Practical analysis for investment professionals
17 November 2011

Anatomy of the MF Global Debacle

MF Global's New York office at 717 5th Avenue

Here we go again: Another high-profile bankruptcy of a financial firm… Another scandal… It’s just another day on Wall Street, it seems. In October, following a series of debilitating credit downgrades and a steep drop in its stock price, commodities brokerage firm MF Global Holdings Ltd. declared bankruptcy. Assets belonging to some 33,000 customers were frozen, examiners descended on the firm’s offices, and its skeleton staff has been interrogated. There are press reports of subpoenas. And today, weeks later, some $600 million in client money that was supposed to be segregated from the firm’s own funds is still unaccounted for, including assets belonging to the managing director of the Standards and Financial Market Integrity Division at CFA Institute, who described being “hornswoggled by one of our industry’s own” in a recent blog post.

How many times can investors and the public muster the energy for outrage? At the heart of the MF Global saga is a breathtaking level of arrogance that reaches directly into the executive suite. Frustrating though it may be, the debacle affords serious investors an important opportunity to look beyond the headlines and analyze exactly what went wrong. In my view there are four acts to this drama.

Act I: The Strategy

In March 2010, a few months after losing his reelection bid for the governorship of New Jersey, former Goldman Sachs CEO Jon Corzine took the helm of MF Global. In a fascinating and revealing interview with Bloomberg News last February, Corzine articulated his strategy. The ex-governor said he wanted to transform MF Global from a broker-dealer into a full-service investment bank to rival the likes of Goldman. According to the interview, the first component of Corzine’s strategy was to “reduce risk and increase yield,” presumably through some sort of “sophisticated” risk arbitrage strategy.

Juxtaposing this statement with the firm’s subsequent bankruptcy is fascinating unto itself — but let’s not skip the intervening acts in this drama.

Act II: The Trade

Astonishingly, Corzine’s firm was felled by a single trade, marking out MF Global as collateral damage of the eurozone crisis. Here’s how it went down: As Europe’s troubles escalated throughout 2011, the Goldman trader-turned-CEO pushed MF Global to take leveraged bets on sovereign bonds of the so-called “PIIGS,” the (unflattering) acronym for Portugal, Ireland, Italy, Greece, and Spain, which collectively make up the weaker, overleveraged peripheral countries of the eurozone.

To execute the trade, MF Global bought $6.3 billion of shorter-maturity bonds offering high yields (because of the stress in Europe) and maturities ending no later than December 2012. These assets were purchased using repo-financing that enabled MF Global to pay less interest than the firm was earning on the bonds. According to people with knowledge of the situation, MF Global was attempting to leverage an explicit guarantee on the bonds from the European Financial Stability Facility (EFSF) — a guarantee that expired in 2013 — and lock in the spread between the cost of funding and the higher yield on the bonds. As is common in such repo deals, MF Global was required to post the sovereign bonds themselves as collateral. Thus as the bonds fell in price as the eurozone crisis intensified, MF Global was forced to post ever more collateral. Even if the bonds turned out to be “money-good,” MF Global was exposed to market risk.

Act III: What Went Wrong

It appears that Corzine and his firm accepted the EFSF and the European Union’s grand plan to stabilize the eurozone at face value. However, MF Global had total equity capital of just $1.3 billion — meaning that an adverse move in the firm’s $6.3 billion European sovereign debt portfolio could quickly render the firm insolvent.

Which brings us back to hubris: What kind of overconfidence does it require in order to believe that a trade can’t move the wrong way, if even for a time? In the case of Europe, guarantees and commitments from governments have been routinely changed throughout the last two years. (Just ask the owners of credit default swaps on Greek sovereign debt.) Given the dynamic nature of the eurozone crisis and the fact that overindebted nations are being asked to pledge assets to the EFSF to support fellow overindebted nations, the viability of the EFSF guarantees were at least open for discussion at the time that MF Global put on its trades. (Although in my opinion, these guarantees have been wholly inadequate all along.)

So exactly what opportunity did Corzine think he saw? Like so many problems in finance, it pays to dissect the decision tree. Consider the following pay-off structure:

Market Favorable to PIIGS Debt Market Unfavorable to PIIGS Debt
PIIGS Debt Pays Off 1) MF Global earns spread. 2) MF Global must post more collateral against repo-financing
PIIGS Debt Defaults 3) MF Global loses AT the default date. 4) MF Global loses BEFORE default date.

 

As the table shows, MF Global’s bet pays off in only a single scenario (cell #1), and works against the firm in each of the other three scenarios. Even if Corzine and other executives at MF Global believed in their heart of hearts that European sovereign debt would ultimately be money-good, they should have at least acknowledged that the market could move against them for some period of time. And as the old saying goes, “The market can remain irrational far longer than an investor can remain solvent.”

It’s one thing when a bright young trader is caught flat-footed by overconfidence. But it is quite another matter when a prominent, experienced financial executive repeats the sins of the recent past. And that’s exactly what Corzine did: On a voluntary basis, even after living through a series of high-profile and catastrophic bankruptcies in 2008 and 2009 (think Lehman Brothers, AIG), he followed the same script by failing to have adequate capital on hand to meet margin calls.

Corzine told his interviewer at Bloomberg News, “I’m not a trader, I’m a salesman.”

I couldn’t have said it better myself.

