MF Global: One Possible Explanation Where Customers' Money Went

Nov.22.11 | About: MF Global (MFGLQ)

Quite where all that money went from the supposedly segregated customer accounts at MF Global (OTC:MFGLQ) is something many people would like to know. Not just the customers, of course; there are varied legal agencies most interested in working it out too, to say nothing of the plaintiff's bar.

There's an explanation possible that makes sense: it lines up all of the economic incentives, explains what happened. I don't insist that it's true, only that it does make sense, which is at least a start.

Start with this piece from Forbes:

After an intense day of investigation, I have just discovered that a CFTC rule (1.29) allowed Jon Corzine’s MF Global to use the margin and cash in customers heretofore segregated accounts to amass a risky $6.3 billion investment in European sovereign debt that backfired. Nor did Corzine have the obligation to inform any of these customers he was gambling with their money. Or that he was intending to keep all the profits for himself and his troubled firm. Nothing for the customers.

The language of Rule1.29 allows “The investment of customer funds in instruments described in 1.29 shall not prevent the futures commission merchant (MF Global) or clearing organization so investing such funds and retaining as its own any increment or interest resulting therefrom.” Increment refers to any trading profits or gains.

OK, what this is referring to is that those client funds don't just sit in MF Global's accounts and do nothing. They're used to make money for the firm rather. Quite a lot of money for the firm, in fact:

At the root of MF Global’s current predicament was a simple problem: the profits in its core business had declined rapidly. That core business was straightforward, even pedestrian; what the firm calls in filings a “significant portion” of total revenue came from the interest it generated by investing the cash clients had in their accounts in higher yielding assets and capturing the spread between that return and what was paid out to clients. As interest rates declined sharply in recent years, so did MF Global’s net interest income, from $1.8 billion in its fiscal 2007 second quarter to just $113 million four years later.

What needs to be understood is that there's nothing unusual about this. It's the way most insurance companies make a profit too, not just futures brokers.

Both types of company have huge positive cashflows. Premiums are paid long before claims are paid out, futures traders have to leave cash collateral with their futures broker. In a competitive market (which is often the case for boh types of company), we therefore expect those companies to invest that money so as to make money for the company. This is Warren Buffett's secret for example. Yes, he's a great investor, but he's not so much investing his own money as the floats from all of the insurance companies he owns (or Berkshire Hathaway (NYSE:BRK.A) does).

The money to be made from doing this tends (only tends) to compete down the amount that can be made from the underlying business. Many insurance companies make a loss on actual underwriting; MF Global never made much as a futures broker, the big profits were always in holding the futures collateral.

However, as you will note, interest rates have been pretty low for a few years now. So while the same amount of money was still there to be used, the amount that could be made had fallen precipitately.

Which is where our third little piece comes in:

Client cash is also meant to be segregated under similar terms. The problem is that client cash is not kept as cash - that is it is not bits of paper sitting in vaults. Client cash is kept as people usually keep cash - in bank deposits when it is small in volume and maybe in short dated government securities when it is large in volume. Brokers have always been allowed to buy government securities as a use of client cash.

While brokers have always been allowed to do this they've nearly always done it in very short term instruments. T-bills for example, maybe 7 or 30 day maturities. They've not gone out and bought T-bonds because that would expose them to possible changes in the capital value; they're just trying to maximise the interest they can receive on this money they're sitting on for free.

They are allowed to buy government paper though. And that's where I think this story makes sense.

Jon Corzine could see that the short term yields on bills were simply terrible. They've actually been negative at one or two points in the last few years. He should stay with sovereign paper as he's absolutely allowed to use client funds to purchase that. So, let's move out in maturity, try to gain some interest by buying higher yielding debt to maturity. Which is, from other stories, just what they did do. Put the money into Southern European sovereigns on a one and two year basis, holding bonds that would mature then.

As we know, that strategy then blew up. But it's not that client funds were diverted, not that they were used to pay off losses on the deal. It's that all brokers all the time put client funds into government paper. It's just that MF Global went from 7 day T-bills to Greek bonds. They managed to lose the money not through any nefarious behaviour, but purely by trying to increase the yield from normal cash management.

As I say, I don't insist that this explanation is true. There's more than a bit of joining the dots in it, dots that may or may not really be there. But it does have the advantage, as a story, of actually making sense. Yes, I can see people deciding to go out a little further on maturity, taking a little more risk in order to gain greater yield. After all, we're doing standard cash management into sovereigns, just as we've always done, right?

Until, of course, it isn't just the same as everyone's always done.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.