Inside The Mess At MF Global

Nov.23.11 | About: MF Global (MFGLQ)

By Ron Rimkus, CFA

Here we go again: Another high-profile bankruptcy of a financial firm… Another scandal… It’s just another day on Wall Street, it seems. In October, following a series of debilitating credit downgrades and a steep drop in its stock price, commodities brokerage firm MF Global Holdings Ltd. (OTC:MFGLQ) declared bankruptcy. Assets belonging to some 33,000 customers were frozen, examiners descended on the firm’s offices, and its skeleton staff has been interrogated. There are press reports of subpoenas. And today, weeks later, some $600 million in client money that was supposed to be segregated from the firm’s own funds is still unaccounted for, including assets belonging to the managing director of the Standards and Financial Market Integrity Division at CFA Institute, who described being “hornswoggled by one of our industry’s own” in a recent blog post.

How many times can investors and the public muster the energy for outrage? At the heart of the MF Global saga is a breathtaking level of arrogance that reaches directly into the executive suite. Frustrating though it may be, the debacle affords serious investors an important opportunity to look beyond the headlines and analyze exactly what went wrong. In my view there are four acts to this drama.

Act I: The Strategy

In March 2010, a few months after losing his reelection bid for the governorship of New Jersey, former Goldman Sachs CEO Jon Corzine took the helm of MF Global. In a fascinating and revealing interview with Bloomberg News last February, Corzine articulated his strategy. The ex-governor said he wanted to transform MF Global from a broker-dealer into a full-service investment bank to rival the likes of Goldman. According to the interview, the first component of Corzine’s strategy was to “reduce risk and increase yield,” presumably through some sort of “sophisticated” risk arbitrage strategy.

Juxtaposing this statement with the firm’s subsequent bankruptcy is fascinating unto itself — but let’s not skip the intervening acts in this drama.

Act II: The Trade

Astonishingly, Corzine’s firm was felled by a single trade, marking out MF Global as collateral damage of the eurozone crisis. Here’s how it went down: As Europe’s troubles escalated throughout 2011, the Goldman trader-turned-CEO pushed MF Global to take leveraged bets on sovereign bonds of the so-called “PIIGS,” the (unflattering) acronym for Portugal, Ireland, Italy, Greece, and Spain, which collectively make up the weaker, overleveraged peripheral countries of the eurozone.

To execute the trade, MF Global bought $6.3 billion of shorter-maturity bonds offering high yields (because of the stress in Europe) and maturities ending no later than December 2012. These assets were purchased using repo-financing that enabled MF Global to pay less interest than the firm was earning on the bonds. According to people with knowledge of the situation, MF Global was attempting to leverage an explicit guarantee on the bonds from the European Financial Stability Facility (EFSF) — a guarantee that expired in 2013 — and lock in the spread between the cost of funding and the higher yield on the bonds. As is common in such repo deals, MF Global was required to post the sovereign bonds themselves as collateral. Thus as the bonds fell in price as the eurozone crisis intensified, MF Global was forced to post ever more collateral. Even if the bonds turned out to be “money-good,” MF Global was exposed to market risk.

Act III: What Went Wrong

It appears that Corzine and his firm accepted the EFSF and the European Union’s grand plan to stabilize the eurozone at face value. However, MF Global had total equity capital of just $1.3 billion — meaning that an adverse move in the firm’s $6.3 billion European sovereign debt portfolio could quickly render the firm insolvent.

Which brings us back to hubris: What kind of overconfidence does it require in order to believe that a trade can’t move the wrong way, if even for a time? In the case of Europe, guarantees and commitments from governments have been routinely changed throughout the last two years. (Just ask the owners of credit default swaps on Greek sovereign debt.) Given the dynamic nature of the eurozone crisis and the fact that overindebted nations are being asked to pledge assets to the EFSF to support fellow overindebted nations, the viability of the EFSF guarantees were at least open for discussion at the time that MF Global put on its trades. (Although in my opinion, these guarantees have been wholly inadequate all along.)

So exactly what opportunity did Corzine think he saw? Like so many problems in finance, it pays to dissect the decision tree. Consider the following pay-off structure:

Market Favorable to PIIGS Debt Market Unfavorable to PIIGS Debt
PIIGS Debt Pays Off 1) MF Global earns spread. 2) MF Global must post more collateral against repo-financing
PIIGS Debt Defaults 3) MF Global loses AT the default date. 4) MF Global loses BEFORE default date.
Click to enlarge

As the table shows, MF Global’s bet pays off in only a single scenario (cell #1), and works against the firm in each of the other three scenarios. Even if Corzine and other executives at MF Global believed in their heart of hearts that European sovereign debt would ultimately be money-good, they should have at least acknowledged that the market could move against them for some period of time. And as the old saying goes, “The market can remain irrational far longer than an investor can remain solvent.”

It’s one thing when a bright young trader is caught flat-footed by overconfidence. But it is quite another matter when a prominent, experienced financial executive repeats the sins of the recent past. And that’s exactly what Corzine did: On a voluntary basis, even after living through a series of high-profile and catastrophic bankruptcies in 2008 and 2009 (think Lehman Brothers, AIG), he followed the same script by failing to have adequate capital on hand to meet margin calls.

Corzine told his interviewer at Bloomberg News, “I’m not a trader, I’m a salesman.”

I couldn’t have said it better myself.

Act IV: The Lessons

I see three key lessons that can be drawn from the collapse of MF Global:

  • Ignore what management says, evaluate what management does. Corzine’s well-publicized strategy of converting MF Global into a full-service investment bank may have sounded good, but the risks involved in getting there were clearly overlooked by regulators, the firm’s board, and its own customers.
  • A guarantee is not the same as an assurance. European politicians have proved an important point that investors and traders should never take it for granted. Regardless of what an entity may commit itself to doing today — be it a government or a corporation —investors do not have the assurance that the guarantee will be fulfilled. MF Global put too much faith in politicians actually doing what they said they would do. The consequences speak for themselves.
  • Respect the markets. Arrogance is a trader’s downfall. Not acknowledging that the market can move against you is the kiss of death. What more needs to be said? It’s flabbergasting.

What lessons do you draw from the MF Global debacle? Share your views in a comment.