Muffing MF Global: 20 Years of Financial Crises Rolled into One

So it seems that MF Global was doing its best Lehman Bros. imitation T+3 years after the Big Seize of ‘08. To be fair, Corzine and Co. were stealing from the acts of other miscreants over the past 20 years, which makes one wonder not only what the executive team at MF Global, but the regulators, too, were thinking. If regulation is always focused on the last crisis, this should have been a tailor-made regulatory success, which it wasn’t.

The litany of similarities with rogue activities of the recent past goes like this:

• MFG appears to have engaged in period-end shell games to understate its leverage to the market, in much the same way that Lehman and others used Repo 105s. Not-so-dissimilar shell games were a part of the deposed Greek government’s effort to keep the extent of its own borrowing excesses hidden from the European Central Bank.

• MF Global decided that the road to success was paved with leveraged excess in a manner reminiscent of the major investment banks prior to their come-to-OCC conversions in late 2008.

• The failure of MFG was reportedly the result of the firm’s attempt to take advantage of former New Jersey Gov./Sen. John Corzine’s failed hunch on European debt markets. Funny thing, Corzine was co-CEO/co-chairman at Goldman Sachs when the firm became embroiled in the government-led bailout of Long-Term Capital Management (LTCM) after the hedge fund’s failed bet on, of all things, Russian sovereign debt in ’98.

• Fraud, through the alleged misappropriation of client funds, harkens back to the dark days of December 2008 when the massive fraud at Madoff’s scheme finally came to light.

• The similarities extend beyond these. Regulatory failure often is a game of gotcha in Washington, and much of the last three years have been spent talking about how the deregulatory days of the last Administration was the cause of the 2007/2008 financial crisis. Given the debacle at MF Global, one might conclude that regulatory failure is a bi-partisan enterprise.

Political Connections Didn’t Help
What is unique in this instance is the direct political nature of some of the players and their proximity to important people and institutions in Washington. A former senator, governor, and major presidential campaign contributor takes the reigns as CEO of one of the largest derivatives firms in the world, oversees it as it leverages its balance sheet, takes increasingly risky bets, and, based on news reports, appears to end up siphoning client funds from supposedly protected accounts to try to remain solvent. Meanwhile, his firm, among others, actively lobbied against proposals from the Commodity Futures Trading Commission — headed by Gary Gensler, a former colleague at Goldman — to impose greater restrictions on how MFG and others could invest client funds. The proposals have remained in mothballs since summer.

Let’s face it, fraud is difficult to detect until the damage is done under the best of circumstances. If a firm or key personnel are determined to hide it and no one on the inside blows the whistle on them, the problems may not come to light until the perpetrators have backed themselves into a corner and there is nothing they can do to remedy the problem. That doesn’t mean there shouldn’t be safeguards in place to at least reduce the number of places they can hide the fraud.

In the past, this is what we thought regulators would do. They had access to better information that they couldn’t share with the marketplace because it might lead to a run on an institution like MF Global. Well, that’s more or less what has been happening since the summer of 2007.

One possible response suggested by a good friend, former CFA Institute Capital Markets Policy Council member, and one of the smartest market observers I know would apply a safeguard from the asset management business. Specifically, he suggested holding customer accounts at independent custodians that are unaffiliated with the brokers or customers, and then enforce the rules to ensure separation. It is remarkable to discover that while derivatives regulators had proposed such rules, they haven’t yet been mandated for the derivatives industry.

All in all, it appears that MF Global was able to find and take advantage of a glaring weakness in the derivatives market regulatory system. Combine that with the use of investment techniques and strategies that had failed others in the past, and regulators that missed the same problems again, and you get the sense that the trend isn’t good.

It’s enough to give one the feeling that we might be heading down this same path again and again in the future.