Why the MF Global Bankruptcy Is Important To You

The privileged have regularly invited their own destruction with their greed. — John Kenneth Galbraith

If you follow the financial news on a semi-regular basis, you know that MF Global, a futures fund run by Jon Corzine, former governor of New Jersey, went bankrupt last week. If you don’t read the financial news, well God bless you. As far as things go, the fact that MF Global went bankrupt isn’t particularly important, in and of itself. In the current financial ecosystem we live in, companies go bankrupt. What makes the MF Global bankruptcy so different is that it was quickly discovered that customer assets to the tune of $600 million went missing when regulators showed up to figure out what the hell happened. Right off the bat, you should be a little nervous. Sure, this is a hedge fund probably catering to high end clientele but there were also plenty of normal people who traded with MF Global. And their money is gone. Missing. Permanent vacation. This is the very scary story of how the oligarchy is looting the proletariat and it has wide ranging implications for the financial system we all operate in and trust in.

Some MF Global history is in order. Even though they were a derivatives broker, they weren’t particularly profitable and somewhere along the way, Mr. Corzine made the decision to start trading with the firm’s own money. Now typically, in more normal times, brokers and trading firms made money by clearing customers’ trades. For example, when you sell or buy a security at Fidelity, they make money on the commission they charge you for handling that transaction. Once upon a time, when the world was flush with cash and the Nasdaq was screaming towards the stratosphere, clearing trades could be pretty profitable without much risk. Then 2008 came and suddenly, people didn’t think trading in the stock market made that much sense any more. The easy money dried up. For the larger firms, they could handle that but firms like MF Global immediately started losing money.

At the time Corzine come on board, two thirds of MF Global’s revenue was based on clearing trades and that wasn’t working out too well. Corzine decided to take the firms’ own money and make leveraged bets on a variety of gambles in an effort to shore up the falling revenues. One of his biggest bets, to the tune of $6.3 billion, was on European sovereign debt with an emphasis on Italy, Portugal and Spain. That sovereign debt was due to mature in 2012.

So what happened? Well, as with so many of the horror stories over the past three years in the financial world, this story begins with the word “leverage”. If you look at the holdings of MF Global as compared to its assets, what you find is that MF Global was using leverage of about 40 to 1 to make these bets. That means for every $40 in securities that MF Global held, it only had $1 backing it. At those levels, the proverbial shit can hit the fan faster than you can imagine. For comparison’s sake, Lehman Brothers was leveraged at about 35 to 1 back in 2008 when it nearly took down the world’s financial system.

How this all went down is slightly complicated, especially if you’re unfamiliar with how the bond market works. And frankly, I’m pretty unfamiliar with it all and thus, the discussion below may be riddled with errors. It’s my understanding based on reading a variety of sources on the MF Global debacle.

Much of the financial media is commenting that this all happened because the proprietary bets that MF Global was making with their own money went south in a hurry two weeks ago when interest rates on Italian debt started going north. But that’s not quite what happened with MF Global. Their bets weren’t based on the expected performance of the bonds. They were essentially a liquidity trade where they used the bonds in a repurchase agreement or repo. What that means is that they bought the bonds then sold them to a counterparty in exchange for cash. The catch is that in a repurchase agreement, the seller–in this case MF Global– had to agree to buy the bonds back at maturity from the counterpart whereupon they could return the bond and collect their coupon value plus the interest. A very simplified example would help.

Let’s say you would like to upgrade your kitchen. It’s going to cost $1000. You don’t have $1000. So you come to me and say that you’d like me to buy a bond from you. If I buy a $1000 12 month bond from you, you will use the $1000 I give you to upgrade your kitchen. The agreement you make with me is that in 12 months, you’ll give me my $1000 back plus an agreed upon interest payment, let’s say 10% or $100 in this case. So I get $100 out of the deal in return for loaning you $1000, you get a new kitchen and everyone is happy. This is a basic bond transaction. Happens all the time. In our MF Global example, you would be a European country in need of cash, say Italy, and I would be MF Global.

