This House Financial Services investigations subcommittee hatchet job on MF Global is, I don’t know, pretty reasonable and not-that-hatchety? It’s 100 pages and not exactly full of new news, but it’s a good read, stuff happens, there’s a clear story arc, heros and villains (kidding, just villains), you’re in suspense until the end. There’s some law of narrative that demands that every financial disaster be a parable for something, and the Fall of the House of Corzine obliges nicely. It reads like the sort of fairy tale where three whatevers come to the guy and tell him “repent repent a thing will happen” and each time he’s like “naaaah” but the third time the thing happens and he’s all “huh, wish I’d repented.”
The thing that was going to happen - which has the benefit of being inevitable in this report though I guess maybe not in real time - was that MF Global’s inventory of fairly short-dated peripheral Eurozone sovereign bonds, which it had bought and then financed via repo-to-maturity transactions, were going to be the death of it. And people kept telling Corzine that and he was all “I SAID NAAAAAH.” And then they were the death of it.
The first people who told him were his auditors at PwC in late 2010, who were troubled by how MF Global was accounting for the repos-to-maturity.1 The RTMs were accounted for as a sale plus a derivative purchase liability; the forward was required to be marked to market but MF Global used its own models to determine that the mark-to-market was so small as to be immaterial because Corzine was pretty sure the chances of default were low. PwC were unamused and advocated a mark-to-market that marked more to the actual market.
Corzine’s response was the best:2
Corzine did not want to discuss accounting specifics and complained that he would not have entered into the European RTM trades if he had understood that marking the derivatives to market could result in volatility in the company’s profits and losses. PwC staff’s impression of the meeting was that Corzine characterized the accounting and valuation requirements as a “PwC issue, and not [MF Global’s].”
I mean, (1) this comes from PwC evidence so is maybe exaggerated/self-serving and (2) I’m sure there are like eight thousand senior bond traders who would have said the same thing, but: FIRE ALL OF THEM. Everything here is horribly wrong but the wrongest part3 is “I wouldn’t have bet my firm on a trade with a volatile mark-to-market if I had known that the volatile mark-to-market would be reflected in my accounting.” If the biggest trade at your firm only works if you can lie about it to your shareholders, then it doesn’t work, and your firm doesn’t work, and shut up.
The second people who told him “beware! repent! etc.” were his regulators at Finra and the SEC, who wanted him to take a capital charge against the RTMs. The response here was not quite as crazy as the “I don’t have a capital charge problem! YOU HAVE A CAPITAL CHARGE PROBLEM!” strategy Corzine tried on PwC, but it was close. It was actually “the rules say we don’t need to take a capital charge against U.S. Treasury bonds, and this is the same thing, only it’s Spanish treasury bonds.” Actually that might be crazier. Anyway it didn’t fool Finra, and MF Global had to take a capital charge, but too late: it raised additional capital, but had to retroactively show a $150 million deficiency for July 2011, which is not a good look, and which sparked its spiral into House subcommittee hearings.
The third people4 who warned Corzine of the error of his ways were LCH.Clearnet, which cleared the RTM trades, as well as the RTM counterparties and assorted other providers of clearing-type services to MF Global (including DTCC and JPMorgan). These guys got taken a little more seriously than nebbishes like the accountants and regulators, for the simple reason that they actually had MF Global’s stuff, so when they were like “put up another $211 in margin or bad things might happen to your precious little repos” they were hard to ignore because they could make those bad things happen. Perhaps a lesson for the SEC. The details here were better laid out in the trustee’s report a while back but the gist is clear enough: margin was called, things deteriorated, more margin was called, cycle until doom. Also, at some point in the cycle, customer money was shipped off to meet the margin calls, which is a bit of a no-no.
