"MF Global - Hoisted on a Petard of Arrogance"

Sydney M. Williams

Thought of the Day
“MF Global – Hoisted on a Petard of Arrogance”
December 1, 2011

Wall Street has a maze of rules and, despite the hoots and hollers from “occupiers” and populist politicians, most are designed to protect investors. Perhaps the most fundamental of these is thou shalt not comingle customer cash with company cash. MF Global, which traces its roots back 228 years and which for the last 19 months had been run by Jon Corzine, former CEO of Goldman Sachs and a former U.S. Senator and Governor of New Jersey, allegedly did just that, according to James Giddens, trustee for the firm that filed for bankruptcy on October 31.

How complicit Mr. Corzine actually was in what would be a criminal act of using client funds for the firm’s purposes will be determined by the courts. But the act also highlights the too-cozy relationship – cronyism – between politicians and Wall Street. MF Global’s chief regulator, the Commodity Future’s Trading Commission (CFTC), which obviously did not perform the oversight they should have, is run by Gary Gensler, a former Goldman Sachs partner. Last February, MF Global was named as one of twenty-two primary dealers by the New York Federal Reserve, joining a select group that includes banks such as BNP Paribas, Goldman Sachs, J.P. Morgan and UBS Securities. The head of the New York Fed is another former Goldman partner, William Dudley. This smacks of crony capitalism at its worse, benefitting a small contingency at the expense of the people.

As a broker dealer, MF Global was able to access the Fed window, so able to borrow overnight funds at the discount rate – 75 basis points. According to their second fiscal quarter report (September 30, 2011), they had a $6.3 billion portfolio invested in “short-duration European sovereign portfolio financed to maturity (repo to maturity) including Belgium, Italy, Spain, Portugal and Ireland.” As the Wall Street Journal notes today in an editorial, “by using a repo to maturity technique, [the firm] was able to consider the bonds ‘sold’ for accounting purposes and therefore they disappeared from MF Global’s balance sheet,” even though the bonds had been pledged against loans.

While Greece was not mentioned, rates in all those countries have risen recently, implying declines in principal values, as risks to the Euro become more visible. It was the spread difference that attracted their interest. For example, with Italian 2-Year notes yielding over 6%, the spreads were as alluring to MF Global traders, as the Sirens were to Odysseus. Odysseus, though, filled his ears with wax and had his men lashed to the mast. He proved wiser than the ill-fated Mr. Corzine, who fell to temptation. Corzine must have concluded that the European Financial Stability Facility (EFSF) would not permit default; so that as long as he held his bonds to maturity he would be fine. However the EFSF has a total capacity of about $580 billion against total European sovereign debt of about $13.7 trillion, and portfolios get marked to market.

At the end of their first quarter (June 30, 2011), the Financial Industry Regulatory Authority (FINRA), Wall Street’s self-regulator, became alarmed when MF Global disclosed that it had bought debt from Italy, Ireland and other troubled European nations. According to a report in the November 2, 2011 issue of the New York Times, FINRA pushed for a capital raise. Mr. Corzine chose to go over their heads directly to the SEC, who sided with FINRA. Thus in August, MF Global raised $650 million in two tranches – $325 million in seven-year, 3.375% senior convertible notes and $325 million in unsecured five-year, 6.25% five-year bonds. The bonds carried an unusual “key man event” trigger. If Mr. Corzine were to be appointed by the President to a role in the federal government before July 1, 2013, the interest rates on the bonds would rise by 100 basis points. Rumors were that Mr. Corzine would be nominated to replace Timothy Geithner, should Mr. Obama win a second term. One cannot help wonder if the “key man event” will be triggered if Jon Corzine is appointed to serve time in a federal penitentiary?

Mr. Corzine reaped an estimated $400 million when Goldman Sachs went public in 1999. He used some of the money to fund his successful bid to become a U.S. Senator and even more to become governor in 2006. Fortunately for residents of New Jersey he lost his bid for re-election in 2010 to Chris Christie. His tenure at MF Global was not covered in glory. During the quarter ended September 30, 2011, the firm, on revenues of $205.9 million, had a GAAP loss of $191.6 million. (A year earlier, with Mr. Corzine at the helm for only a few months, the firm lost a mere $94.3 million. It is amazing what a reckless trader can do with someone else’s money!) Revenues per employee, for the quarter, were approximately $72,000, an unusually low number in this industry. Losses per employee were $66,200, a remarkably high number.

All commerce depends on a sound banking system. And banks have always used leverage; without it growth withers, but when liabilities are treated respectfully and assets purchased are reasonable, the system thrives. Without banks, economies would wither and living standards would retreat to unimaginable levels. In 2008, we saw the consequences of bankers playing fast and loose with monies with which they had been entrusted. The Securities Investor Protection Corporation (SIPC) will, in the worst case situations, protect securities up to $500,000. For any balance beyond that, investors are on their own.

As mentioned at the start of this piece, it is a fundamental given in the business that customer funds are kept segregated from a firm’s capital. It appears that that trust was violated by MF Global. If that proves to be the case, someone needs to go to jail. The fact that no one at Lehman, Bear Stearns or most glaringly, Fannie Mae and Freddie Mac, or politicians that encouraged such behavior have gone to jail is inexcusable. If this act is left unpunished it means that our capitalism is not subjecting itself to tests necessary to allow it to survive and thrive. Cronyism among bankers, business persons, politicians and union leaders is not that different from the Russian oligarchs we claim to abhor.

Most people on Wall Street are hard working, bright and aggressive, but also conscientious and law abiding. Most recognize early on that mistakes and errors are part of their learning experience. Those who labor on the Street tend to have big egos; for self confidence is integral to success, but when confidence morphs into arrogance the results can be ugly. The ancient Greeks knew this as hubris, and considered acts of hubris the greatest of crimes. In the mythology of ancient Greece, the vainglorious, like Icarus and Oedipus, met unhappy ends. If our system of democratic capitalism, a system that relies on trust, is to survive, it means that those who violate its most basic tenants cannot be protected. They must be punished.

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In the interest of providing everyone a break from these essays, I am off tomorrow for a few days of skiing, returning on Thursday, December 8.