But MF Global wasn’t that interested in 10% in 12 months. They needed cash. So they did a repo with counterparties. In our simplified example, let’s say I can’t wait 12 months for the cash but that I don’t turn you down. What I might do is go to our friend Lloyd and say “I have this bond. I’d like to do a repo with you where you give me $1000 in exchange for the bond and pay you $1050 in 12 months.” What I’ve done is cut my $100 profit in half by agreeing to give half of it to Lloyd in exchange for having my $1000 back. But if the going rate for borrowing money is 1%, I’m making a killing with that 5%. And because all this is “financed to maturity”, i.e. nothing really happens until the bond matures, it’s considered to be extremely low risk. On top of that, if I’m a business, I can book the $50 in profit immediately, which if I happen to be reporting to shareholders, is a good thing. And because the original coupon rate of the bond, in our example $1000, is going to get repaid regardless of fluctuations in the bond market, it’s considered a safe way to provide liquidity.

In theory, this is all straightforward, practically risk free. When you’re dealing with sovereign debt, even with a country like Italy, the chance of them defaulting is almost negligible (ignore for the moment the fact that Italy does not have a lender of last resort and thus shouldn’t be considered in the same way a country like the US would be–that’s the subject of another exceptionally long blog post). The only way this situation can get ugly is if the counterparty (our friend Lloyd) decides that maybe I’m not going to have the money to repurchase the bond from him. If for example I get in deep with my bookie who happens to also be Lloyd’s bookie, rumor might get out that I don’t have the money to repay the bookie much less Lloyd. Well Lloyd might come back to me and increase my margin by asking for half the payment of the bond. For $500, maybe I scrape that up by working at WalMart for a month. When we’re talking about the $6.3 billion MF Global had leveraged, that calls for rather desperate measures.

This is essentially what happened with MF Global. The counterparties that had entered the repo agreements with them decided that maybe they weren’t going to have the cash to pay them back, especially given the rather disappointing conference call October 25th reporting a $191 million loss, the largest in the firm’s history, a history that includes annual losses the last three years. You can imagine if you’re Lloyd and the losses are really starting to mount, you might want to protect yourself. So he did. As that news spread, clients of MF Global, the people who are really screwed in this situation, started trying to get their money out. Some probably did. Others seem to have been given checks that bounced. Imagine if you tried to take the money you have in Fidelity out and not only would they not wire you the money as is normal but they sent you a check that bounced. That might just cause a run on Fidelity.

That’s exactly what happened at MF Global. Combine the counterparties with the MF Global clients trying to bail out along with a 40 to 1 leverage problem and suddenly, bankruptcy is the only way out. However, they made one last desperate move before the bankruptcy filing. And it’s sickening. Someone at MF Global decided that there was a chance they could manage the crisis if they could just get through the weekend. Specifically, they were trying to unwind the bets in Europe with Blackrock’s help among others. So what they did either late Wednesday October 26th or very early in the morning October 27th was take a mixed bag of assets and securities out of their clients accounts and moved them into a house account to the tune of about $700 million. These assets were Treasuries, securities and commodities, all things that wouldn’t be noticed very quickly. They then made an agreement with someone as yet unnamed (but who was undoubtedly complicit) to loan them money based on those assets. That party probably refused to loan anymore than about half the amount of the assets values knowing full well the likelihood of a pending MF Global bankruptcy. So MF Global probably got around $400 million for this little agreement. The plan was probably to make it through the weekend, unwind the bond assets, find another lender, repay the lender of last resort and then put the “borrowed” assets back in clients accounts, no one the wiser. Unfortunately, the gambit failed and they had to declare bankruptcy Monday morning.

When MF Global declared bankruptcy, whoever that unnamed last resort lender was took ownership of all those assets. What they probably did was immediately liquidate them to cover their loss. That means the MF Global clients money is GONE. It may never return. This is the part that’s so important to all of us. Someone in power at MF Global essentially looted their clients accounts in attempt to save their own skin. And if you think anyone at MF Global is going to be prosecuted for this travesty, you have a great deal more unfounded faith in the system than I do. The implication here is that no money in the system is safe. This rapidly can become a credibility trap, one in which no one feels that the money they have in the financial market is safe. If that happens, bad shit is going to go down. As Jesse notes above, this is a major test for the Obama Justice Department. If you don’t see perps prosecuted to the fullest extent of the law and all the money returned one way or the other, you can know that this behavior is largely condoned in a very explicit manner.

