its brokerage base by making an aggressive move into proprietary trading. Many believe that this move into proprietary trading spelled its downfall.

According to Eric Lewis writing for CNN: "MF Global's Company Overview and Financial Overview, both dated October 2011, tell a story quite different from that of a company about to plunge into insolvency. At the end of September, it touted $41.05 billion in net assets, $3.7 billion in available liquidity and $2.5 billion in total capital. It was able to sell $325 million in unsecured notes in August. It claimed 'solid risk management,' a 'strong capital position,' 'strong liquidity' and an 'extremely liquid and high quality balance sheet.'

Its balance sheet was huge but terribly fragile. While it had lots of assets on its books, it also had a huge amount of borrowing. For every dollar of its own capital on its books, it had borrowed $40, a leverage even greater than that of Lehman Brothers at the time of its collapse.

Why is that a problem in a time when near-zero interest rates extend as far as the eye can see? Because leverage is always treacherous and 40-to-1 leverage is madness. Even when interest rates are low, lenders demand security. When the value of that security goes down, the demand for margin -- additional collateral to secure the debt -- goes up."

Lewis argues that too-tepid "leverage requirements" in the wake of Dodd-Frank are to blame for MF Global's downfall. "Many will view the demise of MF Capital as just another bit of the 'creative destruction' of capitalism. The Republican candidates complain that Dodd-Frank, last year's financial reform bill passed in response to the credit crisis, is stifling healthy risk-taking. The reality is that Dodd-Frank does not do enough to prevent financial institutions from taking excessive risks with investors' money. While it imposes leverage requirements on banks, those requirements are still quite limited, and institutions not regulated by federal banking agencies are not restricted in their risk-taking in any meaningful way."

As described, Corzine and his traders made very aggressive bets on European debt which would have resulted in spectacular profits had the bonds moved favorably for MF Global, even just slightly. They did not. As Lewis concludes: "Leverage is the steroid of modern finance that creates the hazardous incentives to bet big, keep the winnings and dump the losses onto others. What MF Global shows is that the problem is not too much regulation but too little. Without meaningful leverage restrictions on borrowers and meaningful lending restrictions on those who are willing to underwrite this steroidal debt expansion, MF Global is likely to be the tip of yet another iceberg. And we have yet to recover from the last financial Titanic."

Finally, as reported by Leah McGrath Goodman for CNN/Money yesterday, the MF Global mess keeps getting messier as the bankruptcy trustee announced perhaps as much as $1.2 billion may be missing from customer's accounts, indicating potential misappropriation.

18 comments:

  1. Natasha (Memphis Law)November 23, 2011 at 12:19 PM

    Brokerage files bankruptcy. Investors whose money was lost now become creditors. I wonder if the brokerage's decision to take these risks will be protected by the business judgment rule?

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  2. The same regulators that failed in 2008 also failed in 2011. Despite Dodd-Frank nothing really seems to have changed. Government regulators are always playing catch-up with the banks.

    Instead of more regulation, we need more failure. Or more accurately, financial institutions and their customers need to know that when they fail, they'll suffer the consequences. All the bailouts and Dodd-Frank has done is subsidize the largest financial institutions' capital costs. Impose market discipline on these companies and then their owners might be less willing to takes such risks.

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  3. NatalieB_MemphisLawNovember 23, 2011 at 4:42 PM

    This article made me wonder if the risks will be protected by the business judgment rule as well. The fact that $1.2 million may be missing from customers' accounts, possibly from misappropriation, indicates that some of the business decisions may not have been in good faith, which would not allow directors to use the protection of the business judgment rule. It also seems that even if directors informed themselves about transactions, the huge amount of borrowing may not be believed by a court to be reasonably appropriate under the circumstances.

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  4. we dont need more regulation. Fact is , is that having the CME as their maine reglator was a conflict of interest. Everone knows that the CME looks the other way for other similar firms as well. Had their been an independent regulator that doees not get its income from the firm its regulating we would not be here. Also, there were many blow outs at MF global back in 2007...could it be that we have somthing similar to the situation at Refco ? I think the forensic accountant need to go back to 2007 .

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  5. REFCO, MF Global-What is the common link?

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  6. Kenneth W (Memphis Law)November 26, 2011 at 1:20 PM

    What I cant understand is how MF Global is prop trading on borrowed money. I understand leverage, however high risk leverage increases the likelihood of multiplying the losses sustained when outcomes are unfavorable. The regulation should come in some form of accountability for the firm for making high risk decisions when they are indebted "40 to 1." Moreover, this behavior should be prohibited in the first place. If they dont fail the first time around, then its eventually going to happen. Its like MF Global betting all their money at a crap table, and money that wasnt even theirs. This is what regulatory measures should seek to prevent. Hopefully policymakers can see that Dodd-Frank has work to do to prevent disasters such as these.

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  7. What is truly amazing is that Corzine just two years prior to this collapse was touting regulation as a US Senator that would have prohibited his company from making the kind of risky investments it did while being so extremely highly leveraged. Those who argue for no regulation in this area argue that no relief is ever due to those investors whose money is lost with such risky investments, even while all along the way MF Global called its balance sheet "strong." Would you call your balance sheet strong if you had one dollar, borrowed $40 from a friend, and had it all bet on black? Most of these "investors" are funds that millions of Americans have money in, yet they have no clue that part of their money is invested in such riskiness. This is why regulation is necessary. I'm glad that the free market allows us to take extreme risks. Just let the government assure me that when I think my money is in some "low risk" mutual fund, that its not in some portion invested in some high risk venture.

