The demise of MF Global (MFGLQ.PK) at the end of October shocked many financial market participants. It was not the size of MF Global (which was comparatively small) which was the shocker, it was the fact that retail investors lost money in "customer accounts" and the fact that regulators have been asleep again railed financial markets.
Investors had a lot of trust in the firm led by Jon Corzine, the former governor of New Jersey. The firm was relatively small compared to some of its competitors with $40 billion in assets and $1.5 billion equity. This kind of leverage was in line with competitors. Reported capital ratios under the Tier-1 ratio using the "risk-weighted-assets methodology" looked much more favourable. This methodology is seriously flawed as government bonds were assigned 0% risk and did not appear in the risk weighted assets.
European Sovereign Debt Bet
Over time, Corzine set up a massive bet by going long European sovereign debt in for about $6.3 billion which he financed by shorting high-creditworthy short term bonds in the repo-markets. The US regulator FINRA already warned in June that the positions should not be held off-balance under the GAAP accounting principles. Additionally, MF did not hold any capital against the positions and they were not marked-to-market.
In the period June-November 2011, the 10-year Italian bond lost 10% of its value going from par value to trading 90 cents on the dollar. Corrections in Greece government paper over the period were even bigger. The liquidity shortfall these adverse movements triggered resulted in a collapsing stock price. When rating agencies started downgrading MF's bonds the firm could not escape the negative spiral and went belly up.
Cost For The Industry
While the direct costs of the failure are fairly limited with 2900 people losing their jobs and retail investors still missing $1.2 billion, the bankruptcy has been extremely costly for the industry as a whole:
1. Retail customers lost about $1.2 billion despite having their funds in "segregated" accounts held with MF Global. More and more evidence suggests that in the week before the failure the firm took the money out of the retail accounts. The industry is forced to do something to restore this breach of trust. An industry sponsored bail-out fund or other type of safety net needs to be provided which will impose a lot of costs to market participants.
2. Major banks have been complaining about rising compliance costs under the Dodd-Frank regulation which they consider as imposing unnecessary costs and slowing down growth. The banks, which traditionally favour self-regulation, are proven wrong in this case.
3. Auditor firms get another blow as big four accounting firms signed off MF's paperwork just months before filing Chapter 11.
4. While regulators including FINRA did warn about positions, no enforcement took place.
5. The failure reinforces the image that Wall Street just serves itself. The flash crash in May 2010 and stories about high-frequency trading have already scared away retail investors.
This thing is far from over. The new breach of trust comes at a time when confidence in the financial system is already really low. A serious indictment leading to prison sentence for CEO Jon Corzine would be a first step in recovering public opinion.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.