Our financial system is teetering on the brink. We pushed it to the edge in 2008 and instead of pulling back and reforming the destructive behavior of those who took us there, we built a small glass platform on the edge and told everyone in the world to jump on. That glass platform is growing increasingly unsteady. It will only take one small increase in the load to send us all right over the precipice. And it’s the elite, the oligarchy at the highest levels who are pushing us all out there with little regard for any of the possible destruction. These are extremely dark days and not many of us know it. I’m beginning to think it’s not a matter of “if” we see another collapse but just “when”. Our politicians have shown no interest in accepting the necessary pain required now to avert us from that future disaster. No one is explaining this to the people in a clear and concise manner. We are all just drifting along in a rudderless boat in extremely rocky waters. It’s only a matter of time before we end up with a huge hole in the side of the boat that can’t be patched.

A Bedtime Story To Haunt Your Sleep

Imagine if you will a friend–perhaps imaginary, perhaps not–who spends money as if it grew on trees. He buys things constantly, upgrading to the latest and greatest, always drives a new car. None of this is a problem if he’s independently wealthy but let’s say he’s not. Let’s say he makes $40,000 a year but has outstanding debt $66,400. At first, this isn’t a problem. Nik makes the minimum payments, creditors are happy and Nik goes on his merry way. One month though, Nik misses a payment. Suddenly, one of the credit cards he has jumps from 9.9% to 18.9%. Not a deal breaker for his lifestyle but a sign that maybe things aren’t going too well. Then something bad happens. Nik loses his job. Lucky for him, he finds another one but it only pays him $35,000 a year and in the meantime, he’s missed a payment on another credit card, jumping that rate up to 18.9% too.

Suddenly, Nik is in a bit of a spot. He’s making less money, still has the same debt but has to pay more on that debt just to service it because his overall interest rate has gone up. In the real world, Nik has a few options. He can try to get a better job and make more money. He can drastically cut back on his spending, lowering his quality of life and make larger payments towards the debt. He can try to approach his creditors and negotiate his debt down, either by lowering the interest rate or the amount or both. Or he can default, declare bankruptcy and try to get a fresh start. What he chooses depends on his particular situation but as his friend, you are in impartial observer for the most part.

However, let’s change the story a little. Let’s say that late in the game, Nik decided to go to the local loan shark, Heinrich. He wants to borrow some money from Heinrich to keep the lifestyle going. Heinrich, normally the lender of last resort, takes one look at Nik’s balance sheet and says, “yeah, not so much. There’s no way you’re going to be able to pay me back so I’m not loaning you any money.” Nik tells you this sob story over coffee one day and you get a brilliant idea to make some money off Nik. You’ll go to Heinrich and tell him that you’ll sell him an insurance policy that essentially says, if Nik declares bankruptcy, you’ll pay Heinrich for Nik. You’re a model upstanding citizen with a large bank account so Heinrich agrees. He gives Nik the money and then every so often at agreed upon intervals, Heinrich gives you a small insurance payment. Everybody is happy.

Unless Nik declares bankruptcy. Then, you’re not so happy because you have to pay Heinrich back. Suddenly, you have some skin in the game. Now in normal circumstances, you’d probably never agree to sell Heinrich that insurance policy no matter how much money you had or how good a friend Nik was. It’s just not very smart. But what if you had a pretty good idea that the insurance policy was guaranteed, e.g. there was no way Nik would default? Nik would never default, Heinrich would keep paying you insurance and you were guaranteed never to have to pay off the policy. Well then, it’s free money! Yay for free money! Even if it wasn’t guaranteed that Nik wouldn’t default, you’d have a strong self-interest in making sure he didn’t. You might even act in ways that were contrary to Nik’s long term success just to keep him from defaulting, if you could. Man, you’re a shitty friend.