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  8. I agree with Denny that regulation is necessary, and the key to effective regulation is clarity and specificity. Piling on regulations will not help the situation where the regs are broad such that they give too much discretion to financial firms to determine the boundaries. Regulations requiring "reasonable" leverage would probably disallow a 40-to-1 situation, like here, but even that might be too broad for cases less extreme than this one. Perhaps even requiring financial firms to propose their own set of internal guidelines and boundaries (along the lines of the Goldman Sachs internal policy) would be a good launching-off point.

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  9. Internal guidelines could be helpful to help keep the financial firms in check; however, what about the banks who are lending money to the financial firms when they are already leveraged 40-to-1? I know it is their money and they can do what they want to with it, provided they don't violate their fiduciary duties to their stockholders, but is seems there should be some regulations on their end as well.

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  10. You gotta love Corzine, right?

    But in all seriousness, I agree with points Aaron and Natalie mentioned above. One, the Dodd-Frank Act seems to have done very little in curbing the abuses of these major investment firms. Shockingly enough, banks that are able to invest more money in intelligent individuals continue to find ways to subvert or manipulate governmental regulations. The government is always a step behind corporate America. Corporate America does a better job of manipulating and working the system than having the system applied to them. At some point wouldn't it be rational to see how a truly free market system would punish and regulate these firms? At this point, what investor in their right mind would consider putting money into these firms. Two, I think the BJR might provide protection here. There is the issue of fraud and misappropriation. However, most of the issue seems to steam from just bad business decisions.

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  11. I agree with Mr. Bradley; however there are insane investors who are willing to put money in these financial institutions. MF Global was leveraged 40-to-1. That is an astronomically unreasonable, irresponsible, and unbelievable figure. What were the investors thinking when they invest in a firm who is already leveraged like that. I think at the very least there has to be a violation of the duty of care simply because of irresponsibility of these actions. The fact that this is the second company Corzine has done this too is just a contributing factor piling on the madness. At some point the people in charge of these companies who are lending the money and making these bad investments have to be held responsible.

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  12. Gray N. Memphis LawNovember 28, 2011 at 3:09 PM

    The Dodd-Frank Act appears to to be all bark with little bite with regard to limiting the amount of leverage a company can create in investing. MF Global's 40-1 leverage was incredibly unwise, and as we now see, fatal to the company. The Dodd-Frank Act should be revised to set well-defined limits on how much money companies can borrow based on their capital. Any regulatory act that allows companies to borrow more than forty times what they actually own is highly inadequate.

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  13. Natasha_Memphis LawNovember 28, 2011 at 3:26 PM

    Perhaps the Dodd-Frank Act opens the door for the SEC to promulgate rules regarding fiduciary duties broker-dealers owe to investors. It seems that a duty of loyalty violation would be easy to spot, but a duty of care violation might not be as easy because risk is assumed when you invest money.

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  14. MF Global's downfall seems to have some factual comparison to that of Enron. Both had enormous profits and liquidity on the books, so their bankruptcies came as a big surprise. Of course the cause of their failure is different - fraud vs. risky investments - but the result is the same. It does create a good argument for more regulation, and more prudence on the part of shareholders and in MF Global's case, customers, to be as informed as possible about how their investment in the company is being put to use. It will be interesting to find out what happened to the $1.2 billion missing from customer accounts...there may be more factual comparisons with Enron to be made.

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  15. The missing $1.2 billion is certainly troubling and rightfully incites suspicion, especially considering the figure is much higher than what MF Global had previously reported to regulators. If MF Global did take from customer accounts to offset their worsening financial condition it seems that behavior would implicate securities law. This also raises further questions about the appropriateness of regulatory rules in this area. How well regulated is this sector if MF Global thought using money from customer accounts (assuming that is what happened to the missing $1.2 billion) was an acceptable course of action? If on-point regulations were in place, were they broad to the extent that MF Global thought it could exploit a loophole?

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  16. Franklin A (Memphis Law)November 28, 2011 at 8:22 PM

    Kate is right. If proper regulations were in place and proper use of those regulations implemented then questionable behavior such as taking money from customer accounts would not occur or would at least be caught early, thereby reducing the lose incurred by individual investors. Also concerning the leverage here, if a institution wants to take high risk investments they should not be prevented from doing so, however, investors should be made aware of this investment strategy so that they can choose whether or not to partake in the high risk investments.

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  17. Lindsey G (Memphis Law)November 28, 2011 at 9:37 PM

    To piggy-back on what Kate and Franklin have said, I agree that this type of behavior is highly questionable. Too often we see CEOs willing to take huge risks with money that is not theirs. It is one thing to use corporate funds to make a business investment (tagging onto what Josh Bradley said, the BJR could be argued) but it is quite another to misappropriate funds from customer accounts in an attempt to make-up for previous bad business decisions. If a company wants to place risky bets, I agree with Franklin that investors should be made adequately aware of the type and risk of investment so they may decide whether or not to take that risk. When it comes to misappropriating money (i.e. $1.2 billion) from customer accounts, that type of behavior is never acceptable and should be prosecuted as a securities violation.

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  18. I think that what Wall Street needs is not tougher rules, but a different set of rules. Every couple of months another CEO makes headlines for taking fraudulent risks with investor money and losing. What does not ever make headlines is the story of the CEO who took huge risks that paid off. Rouge CEO's will continue to take these fraudulent risks because, if they are successful, they will reap huge rewards and most likely will not get caught. Our current regulatory scheme focuses on those fraudulent transactions that fail. What the country needs is a regulatory scheme that also focuses on exposing CEO's that make fraudulent transactions that DO pay off for their investors. If the incentive for executing a fraudulent transaction is removed then the amount of occurrences will drop.

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