Was the MF Global (OTC:MFGLQ) failure "idiosyncratic," as Fed Chairman Bernanke stated Wednesday in his post-FOMC press conference? In other words, was it an isolated case without bearing on anything broader, one that won't impact financial stability? With total June 30, 2011 assets of $41.0 billion, MF was just a fraction of Lehman’s size at its September 2008 failure. And, at least for the present, the direct impacts seem limited, beyond those to the company’s unfortunate customers, whose accounts remain $593 million short at the latest tally.
But isn't the broader issue what motivated MF to go net $5.0 billion deep into laddered repo-to-maturity trades in Italian, Spanish, and Portuguese sovereign debt? And does the answer bear at all on Fed policy? For example, what behaviors might be motivated by a Fed funds rate of 0% to 0.25%, when eurozone repo rates are 125 bps higher?
According to its financial disclosures, MF’s revenues came from 3 sources: commissions, principal transactions, and net interest income on client accounts and the firm’s collateralized financial arrangements and principal transactions. In 2011, commissions and principal transactions comprised about 68% of $1.099 billion in net revenues, down slightly from 68.4% of $1.015 billion in 2010. Net interest income was 28.8% of net revenues, compared to 27.4% in 2010.
One looming problem was that MF hadn’t reported a profit since 2007. In FY 2010 ending March 31, when the company hired John Corzine to restructure operations, MF lost $137.0 million. In 2011, MF narrowed the loss to $81.2 million. But much of the restructuring effort entailed a sharp cut in the size of its balance sheet, from $51.0 billion at March 31, 2010, and most of that through a reduction in securities purchased and sold under repo agreements. In the context of a smaller balance sheet and a federal funds rate at “exceptionally low levels,” should it come as any surprise that a stressed MF might look to enhance net interest income with investments in highly-rated European sovereign debt?
And while some conclude that these investments caused the MF collapse, they were certainly disclosed in the FY 2011 10-K and more recent company presentations. In my opinion, the better analysis is that these were a sideshow to the $191.6 million loss reported in its 2FQ2012 earnings on October 25th, accompanied by financial leverage of 33.3x. The market concluded that MF had business model and risk-management problems. And having lost market confidence, within a few days, the company found itself without funding enough to stay in business.
But, if repo and other interest rate differentials between the U.S. and Europe motivate money to move where it may be better rewarded, what explains Bernanke’s conclusion that MF was just idiosyncratic? The better and more obvious conclusion is that exceptionally low U.S. interest rates will result in large compensatory changes in financial behavior and that MF is but one example. And while this result is to be expected, why is the Fed chairman seemingly oblivious to the monetary policy, regulatory, and risk management implications?