While this is a highly simplified little story, it’s somewhat analogous to what’s going on on the world’s economic stage right now, as best as we can tell. Imagine if you will that Nik is Greece, Heinrich is Germany and you are the hedge funds and money markets of America. Most countries look at Greece’s finances and say, “no way in hell are we loaning them any more money, they can’t pay back what they already owe.” But somewhere along the way, American hedge funds and money markets thought to themselves, “There’s no way that Greece is defaulting, the EU won’t allow it. It would cause huge catastrophe. On top of that, our own government has shown in the past that they will step in and backstop companies like AIG and Lehman Brothers if need be. We could sell insurance on Greek debt that would essentially be guaranteed not to be collected on and make a mint.”

This is the very definition of moral hazard. And while we have no explicit proof of the above scenario to my knowledge, we have some pretty good circumstantial evidence that it’s going on:

And the Europeans are very angry that a few weeks ago Tim Geithner, the bank lobbyist, came over and insisted that Europe not forgive Greece’s bank loans, not let Greece write down the loans, and indeed that it not even claim that Greece should do what Argentina is and write down the loans as a premise. Mr. Geithner explained to the Europeans that the largest insurers of the Greek debt are American money market funds and hedge funds. And he said American hedge funds and banks would lose money and actually would crash the U.S. economy, if Europe made a concession to Greece to bring debts down to the ability to pay. So, instead of a debt write-down or a haircut, the banks said, “OK, we will agree with what the Americans are insisting on, and we will ask for a voluntary write-down by the banks on the Greek debt they hold.” Obviously, European banks who are not part of the credit default swaps have disagreed with this. So the Americans are putting immense pressure on Europe, saying, “We will wreck your economy, if you don’t wreck Greece’s economy.”

Last week, when a deal for a supposed bailout for Greece was announced, the market celebrated. Monday, when the Greek Prime Minister said he was going to put it to a vote of the Greek people, the market tanked. Today, when the referendum was yanked back off the table, the market celebrated. Why do we think that is so? Because the market knows that bailouts for Greece are good for the market whether they are good for the Greek people or not. The Greek people are starting to see that bailouts when they come with the conditions of severe austerity programs are not actually good for them. It is fun for certain people to say this is what they deserved all along, that they should have lived within their means. But this continued insistence that the only people at fault in these situations are the debtors is ludicrous. In every agreement between a creditor and debtor, blame lies equally with both. Without one, you cannot have the other. The countries that continually loaned money to Greece well beyond the amount they could possibly pay are equally to blame for this crisis as are the Greeks. But the major players on the stage do not care one whit about the Greek people. They only want to keep making money. They knew–or thought they knew–that loaning money to an EU partner that that partner could not possibly repay would be guaranteed by someone. Moral hazard has created a situation where the financial elite and the oligarchy make decisions based on what they expect from some governmental entity in the future.

Satyajit Das has pointed out that the European debt crisis can end in one of three ways:

The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults.

Of the three, the first is almost completely out the window. Even if the German populace would agree to it, they don’t have as much wiggle room as would be necessary to fix the debt problem of all the weaker EU countries. The European Central Bank (ECB) has a set policy against expanding its balance sheet which makes number 2 difficult as well. That leaves us with sovereign defaults which means all the bailouts in the world only kick the can slightly farther down the road until the market forces the politicians’ hands.

So what happens if we get a sovereign default or two? Well, contrary to the many people in America who think they are largely insulated from such an occurrence, if the above scenario is true and the hedge funds and money markets of America have engaged in selling insurance (credit default swaps) on Greek, Italian and other European debt, we have a situation where economic collapse could easily happen in America. If those CDS are cashed in, people may discover that they can’t pull any money out of their money market funds. That could cause a run on banks and we all know how that ends up.

We had a chance to handle instances of moral hazard back in 2008. Our politicians completely let us down at the time and only reinforced the idea for the banks and the oligarchy that the government will always backstop them. By doing so and refusing to significantly reform the financial system, they opened up a scenario where a small country in Europe could possibly bring down the financial system around the world. They kicked the can a little farther down the road but we’re all going to be paying for it for a very long time.

