If I were writing a 275-page report explaining What Went Wrong At A Big Thing That Went Wrong, and I knew the answer, I guess I would bury it somewhere around page 117 just to see if anyone was paying attention*:
The party of the first part forwarded the bailment documents to the party of the second part in accordance with provision (ii) of section 408(b) of the second amended and restated indenture (such provision, the "Provision," and such second amended and restated indenture the "Second Amended and Restated Indenture") and then Jon Corzine just wrote himself a check for $1.6 billion and walked out of the building with his hands in his pockets whistling a jaunty tune and pursuant to said Provision and certain other provisions of the Second Amended and Restated Indenture the indenture trustee for the party of the second part did take possession of said bailment documents for the benefit of the party of the second part.
Weirdly, though, the MF Global trustee report released today is actually pretty readable and, as these things go, a ripping good yarn. The lack of a pockets-and-whistling smoking gun appears to be due mainly to the fact that there are so darn many smoking guns.** Pretty much everyone was doing their best to blow up MF Global in the most embarrassing way possible, and at that, at least, they seem to have been successful.
The story starts with a sleepy futures commission merchant in Chicago; actually to be technical it starts with a sleepy "cooperage" in England in 1783 but it ended up with a publicly traded FCM that Jon Corzine took over in 2010. His arrival divided MF Global into two cultures, an FCM culture in Chicago that did things like handle money for clients, and a broker-dealer-prop-trader in New York that facilitated Jon Corzine's Blackberry-based trading in European bonds. In August 2011 it adopted changes to its risk policies intended to shift it "from [the] extremely conservative profile of an FCM to the more risk-accepting profile of a broker-dealer," which, I suspect, it did not mention to its FCM clients.
Corzine's prop trading did not generate sufficient cash to fund itself, but fortunately somebody else did. The somebody else was the FCM customers, who generated cash for the prop traders by (1) depositing it with MF Global, (2) thinking that it was segregated, and (3) it not being segregated. Evil, right? Except that, at least to begin with, this was just fine, for loose senses of "just fine." A key problem for MF Global seems to have been that it was allowed to plunder some of its customer accounts:
[T]he regulations for Customer Segregated accounts [customer accounts for trading on domestic futures exchanges] require a daily accounting of the net liquidation value of the customer funds in the account (the “Net Liquidating Method”). CFTC regulations, however, did not require that all customer funds necessarily be maintained on a dollar-by-dollar basis in the Foreign Secured accounts [similar customer accounts for trading on foreign futures exchanges]. Instead, unlike Customer Segregated accounts (for trades on domestic exchanges), the CFTC regulations allowed an “Alternative Method” for calculating whether Foreign Secured accounts were in regulatory compliance even though less than all customer funds deposited for trading on foreign exchanges might actually be deposited in Foreign Secured accounts. MFGI used this “Alternative Method,” and during the month of October 2011, the amount of “Regulatory Excess” — the average amount of customer funds in excess of the regulatory requirement under the Alternative Method (but not the Net Liquidating Method) — was approximately $1 billion. Some at MF Global considered the Regulatory Excess to be a potential source of funds for intraday, or even overnight, transfers to fund the non-FCM activities of MF Global, although others were of the view that the Regulatory Excess would still have to be “locked up” for the benefit of customers. ...
During the month of October 2011, the Regulatory Excess was, on average, $1.04 billion, representing the amount of customer balances that MF Global would not be required to lock up in the secured calculation. The difference between the two methods is attributable primarily to the fact that the Alternative Method does not include in the calculation any customer ledger or cash balance amounts in excess of the maintenance margin requirement. Thus, an account that has no open foreign futures and options positions, but contains a positive ledger balance, would have a secured amount requirement of $0. As such, the FCM would not be required to set aside funds in the secured calculation for these customers.
Got that? If you had cash in MF Global for use in foreign futures trading, and that money was not needed to post margin - because you'd just opened your account and hadn't yet traded, or because you'd closed out a position, or because you just overfunded your account - then MF Global could use 100% of that money for its own purposes. And, as these things go, first it didn't, then it did. It started small:
Although the policy of MFGI was that overnight loans were limited to the Firm Invested in Excess undefined, former MFGI employees believed that the Regulatory Excess undefined was available to use for intraday transfers if the funds were repaid by the close of business the same day.
And then "we get to plunder some customer money as long as we return it by the end of the day" became confused with "we get to plunder all customer money as long as we return it by the end of the day":
Because compliance with the CFTC regulations was computed as of the close of business, as long as the transfers were returned before the end of each day, some MFGI employees did not consider the transfers to have any regulatory implications, although the CFTC has stated that FCMs must be in regulatory compliance at all times.
