Truth be told, I hadn’t paid much attention to the implosion of MF Global, because so many hedge funds went under during the crisis that yet another levered trading firm death seems less than newsworthy unless it is big enough to constitute a possible systemic event. The collapse of MF Global didn’t seem all that unusual, save for the titilating angle that the firm was headed by former Goldman CEO and New Jersey state governor Jon Corzine (I’d treated the failure of hedge funds by other storied names, such as Jon Meriwether and Myron Scholes as comment-in-passing incidents).
But the picture changes considerably with the report that hundreds of millions of customer assets may be “missing”. If this is true, there are pretty much no savory explanations.
One possibility is the firm raided customer accounts to try to shore up its principal business. That’s a fraudulent use of customer assets, and one would think anyone associated with it (and that would include the managing partner) would be subject to fines and barred from the securities industry for at least a period of time. I’m not certain what level of abuse is considered to be criminal. Informed readers are encouraged to pipe up.
The Times does mention that the missing money may simply be really bad bookkeeping (or more likely, poor internal controls, particularly, sloppy validation of how employees marked trades in illiquid markets, allowing staff to game the system, either to boost their bonuses or to cover up losses they optimistically assumed they’d be able to reverse). But even so, that raises questions about the competence of the firm’s management, and whether past accounting “errors” led to profits being exaggerated.
From the New York Times:
The recognition that money was missing scuttled at the 11th hour an agreement to sell a major part of MF Global to a rival brokerage firm. MF Global had staked its survival on completing the deal. Instead, the New York-based firm filed for bankruptcy on Monday.
Regulators are examining whether MF Global diverted some customer funds to support its own trades as the firm teetered on the brink of collapse.
The discovery that money could not be located might simply reflect sloppy internal controls at MF Global. It is still unclear where the money went. At first, as much as $950 million was believed to be missing, but as the firm sorted through its bankruptcy, that figure fell to less than $700 million by late Monday, the people briefed on the matter said. Additional funds are expected to trickle in over the coming days.
But the investigation, which is in its earliest stages, may uncover something more intentional and troubling.
The trading strategy that blew up the firm appears to result from Corzine not adjusting his trading strategy to a smaller platform:
Mr. Corzine sought to bolster profits by increasing the number of bets the firm made using its own capital. It was a strategy born of his own experience at Goldman, where he rose through the ranks by building out the investment bank’s formidable United States government bond trading arm.
One of his hallmark traits, according to the 1999 book on Goldman, “Goldman Sachs: The Culture of Success,” by Lisa Endlich, was his willingness to tolerate losses if the theory behind the trades was well thought out.
He made a similar wager at MF Global in buying up big holdings of debt from Spain, Italy, Portugal, Belgium and Ireland at a discount. Once Europe had solved its fiscal problems, those bonds would be very profitable.
But when that bet came to light in a regulatory filing, it set off alarms on Wall Street. While the bonds themselves have lost little value and mature in less than a year, MF Global was seen as having taken on an enormous amount of risk with little room for error given its size.
First, readers of this blog are probably not all that sanguine that the Europe mess will be resolved in the way Corzine assumed. This seems an awful lot like betting that subprime would be “contained” as of May 2007.
Second, a basic rule of risk control is not to take excessive risks relative to your capital. As John Manyard Keynes is often cited as saying, “The market can remain irrational longer than you remain solvent.” The textbook case is LTCM, which took hugely levered bets that it was confident would eventually be proven right, but “eventually” turned out to take a little long. And a smaller firm has to be even more careful about its wagers for the very reason that brought MF Global down: counterparties will not cut you all that much slack, particularly if they don’t buy your investment thesis.
But if the customer monies really are gone, this will deservedly be a very ugly episode for Corzine. His investors and the authorities should rake him over the coals.
Update: I’ve corrected the post for my inaccurately describing MF Global as a “hedge fund”. The salient characteristic of a hedge fund is that it has raised third party funds pursuant to an investment agreement, which describes the fund’s investment strategy, among other things, and has typically steep performance based fees. Even though MF Global was using a highly levered trading strategy, it was a principal, using shareholder money, not funds in an asset management vehicle.