An Exogenous Event

Last week, it appeared that something of a plan, however roughly sketched out, had been drawn up in the great European debt crisis. Markets around the world rejoiced with something bordering on abandon even though astute observers questioned the lack of details in the plan. The plan revolved around bondholders taking an approximate 50% haircut on their holdings in return for another large bailout for the stricken economies, specifically Greece. Much backslapping and handshaking commenced and the wool was pulled over everyone’s eyes.

That is, until yesterday when the wool was yanked off by the temerity of the Greek Prime Minister when he dared to take the proposed changes to a referendum for the Greek people to decide upon. Imagine the boldness of a leader who thought maybe his people should vote on the proposed austerity changes necessary to get the bailout. While there is no doubt Prime Minister George Papandreou has his own reasons for doing this (and we can promise they have little to do with the democracy of the Greek people), the very fact he’s doing it at all tells us a great deal about the likelihood of a successful resolution to the European debt crisis. You can imagine the shock of the financial and political elite upon finding out that Mssr. Papandreou was putting the bailout to a vote.

The announcement came “out of the blue, it’s surprising, very risky,” Norbert Barthle, the ranking member of German Chancellor Angela Merkel’s Christian Democratic Union party on parliament’s budget committee, said in a telephone interview. “There’s an enormous amount at stake. Do we know how the Greek people will treat their government in this referendum? No. We have a new unknown.”

“If the Greek people don’t see the necessity of backing Papandreou we have a whole different ballgame,” Otto Fricke, the budget spokesman in parliament for Merkel’s Free Democratic Party coalition partner, said by phone. “If he doesn’t get a majority, then there’s no second aid package, no voluntary haircut. We’d have a potentially explosive situation, one that leaves us today baffled as to what we could possibly do next.”

Le chef de l’Etat est consterné par l’annonce de ce référendum, selon Arnaud Leparmentier, journaliste du Monde, qui suit l’Elysée. “Le geste des Grecs est irrationnel et de leur point de vue dangereux”, selon un proche du président. (Which roughly translates to “What the hell does that idiot Papandreou think he’s doing asking the people for support? That’s not the way we do it in France”) Source

Understand, the Greeks are being asked to take on austerity measures that are draconian in nature. Their standard of living and wages will be negatively affected for decades. The people of Greece have seen little of the boom years while their politicians and financial elite have made a fine living. You can imagine the people of Greece might be hesitant to accept such a bargain. Obviously, the German and French elite are shocked with the possibility that their bailout may hinge on the whims of the people of Greece. Here they had a plan all figured out whereupon they could get at least some of their money back from those profligate Greeks and it may all go south in a hurry.

This little debacle aside, on a larger scale, this could be the exogenous event that takes down the European Union and with it, the tenuous uptick in the global economy. The European politicians have been slow to respond throughout this crisis and the plan they came up with seems to have no Plan B should it fail. Should the Union fail, there is absolutely no telling what reverberations it might have on the global economy. Initially, finance would flow into the US as a perceived safe haven. But past the initial shock and short term catastrophe, the future is exceptionally murky. The US fortunes are largely tied to the European Union having loaned billions of dollars to French and German banks. Should one or more of those banks fail, we’ll have an event that makes 2008 look practically kitten like in its severity. You can count on those loans being insured somehow much the same way that the mortgage bets were insured in 2008 and that nearly took down AIG. A large bank failure in Europe will ripple across the Atlantic in ways no one can predict at this point.

Solving the European crisis has been practically doomed from the start as it is next to impossible to get the necessary participants to agree on any solution that is mutually beneficial. All politicians are only concerned with the short term and their own skin. Asking them to look into the future and solve a problem with a lot of pain short term was asking too much. There seems to have been no consideration that countries within the EU might need to default or be backstopped in such a way. Instead of an orderly solution, we’re likely to see an extremely disorderly solution when the market tries to figure out what the politicians could not. The market has largely been suppressed in its discovery which will only serve to make things worse. As we find out who owes who what, entire economies may collapse. It would all make for such interesting theatre if we weren’t all players on the stage.