Not as much of a no-no as it should have been though! After recounting the demise of MF Global, the House report moves on to recommendations, and again these are mostly sensible enough. Most sensible of all is the recommendation that the CFTC get rid of the Alternative Method for calculating client segregated funds, which we’ve talked about before, and which is called that because it is an alternative to “keeping all customer funds segregated.” Instead you just keep some of them segregated, and the rest you use for your own prop-trading purposes, including shipping it off to meet margin calls on your RTMs and leaving your customers unable to recover their money. That is weird right? Here is a sentence from the “Sunday, October 30, 2011” bit of the report, as MF Global was two days from bankruptcy:
The concern that there would be a shortfall in amounts owed to customers, despite the fact that MF Global was technically in compliance with the rules, prompted Chairman Gensler to remark that the CFTC should consider whether to abandon the Alternative Method.
Well-timed casual remark, Gensler!5
Behind Corzine, Gensler may be the guy who’s most disappointed in this report. In addition to casting a skeptical eye at the CFTC’s (nutty!) Alternative Method for letting futures commission merchants use customer money, the subcommittee floated the idea of merging the CFTC and SEC to have one regulator to oversee derivatives dealers of all flavors. The panel found both that the SEC and CFTC didn’t share information - “Staff at the SEC’s Division of Trading and Markets was surprised to learn MF Global was using the Alternative Method,” which well might they have been, so was Gensler it sounds like - and that:
Even when the SEC and the CFTC finally began communicating with one another during MF Global’s last week of operations, the agencies often worked at cross-purposes. When MF Global reported that it had set aside $220 million above the amount it was required to hold for its broker-dealer customers, the SEC instructed the company not to transfer any of these funds without prior approval. Nonetheless, the CFTC later instructed the company to transfer the funds to the FCM side of its business. When informed of the transfer, SEC Chairman Mary Schapiro stated that the transfer was “unacceptable” and that the CFTC should not have ordered the transfer without telling the SEC.
Hahaha jerks. There’s a good argument that having one regulator to protect one set of investors and another to protect another set of investors, and then just letting them loose to fight, is not the best way to protect all investors.
Other villains abound; the ratings agencies get a pretty good scolding for having no idea what was going on at the company they were rating:
Moody’s and S&P also did not understand the nature of MF Global’s European sovereign exposure. Both firms believed that the European RTM trades were client-driven transactions, and that MF Global hedged the risks of these transactions. But, their understanding was inconsistent with MF Global’s public filings, which stated that the company maintained exposure to the underlying sovereign issuer and that mark to market movements associated with the European RTM trades could cause volatility in MF Global’s financial results.
But the subcommittee’s recommendation is mostly just “they should stop being terrible,” which is disappointing.
The main villain is of course Corzine; this is as good a summary as any of his problem:
Although Corzine firmly believed that the existence of the EFSF mitigated default risk, he did not develop a strategy for managing the liquidity risks that would result if a credit downgrade prompted margin demands from counterparties. As Corzine built the company’s European bond portfolio, counterparty margin demands became a major draw on MF Global’s cash reserves, further exacerbating the company’s liquidity strain.
It’s a shame, since so many people tried to warn him.
1.Repo-to-maturities? Hereinafter “RTMs.”
2.Page 44 of the report. The report cites to contemporaneous PwC emails and memos here.
3.Though “a PwC issue, and not MF Global’s” is pretty close! If your accounting is bad it’s on you. PwC just work here, man.
4.Oh how I simplify! Also ratings agencies, the Wall Street Journal, etc., though they feature less prominently in the report than PwC, Finra/SEC, and LCHC.
5.The House report adds that not only is the Alternative Method dumb in itself, in that it allows futures commission merchants to use customer funds for their own trading, but it also increases the chances of FCMs mistakenly or nefariously using customer funds that the’re not allowed to use:
In addition, MFGI’s use of the Alternative Method contributed to the $900 million shortfall in the company’s segregated accounts. The substantial excess funds in secured accounts under the Alternative Method made customer accounts a more attractive source of liquidity for the company’s day-to-day activities. In MFGI’s hectic final days, the company repeatedly transferred funds into and out of segregated accounts, amplifying the risk that it would miscalculate account balances for regulatory purposes. The Alternative Method, combined with the risk that such a miscalculation would occur, increased the chance that transfers made by MFGI would result in a deficiency of customer funds.