Act IV: The Lessons

I see three key lessons that can be drawn from the collapse of MF Global:

  • Ignore what management says, evaluate what management does. Corzine’s well-publicized strategy of converting MF Global into a full-service investment bank may have sounded good, but the risks involved in getting there were clearly overlooked by regulators, the firm’s board, and its own customers.
  • A guarantee is not the same as an assurance. European politicians have proved an important point that investors and traders should never take it for granted. Regardless of what an entity may commit itself to doing today — be it a government or a corporation —investors do not have the assurance that the guarantee will be fulfilled. MF Global put too much faith in politicians actually doing what they said they would do. The consequences speak for themselves.
  • Respect the markets. Arrogance is a trader’s downfall. Not acknowledging that the market can move against you is the kiss of death. What more needs to be said? It’s flabbergasting.

What lessons do you draw from the MF Global debacle? Share your views in a comment.

About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

18 thoughts on “Anatomy of the MF Global Debacle”

  1. Samuel B. Jones, Jr. CFA says:

    Very succinct and easily understandable overview of MF Global’s follies and failures.

  2. Baby Deals says:

    Even a layman can understand risk reward table mentioned in article. Odds of winning is just 25%. Still these suite clad guys went ahead with bets. It clearly shows these people do not care about other peoples money (investor, shareholder, creditor etc). They are just playing casino.

    1. Ron Rimkus says:

      Just to clarify, the pay-off table above says nothing about the probabilities of each scenario. In reality, the players in the trade likely thought that strong market movement against their positions was remote. So, perhaps they assigned a very low probability to these adverse events. The important take-away is that given the behavior of the markets since the crisis first manifested itself in 2008, potentially big moves in assets previously thought of as safe stepped from unrealistic to realistic possibilities. And given that the cost of the adverse outcomes each resulted in failure of the firm, they should not have made a leveraged bet.

  3. sunil kumar singh says:

    Highly unfortunate! When things r so obvious, how can seasoned ex Goldman Sachs professional and his qualified team of professionas commit such a blunder!

  4. World banker says:

    I don’t think these finance savvy professional would have not factored these before making crucial investment/trading decisions. They must have seen some hidden gain in the deal which cannot be seen by others easily.
    Probably they did not analyse many worst case scenarios.

  5. daniel sucker says:

    good stuff

  6. layman says:

    “Even a layman can understand risk reward table mentioned in article. Odds of winning is just 25%.”

    I am sorry fellow layman, that’s not how probability works.

    Based on other probabilities it could’ve been anywhere between 0 to 100% (theoretically).

  7. IFA says:

    Good piece, but aren’t the client missing funds up to $1.2 billion now?

    The whole thing is tragic – for the firm’s clients (ironically, MF had even started charging them custodian fees), for the taxpayers that will get left with the bill for Corzine’s bad bet, and as well-connected bankers watching this play out once again rest assured they can do practically anything without fear of proper consequences.

    1. Ron Rimkus says:

      Yes, the most recent estimate of lost client funds stands at $1.2 billion. A genuine tragedy.

  8. Great summary of what happened! Is a majority of investment bankers predominantly salesmen, isn’t it?

  9. IFA says:

    Surprise, surprise – Corzine and MF stole $1.2 billion in client assets – legally! Just like insider trading loopholes for politicians – the game is rigged more than even I imagined. Naive I guess.

    http://newsandinsight.thomsonreuters.com/Securities/Insight/2011/12_-_December/MF_Global_and_the_great_Wall_St_re-hypothecation_scandal/

  10. Glenn Bunston says:

    My understanding is that MF Global actually used their clients funds to purchase European soveriegn debt using a procedure called re-hypothecation. Apparently there are limits on this in the U.S. but not in the UK and they used their UK sub to maximize the leverage created by the strategy. The IMF estimates that U.S. banks have raised as much as $4 trillion through this strategy.

    http://newsandinsight.thomsonreuters.com/Securities/Insight/2011/12_-_December/MF_Global_and_the_great_Wall_St_re-hypothecation_scandal/

    1. chiu ying says:

      Great link! thanks Glenn. The article from the link sheds light on the underbelly of the financial world that has been hidden from investors for far too long. How can regulators allow this to happen? I wonder if there are other means that are yet to be uncovered though.

  11. Robert braun says:

    Mr. Rimkus, you wrote:

    “Corzine told his interviewer at Bloomberg News, “I’m not a trader, I’m a salesman.”

    I couldn’t have said it better myself.”

    In the name of all honest sales people in the industry – and there are quite a few – I demand a groveling apology for such an unwarranted, insensititve and ignorant blanket indictment. It casts a pale on the entire article.

    1. Ron Rimkus says:

      Mr. Braun, I am sorry you found the highlighted comment offensive. For clarification, my emphasis was on the fact that Mr. Corzine was “not a trader” (in his words) and yet pushed the firm into a reckless trade. It was not, however, a blanket indictment of salespeople. That said, I can see how you may have interpreted it that way. Please accept my sincere apology.

      1. Robert braun says:

        I can see how you may have meant no harm. But words are powerful things and we should be very careful how we use them. Particularly in the business of publishing… but also when selling.

        Apology accepted.

  12. Greg says:

    >> “Which brings us back to hubris: What kind of overconfidence does it require in order to believe that a trade can’t move the wrong way, if even for a time?”

    Answer: Not over confidence. It was Corzine’s belief that his cronies, Tim Geithner Hank Paulson, still had the game rigged

  13. Lana says:

    Goldman and their CEO clowns missed the auditions for cirque du soleil and now we pay the price…

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