And this led to large customer-money transfers to proprietary trading counterparties in MF Global's final days:
[On the morning of October 25,] Operations in New York then requested an intraday transfer of $200 million, to facilitate the settlement of bonds being returned. [Treasurer Edna] O’Brien approved the request even though the Firm Invested in Excess as of October 24 was less than $55 million, thereby transferred customer funds from the Regulatory Excess for proprietary activities. [Treasury employee Irma] Romo instructed, with Ms. O’Brien’s approval, Treasury Operations to transfer the money from the JPM Customer Trust Account to the Treasury House Account and then to the BNYM DTC Account.
The report doesn't exactly blame all of MF Global's disappearing customer funds on this regulatory quirk and the slow slide into exploiting it, but the pattern is suggestive. It's not that everyone at MF Global basically went around asking themselves how they could take as much customer money as possible for their own nefarious purposes. Rather, only about half of the people at MF Global went around asking that. The other half more or less tried to stop them. The trustee has lots of "some at MF Global thought ... while others thought ...," which is presumably where all this dirt comes from. It also probably contributed to the problem: customers didn't think they were dealing with rapacious prop traders because they were actually dealing with the relatively conservative, customer-fund-protecting FCM employees. It's just that those employees were dealing with the rapacious prop traders. And the rapacious prop traders were in charge:
During the summer of 2011, some senior executives appear to have been in deliberate denial of the extent of the liquidity stresses. Most strikingly, on August 11, in an email exchange between Ms. O’Brien and a Global Treasury employee at MF Global Hong Kong, Ms. O’Brien wrote that “[CFO] Henri [Steenkamp] says to me today . . . ‘we have plenty of cash.’ I was rendered speechless and wanted to say ‘Really, then why is it I need to spend hours every day shuffling cash and loans from entity to entity?’”, a process that she described as a “shell game.”
Pro tip: if you're going to call your business activities a "shell game," keep it off email!
The nice Treasury-and-FCM people shouldn't get off too easy, though; they had deliberate denial of their own. They developed a novel approach to managing liquidity in which, when accounts showed that they had no money, they just wrote down that in fact they had lots of money. I have to say I sympathize with this but, y'know, who else will:
On the morning of October 28, when [MFG financial regulatory group employee Philip] Cooley prepared the Segregation Statement and Secured Statement as of close of business on October 27, he discovered a deficit in the Segregation Statement of approximately $300 million. Mr. Cooley and [his boss Matthew] Hughey went to Treasury to meet with Ms. O’Brien to discuss the deficit and potential reconciliation items. After a preliminary discussion with Ms. O’Brien (who was on the phone with JPM), she asked [Treasury employee Jason] Chenoweth to handle the matter. After reviewing the wires and bank reconciliations, it appears that Mr. Chenoweth and Ms. Romo concluded that $540 million in wires that were sent from BNYM the day before were not properly recorded. Based on these discussions, an erroneous $540 million manual adjustment was made to the Segregation Statement by personnel in the Financial Regulatory Group, although they did not have backup for the adjustment. The witnesses’ descriptions regarding this matter are confusing and contradictory.
I bet! Imagination became the preferred approach for addressing deficits in MFG's last week:
Later in the day [of October 30], after continued review and audit of the bank reconciliations, Treasury identified an item that they believed might offset the deficit. Treasury enlisted an Assistant Controller to review their findings. At 6:06 p.m., Ms. O’Brien reported to Laurie Ferber and others that, “there has been an item(s) identified that may offset the Seg debit. The figure appears to be @ 900 million. Matt and I shared this with both the CME and CFTC ... Jason is proving this out ....” Upon completing their review, however, Ms. Dean and Mr. Chenoweth determined there was in fact no offsetting item. Instead, they concluded with some degree of certainty that the Segregation Statement was accurate and there was in fact a deficit of $952,047,822. They also concluded that the $540 million adjustment that had been made on October 28 was wrong and thus there had been a deficit on Thursday, October 27 in the amount of $339,821,088.
The trustee is pondering suing everyone in sight (Corzine, Steenkamp and O'Brien for breach of fiduciary duty and negligence, plus maybe JPMorgan and some clearing agencies) to get back customer money. JPMorgan et al. may be able to point to the schizophrenia within MF Global as a defense against claims that they should have known they were getting customer money. Corzine and his crew, on the other hand, seem to me to have tougher defenses: this report reads more "stupid" than "criminal," but emails about "shell games" and shortfalls covered with imaginary money are not going to look great in a negligence lawsuit.
* I know, I know - I could probably do that now.
** Actually "smoking garrote," or whatever a freshly-used garrote does; the trustee much enjoys one MF Global exec's description of its demise as due to a "liquidity asphyxiation."