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Maybe MF Global Invested $700mm Of Customer Funds In A Few Hands On Full Tilt Poker?

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Here is the conventional wisdom on MF Global, which I’ve sort of defended when provoked:

[I]n many ways, it's a very satisfying morality tale. We're in this time of Occupy Wall Street, a lot of people are already dissatisfied with Wall Street in general, and this is moral hazard -- excessive risk-taking. Here, the firm fails, it happens in an orderly way, it doesn't take down the financial system and everyone feels that this is the way things are supposed to work. We're not supposed to stop financial firms from failing, but if they must fail -- due to their own actions -- shouldn't it be this way? In a way that doesn't hurt too many other people?

Isn’t it pretty to think so?

The problem is that it hurts the heck out of some people - people like the MF Global customers who are "scrambling for money" because apparently someone at MF Global thought they were running an online poker site rather than a futures broker. Those people will probably get their money, I guess, but I suspect that they're not as jazzed as everyone else about creative destruction, the free workings of the market, and slaying the beast of moral hazard.

And it's not hard to feel some sympathy for them. MF's finances were not totally transparent. Life is complicated and you have to make decisions at the margin not only with your money but with your attention. Rational ignorance can be, well, rational; I for example let other people worry about the Kardashians and spend my time on regulatory flowcharts. I’m quite certain that Western civilization would collapse if someone wasn’t keeping constant track of the mark-to-market on Kardashian nuptials, but it doesn’t have to be me. Similarly, if you trade commodity futures, you spend a lot of time diligencing your positions and thinking about - I'm gonna stick with soil erosion. Spending time worrying about the security of your brokerage accounts can be an annoying distraction from that - and, almost all of the time, will be less relevant to your returns than the soil erosion.

Many problems in the world come from people not understanding what level of diligence they’re supposed to exercise with different things. Rich people know they can lose a lot of money in angel investing but don’t expect their 10%-a-year, steady and stable, hedge fund run by a former head of Nasdaq to turn out to be a Ponzi – and they certainly don’t expect their fund-of-funds with its emphasis on due diligence and diversification to be just a front for a Ponzi. Companies know they’re supposed to do a lengthy due diligence process before spending $50mm on an acquisition, but can pretty casually decide to park $100mm in the nearest money market fund. Local banks know they’re supposed to have a certain percentage of their assets in AAA rated bonds but don’t want to do the credit work to figure out which AAA bonds.

If you were trading commodity futures in the last few years, a lot of things could have gone wrong. Like, your commodities could have moved against you. One thing that you were probably less focused on was that your CME member, CFTC regulated, SIPC insured futures broker would not only file for bankruptcy but also maybe forget where it put your money. In the future, you'll be focused on it.

So the main fallout from MF Global probably isn’t going to be ruin at JC Flowers (out on $150mm face of preferred and also exposed, as are MF Global, the Treasury, and Dealbreaker, to volatility in the market for loving and/or hating Goldman alums), Jefferies ($9mm of bonds), or Fortress (“literally zero”).

The main fallout will probably be that if you have the choice to work with a too-big-to-fail bank or a just-small-enough to fail bank, on a whole variety of things, you’re going to go too-big-to-fail. Sure, there are lots of small brokers who are well capitalized and take the time to get the little things right, like segregating customer accounts. But how can you know unless you do a lot of diligence? Easier to just trust that a megabank squarely in the regulators' sights will get it right - or, if they get it wrong, won't be allowed to blow up in a way that blows up customers.

You can hear this from Jamie Dimon: he may think that capital surcharges on "global systemically important financial institutions" are un-American, but he also knows that "In some ways a G-SIFI will be a plus. You'll win business that other people will have hard a time competing for us." Increasing capital by a few hundred basis points for an official stamp of "customers are never going to have their positions shut down and their money spirited away in the dead of night" is a pretty cheap price to pay.

And you can sort of see it with BofA. That's a behemoth big enough that a bankruptcy of any of its bits would be systemically challenging and might get government support – though Moody’s isn't so sure. But, still, just to be on the safe side, wouldn��t you rather have your BofA derivatives with the FDIC insured bit rather than the broker-dealer bit that is protected only by the document-mangling crowd at the SEC and FINRA?

The easy answer is to say “well, in a first-best world, there would be no too big to fail government-backstopped banks” - or, alternatively, that those banks would no longer be risky because of Volcker or whatever. That is appealing when you talk about stockholders, and almost as easy when you talk about bondholders. Few will shed tears for those who bought MF Global bonds at 6.25% in August.

But it can’t really be true for customers. You do actually want a financial system where some decisions can be made without extensive due diligence. Rational ignorance is frequently valuable; we don't want people to have to devote a lot of time to examining the books of their FDIC insured banks just to open a savings account.

I don't think there's an easy answer to this. Obviously the CFTC-SEC-FINRA-CME crowd could do a better job of checking that the dealers they regulate are actually segregating money rather than, y'know, not. And obviously SIPC and similar protections mean that most customers are going to be inconvenienced rather than exploded by MF's meltdown. But still. This week we have a blowup of a non-bank, non-too-big-to-fail, $40-billion balance sheet broker-dealer, futures merchant and Fed primary dealer. Customer trading was disrupted, customer accounts were confused, commentators are saying "this is the way things are supposed to work," and regulators and politicians are keeping relatively quiet to avoid seeming to be too close to the politically connected CEO of the company. That is sort of just the ticket to encourage everyone to move all their financial dealings to the top half-dozen banks whose political support is at this point explicit and, y'know, actually being paid for in capital requirements.