MF Global Proves It's Not Too Big To Fail

| About: MF Global (MFGLQ)

This morning (Monday), MF Global (MF), a worldwide heavy weight contender in the futures markets, filed for Chapter 11 bankruptcy in the U.S. Bankruptcy Court for the Southern District of New York. According to reports, the company got caught in high-risk trades, seeking to profit from a big rise in the value of European debt. Its CEO, former Goldman Sachs bigwig and former governor of New Jersey, Jon Corzine, believed that Italian and Spanish debt was deeply depreciated. Big bonus pay was in store for him if the trades had worked out, but they didn't. Instead, European debt continued to depreciate even more. Now the stock and bond holders of MF Global will pay the price.

I have stored a copy of the Petition in Bankruptcy, along with the initial minimum schedule of the largest unsecured creditors, for my readers to review. The company claims total assets and liabilities in the approximate amount of $41.05 billion and $39.64 billion, respectively. It is likely that, in light of today's market action, those figures will have changed significantly, either up or down, when marked to market. Based upon its prior action in raising silver margins far above the levels required by the exchanges, during critical periods of time during which speculative long positions were stressed, we can reasonably assume that the company was and probably is short silver. So the company probably made money today, given that silver is down in price for the moment.

The two biggest unsecured creditors are listed as JPMorgan Chase (NYSE:JPM), which is the "indenture trustee" of a bond issuance just shy of $1.3 billion, and Deutsche Bank (NYSE:DB), which is similarly responsible for a little over $1.01 billion in other bonds. An indenture trustee is the "person" who legally assumes fiduciary responsibility to handle crucial administrative acts involved with a bond issuance. This includes monitoring interest payments, redemptions, and communications with investors. In other words, the individual banks involved may have no capital at risk. It all depends on whether they own any of the bonds as "bank capital." They may just have underwritten the bonds, and given themselves the servicing job. Most likely, the bank customers are the only ones at risk.

The bondholders are likely to be pension funds, smaller banks, insurance companies, brokerage houses, independent investors and little old ladies in Florida, among others. All these folks, having been starved of yield by the actions of the Federal Reserve in reducing interest rates to zero, have been taking big risks on junk bonds. In addition to the bondholders, though, MF Global appears to have millions in past-due legal bills. The business media is also owed a lot of money. The company owes over $800,000 to CNBC, owned by General Electric (NYSE:GE), and hundreds of thousand of dollars to privately held Bloomberg LP, probably the result of either the sale of information services (in the case of Bloomberg) or advertising services from CNBC.

Only time will tell how this pans out. However, at the risk of being cynical, in my experience, Chapter 11 reorganizations rarely work out well for anyone other than the people who run their companies into the ground. Of course, it doesn't usually work out too well for them, either, since they are eventually put out of a job, but it tends to work out better for them than for anyone else, especially stock and bond holders. Usually by the time the "debtor in possession" is ready to give up the ghost, it manages to waste otherwise liquidatable assets.

The clearing house (CME, ICE, etc.) guarantees performance to third parties by clearing members, like MF Global. Thus, anyone who happens to have MF Global as a counterparty at the exchange-traded markets will have the too-big-to-fail banks -- and their guarantor, the U.S. government -- to back them up. The guaranty, if any, to MF Global's own customers, however, is less clear from a legal standpoint. Faith in the entire system would be placed in severe jeapardy if MF Global customers lose money. After that, few people will be ready to deposit performance bonds with any futures market participating brokerage.

Apparently, unlike the big Federal Reserve primary dealers, like Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS), JPMorgan, Merrill Lynch and Citigroup (NYSE:C), MF Global is not too big to fail. The New York Federal Reserve announced it would no longer do business with the company before it filed bankruptcy. Indeed, a strategic bankruptcy of a small primary dealer might be just what the doctor ordered for the big firms, who may use this as an opportunity to exit short positions in the futures markets at a more reasonable price.

The too-big-to-fail banks and the government, however, as well as all the derivatives clearing houses, have a huge stake in making sure MF Global's customers do not lose too much money. But many customers will lose money anyway. According to Dow Jones' Marketwatch, futures exchanges are enforcing a "liquidation only" policy upon brokers who clear through MF Global, as well as on employees of the company itself.

Liquidation-only will also cause losses to counterparties, because various commodity futures contracts may fall, in the short run, as a result. Eventually, however, this failure is probably a positive for precious metals investors. MF Global was one of the brokerage houses that led the way to raising silver performance bonds well above the increases imposed by the clearing houses. We can safely assume that they were short silver. It seems unlikely that they would destabilize their customers' accounts and torpedo the silver price if they were long.

Right now, the first positions being liquidated are those of MF Global customers. Like all the customers of clearing members of all the futures exchanges, these positions are going to be heavily long bets on a price rise. Customers are the first ones to want to get out of positions, if they can, to grease the move to other brokerage houses, and/or to reaccess a process that has probably shocked them, and about which they have little information. All most of them know is that their brokerage house is going bankrupt, leading to a desire to cash out.

Eventually, however, the company's own short side positions will be liquidated or significantly reduced. Bankruptcy court orders are needed before that happens. When the initial period of customer fear and liquidation subsides, and the company begins to liquidate short positions, substantial upward price pressure on commodities upon which MFG was short will occur. Among other commodities, I feel sure the company held a substantial silver short position.

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

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