MF Global: Fraud, Incompetence, or a Bit of Both?
In the wake of its futures-market-rattling bankruptcy, there is a huge shortage of client funds at MF Global (OTC: MFGLQ). But when we look back at what led to the broker's collapse, one thing is clear: There's no shortage of incompetence.
Sure, the question of fraud is what has grabbed much of the headlines, but even if there was bona fide fraud, it was served up with a hefty helping of poor judgment, miscalculation, and a seeming inability to learn from even the very recent past.
At this point, the one thing that we can say for sure in the case of futures broker is that it is an epic disaster. A brokerage that traces its roots back to 1783 is now bankrupt and liquidating, billions of dollars of supposedly safe customer money has been frozen, more than $1 billion of it appears to be missing, and there're no shortage of calls for the head of former CEO Jon Corzine.
But what was actually fraudulent here and what was just plain dumb?
Man was that stupid!
Chief among the incompetence offenders here is Corzine, who set an ambitious strategy to turn the futures broker into an investment bank that would compete with the likes of Goldman Sachs (NYS: GS) and Morgan Stanley (NYS: MS) . One of Corzine's primary steps in this direction was building a principal-trading operation within MF Global that risked the firm's own capital.
What Corzine didn't do, however, was put the company in a position where it could safely make such a transition. MF Global was already highly levered when Corzine took over, but he kept the massive leverage -- 30-to-1 as of Sept. 30 -- even as he ratcheted up trading risk. This gave MF Global and its fledgling principal strategy desk precious little room for error without blowing up the entire company. Leverage at that level was what sunk Lehman and Bear Stearns and put all the other big banks at risk in 2008. That Corzine somehow missed that boggles the mind.
Then, of course, there was the huge bet on European debt that played a major role in sinking MF Global. Along with the hefty leverage, avoiding concentrated bets was another lesson that any reasonably informed average Joe could have learned from the financial crisis that took place a mere three years ago.
Even if Corzine Rip Van Winkled his way through the recent financial meltdown, he should know plenty about the dangers of making big bets while being highly leveraged. When he was the co-CEO of Goldman Sachs, he took part in the bailout of the overly leveraged Long-Term Capital Management. LTCM failed after large, concentrated bets it made went the wrong way.
Of course, Corzine wasn't alone in this disaster. MF Global had a chief risk officer, Michael Stockman, who presumably should have had something to say about the crazy risk profile at MF Global. To be sure, Stockman said the right words when it came to the issues that caused the 2008 financial crisis. He co-wrote a research paper, "The-100 Year Flood," about the meltdown and helped design a course at Dartmouth's business school that -- according to his MF Global bio -- focused on "risk management insights."
And yet Stockman seemed to bring none of this insight to MF Global. A candidate for the foot-in-mouth Hall of Fame, Stockman was quoted by Risk.net as recently as March as saying, "I would suggest we are not taking enough risk."
And while those may be some of the most glaring examples of idiocy at MF Global, it really only scratches the surface, as we could also potentially include the current CFO, the former CFO, and the traders on the prop desk, among many others.
Limber up for the perp walk
For better or for worse, CEOs and other executives can make certain stupid decisions and not be jailed for it. The extent of MF Global's leverage was a secret to no one. And though there are some folks complaining that the company didn't disclose enough about its bet on European debt, its annual report -- which was released in May -- makes it pretty clear that the company had huge exposure:
At March 31, 2011, securities sold under agreements to repurchase of $14,520,341, at contract value, were de-recognized, of which 52.6% were collateralized with European sovereign debt. [Author's note: Dollars in thousands.]
But when clearly defined rules are in place, and a company and its executive team violate those rules, it's time to break out the handcuffs.
In MF Global's case, the most glaring issue is the fact that as much as $1.2 billion of customer money is currently missing. Under Commodity Futures Trading Commission rules, customer money can be invested in certain ways to earn money for the brokerage, but it cannot, under any circumstances, be used by the company to fund itself or its own trades.
The question of what happened to that money is still under investigation, but many -- including CFTC Commissioner Bart Chilton and accounting expert and Forbes columnist Francine McKenna -- think that foul play is involved.
One possibility is that in a fit of desperation as the company was crumbling, Corzine, or somebody else at the top of MF Global, decided that it would be OK if customer funds were used to shore up the company's trading positions. If this turns out to be the case, it's bad news for the execs at MF Global because that's just plain illegal.
It's also possible that something has been fishy at MF Global for a long time and it was only the blaring light of bankruptcy that revealed the company's misuse of customer money. Once again, if this is the case, we'd expect to see somebody end up behind bars. The big question here would be what, as the CEO of the company, Corzine would be on the hook for if he didn't explicitly know what was going on.
Answer: (D) All of the above
The more details that trickle out from the investigators on MF Global, the more it seems like this was a lethal mix of incompetence, hubris, and idiocy along with a nasty dose of fraud.
Of course, to be fair, particularly when it comes to possible incompetence, there's plenty to go around outside of MF Global. Remember, a company like MF Global can't reach untold heights of leverage without the aid of willing lenders like JPMorgan Chase (NYS: JPM) , Bank of America (NYS: BAC) , and Deutsche Bank. Additionally, futures exchanges like CME Group (NAS: CME) and IntercontinentalExchange (NYS: ICE) are supposed to keep a close eye on their members and, specifically, the segregated customer assets. It would seem that some less-than-top-notch work from all of the above may have also gone into the MF Global debacle.
Post-implosion, there's still a pressing need to get client funds -- every last penny of them -- back to MF Global's customers. After that, the courts will sort out what's left in the company for its creditors.
But as the picture becomes clearer regarding what precipitated MF Global's failure and how hundreds of millions of dollars of client funds disappeared, it will be imperative that regulators and the legal system sort out where there was fraud and where there was incompetence. Incompetence is obviously not ideal, but it exists, and when investors and creditors back incompetent management, it's reasonable for them to end up on the wrong end of a blowup. Fraud, however, needs to be swiftly and severely punished to show that regulations are to be taken seriously.
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