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Now that the MF Global bankruptcy (OTC:MFGLQ) trustee has doubled the probable loss of client funds to $1.2 billion, where did those monies go?

Many facts are well known. When the Fed dialed down U.S. interest rates to near zero, it squeezed trading houses' net interest margins, too. And an unprofitable firm like MF Global, which hadn't had a profit since 2007, responded by placing a net $5.3 billion in laddered, highly-rated eurozone sovereign debt. And in so doing, the firm picked up about 150 basis points in yield.

MF Global was also highly levered (about 33 times)and dependent on short-term borrowings and client funds for most of its liquidity. Such funding largely disappeared after October 25th, when the firm reported a substantial loss for the quarter ended September 30th.

Other facts are less well known, such as financing and collateral arrangements in the days after the earnings release, but before the bankruptcy filing 4 days later.

The principal "known unknown" is, 23 days following the bankruptcy filing, where's the money? Likely, it's lost, gone to trading losses as liquidity flight forced the firm to sell its investments to raise cash, whether in held-to-maturity sovereign debt repos or various other, more prosaic investments, as well.

What's to be learned? First, a weak business model, excessive leverage, and a lack of profitability combine poorly. In a liquidity squeeze as MF Global experienced, customer funds can be lost, even if properly held in segregated accounts.

Second, when central banks misprice interest rates, the consequent market distortions are never "idiosyncratic", to borrow Fed Chairman Bernanke's word. They become widespread in due course. Bad policy begets bad decisions. Firms will misdirect credit and miscalculate risks, but surely MF Global is not alone in that particular.

What of the legality of MF Global's actions? The firm's investment in held-to-maturity repos in highly rated European sovereign debt doesn't appear illegal, fraudulent or contrary to regulation, even if an unwise risk for a highly levered, unprofitable trading house. The firm's management of its collapse, how it may have collateralized emergency funding after October 25th, its investment liquidation, and control and use of funds received are where illegality and fraud may ultimately be found.

Source: MF Global: Show Me The Money!