There doesn’t have to be a full-blown financial crisis for there to be dead bodies, so to speak, on Wall Street.
There’s been increasing speculation over the past few weeks about whether the European debt problems would cause financial problems for a U.S. bank. Most of the concerns focused not on the debt of the Europe nations themselves, but on the exposure of U.S. banks, which hold a lot of Greek and Italian and Portuguese debt, and the debt of other countries that might have troubles paying it back. Morgan Stanley had to deflect rumors it was in trouble, and so far it’s avoided any obvious signs of trouble.
(SPECIAL: Sizing Up 7 Key Efforts of Financial Reform)
Still, it appears that investors were somewhat right to be worried about U.S. banks and their ties to Europe’s financial problems. The mini-financial crisis, for now, has claimed its first U.S. victim – MF Global, a little known financial firm that is headed by a well-known financier, former NJ governor Jon Corzine. MF Global filed for bankruptcy protection on Monday. And there are some worries it could claim more. Here’s what you need to know about the MF Global failure and what it means:
What is MF Global?
MF Global is a now-bankrupt brokerage with roots going back more than 200 years to a London trading firm. But unlike what we normally think of when we think of brokers, it isn’t principally in the business of buying and selling stocks or for that matter principally European bonds. Instead, MF Global for most of its existence focused on helping investors make bets on the direction of stocks, bonds and commodity prices are using so-called futures contracts. These are a type of financial derivative. But what is surprising and interesting about its failure is that MF Global doesn’t specialize in the credit default swaps type of derivatives that got AIG and others in trouble in the past. Instead, it specialized in more plain vanilla derivatives that are traded on exchanges.
(PHOTOS: Tensions Mount at Occupy Wall Street)
At least that was the case until March 2010, when the firm was taken over by a new leader, the former NJ governor Jon Corzine. In addition having run New Jersey, Corzine was also a former head of Goldman Sachs. And after taking over MF Global he vowed to turn the firm into a Goldman Sachs-like investment bank. But Goldman has never really been like other Wall Street firms, which historically made their money off advising companies on mergers, and stock and bond offerings. Instead Corzine plunged the firm into proprietary trading – a risky business from which recent banking reforms have tried, perhaps unsuccessfully, to ban the big banks from doing.
Why Did MF Global fail?
The big bet that MF Global placed, and Corzine appears to have pushed for and approved himself, was on European bonds, particularly the debt of some of the EU nations that appear to be the most unable to pay back their debt, including Greece, Italy and Portugal. Corzine’s idea was that the stronger European nation’s were never going to let the weaker nations fully default, and risk the end of the Euro. Germany, for one, had benefited too much from the Euro. So even though the bonds were trading a steep discounts, Corzine believed that after some sort of bailout, the weaker EU nation’s would still make good on their debts, and MF would make a killing.
Corzine does appear to have been, right so far, at least in part. But the bonds trade all the time, and the prices of those bonds have continued to fall, even though they still might pay out in the end. The problem is that MF Global didn’t just buy up the bonds of European nations. It borrowed a bunch of money to do it. And the way MF made its leveraged trades (for more on that check out Felix Salmon’s What Happened at MF Global), the firm had to put up more and more collateral to finance the bet. Eventually, the money it needed to put up was more than the firm had. MF Global’s shares tumbled, but the company was still worth as much as $200 million late last week. As of the end of March, the firm employed about 2,500 people.
In the past week, it looked likely that MF Global, which still had a good-sized and profitable futures trading business would be sold to a competitor. But over the weekend, as a deal was to be sealed, it was discovered that as much as $700 million might be missing from the firm’s client’s accounts. It’s not clear if the money was stolen, or misappropriated or is just temporarily lost – to be found in some far-flung trading account. Either way, it raised one question too many about the firm. As a result, the last potential buyer Interactive Brokers backed out over the weekend. And MF Global was forced to file for bankruptcy.
Did New Bank Regulations Fail?
Dodd-Frank, the financial reform bill that was adopted last year, did little to save MF Global in part because the changes Dodd-Frank mandates aren’t fully in place, but also in part because they aren’t supposed to. In fact, the MF Global failure is evidence that, despite the contention of some, Dodd-Frank preserves and relies free market forces. MF Global wasn’t a small firm – it had $40 billion in assets and ranks as the nation’s 8th largest bankruptcy in U.S. history – but it wasn’t ” too big to fail” as defined by Dodd-Frank. The cut off for that in the law is $50 billion. So firms like MF Global are still allowed to make big bets and crap out under Dodd-Frank. It appears regulators did little to save the firm, even though there was some indication for months that it may have been in trouble. At least for now, MF Global’s failure doesn’t appear to have caused any larger problems for the financial markets. Roy Smith, a finance professor at New York University’s Stern Business School, says that shows that Dodd-Frank’s $50 billion cut off is at the least not too high. “We are going to have significant players in the shadow banking business have liquidity problems and we have to be willing to allow firms to sour when that occurs,” says Smith. “MF Global was correct to be identified as small enough to fail.”
(TIME MAGAZINE: Why We Care About the Euro?)
The more troubling question is whether Dodd-Frank would prevent a large systemic bank from getting into the same problems that MF got itself into. That’s not clear. MF Global’s problem, at least its immediate problem, was a liquidity crunch. Dodd-Frank focuses on capital, meaning making sure the banks have enough money on their books to cover their potential losses. But it does little to make sure that the banks have access to that cash in a hurry, as in the current case.
What happened to the missing $700 million in customer funds?
It’s not clear, or if Corzine or anyone else at MF Global violated the law. When bankruptcies occur often it takes accountants months to account for all the assets. That’s especially true for financial firms which tend to have a lot of legal entities and may have had to put up collateral with many of its trading partners. Trading partners would be slow to give that money back, even if they are not fully entitled to it, now that it is clear MF Global won’t be able to pay off some of its bets.
But it’s not looking good for Corzine and his colleagues. The Wall Street Journal is reporting that officials at the firm have admitted to regulators that the firm did divert money out of clients’ accounts, which is typically a no-no. The FBI has also said it plans to probe MF Global about the missing money. But regulators have yet to say whether MF Global’s employees broke any laws. The Securities Investor Protection Corporation is investigating client losses at MF Global as well.
Are other U.S. banks at risk of failure?
So far, the problems at MF Global appear to not be spreading to other banks. While MF Global has $40 billion in assets, it only owed about $2 billion outright to other banks. What’s more, more than half of that debt is owed to J.P. Morgan, which is one of the strongest banks around. There are other banks that are owed $6.3 billion from loans MF Global took out to make its Euro debt bets. But those debts are backed by the bonds that MF bought, and if they end up being good as Corzine claimed, then those banks should get their money back, as well as the profits Corzine hoped to pocket for his firm. MF Global does not appear to have the same type of derivatives exposure to other banks that led to the demise of Bear Stearns and Lehman Brothers.
The question for investors is whether there are other similarly situated banks that may have made large bets in Europe that might do them in as well. Again it appears, MF stands alone in its outsized, and ultimately fatal, Euro bet. That hasn’t stopped some investors from being worried. Shares of another mid-sized brokerage firm Jefferies & Co. fell 10% on Monday on fears that it too had bought up large amounts of Europe debt. But Jefferies issued a statement this morning saying that it hadn’t made any large bets on the debt of Europe’s most financially troubled nations. Still, the stock market fell nearly 300 points on Tuesday, on fears that the Euro rescue plan wouldn’t do the trick. At the very least, that means that the ability of the Europe’s debt problems to continue to rock U.S. markets won’t end with MF Global.