By Robert Stammers, CFA
As John Corzine’s testimony in front of the House Agriculture Committee on 8 December 2011 further clarifies, this is a clear example of a time when investors would have been better served if they understood the risk tolerances and managerial limitations of the people controlling their money. Regardless, most account holders should have expected an experienced financial executive like Mr. Corzine to say something quite different than this (emphasis ours):
As the chief executive officer of MF Global, I ultimately had overall responsibility for the firm. I did not, however, generally involve myself in the mechanics of the clearing and settlement of trades, or in the movement of cash and collateral. Nor was I an expert on the complicated rules and regulations governing the various different operating businesses that comprised MF Global. I had little expertise or experience in those operational aspects of the business.
For background on the specific nature of the activity they were involved in—proprietary trading—we refer to page 53 of the Forbes/CFA Institute Investment Course:
You may have read in the press about large financial institutions engaging in proprietary trading, or prop trading. This term describes a bank investing in financial instruments for its own benefit; as opposed to maintaining inventory for customer trades….Some politicians and regulators have long wanted to bar banks from proprietary trading altogether.
It’s not clear that retail investors could have seen this coming, considering experienced professionals are counted among MF’s victims. Kurt Schacht, CFA, is managing director of our Standards and Financial Market Integrity division. He blogged recently about his experience as a customer of MF Global and his research into the rules that he believed were protecting his money. Kurt admits to feeling deceived by the brokerage firm, and surprised as well, since SEC Rule 15c3-3 prohibits any broker-dealer using their customers’ capital to fund the firm’s own investments.
Now, it’s obvious that retail investors still might not understand exactly what happened at MF Global. Nevertheless, it’s important to underscore Kurt’s next point:
I am supposed to know the difference between an ethical operator and one that is not. The truth is that it often is very difficult to tell them apart. Over the two decades I’ve been with MF Global and its predecessor firms, nothing in particular tipped me off that something was amiss. That makes protective regulation and effective regulators all the more important.
What Happened?
It can be very difficult to understand a complex operation like MF Global from the outside. To better comprehend what happened, it’s useful to look at the company’s history.
The company spun off from the Man Group in 2007, and on March 23, 2010, Jon Corzine was hired as CEO. Corzine hoped to transform MF Global from a pure brokerage firm into a risk-on brokerage and trading business. At the time of Corzine’s hire, MF was trading at $7.17 per share. Just one month after Corzine came on board, the share price hit a high of $9.94.
Last year, the principal trading segment of MF Global bought about $6.3 billion in European sovereign debt, weighted to mature in late 2012. After Moody’s and the other credit rating agencies cited the sovereign debt holdings and profitability concerns in a downgrade of MF’s credit, the company started to experience an increase in margin calls. As confidence eroded, clients began pulling money out. With a dwindling $1 billion equity capital base to cover over $6 billion in at-risk securities, large unsecured creditors like JPMorgan Chase & Co. (NYSE: JPM) and Deutsche Bank AG (NYSE: DB) asked for MF global to post additional collateral, which it didn’t have.
Pressure on the firm increased after the second quarter earnings report revealed a huge $186.6 million loss. Low interest rates, a difficult trading environment, restructuring costs, and charges related to deferred tax assets sent MF Global deeper into the red than ever before.
A last-ditch effort to stave off bankruptcy failed when a deal to sell some assets to Interactive Brokers (NASDAQ: IBKR) fell through. On Halloween, MF Global filed for Chapter 11 bankruptcy and the New York Federal Reserve suspended the company as a primary dealer.
In a November 2011 blog posting, Ron Rimkus, CFA, assesses what exactly went wrong, pointing out that Corzine put too much trust in the EU’s ability to stabilize the eurozone. By doing so he put his firm at risk since with only $1.3 billion in equity capital even a small adverse move in MF Global’s $6.3 billion dollar European sovereign debt portfolio had the potential to take the company down with it.
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… Given the dynamic nature of the Eurozone crisis and the fact that over indebted nations are being asked to pledge assets to the EFSF to support fellow over indebted nations, the viability of the EFSF guarantees were at least open for discussion at the time that MF Global put on its trades.
Rimkus goes on to underscore three essential lessons that investors should take away from the demise of MF Global:
- Look beyond what management says and focus on what management does.
- Understand that a guarantee, in any form, may not come to fruition.
- Respect markets and the risks involved in any financial transaction.
Investors should remember to think in an exploratory fashion about risk, really probing their hypotheses to make sure that they understand what their exposures are. These operational risks that Corzine referred to were eventually the downfall of his firm. This is just another example of an obscure risk manifesting in an unexpected way.
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Matt Cavallaro and William Ortel contributed research and reporting
The information contained in this article and from any related communication is for informational and educational purposes only. The information in this article should not be interpreted or used as investment advice. CFA Institute does not recommend or endorse any investment security, product, or strategy or any service, product or material submitted by or linked to this article by third parties.
