It’s 2011 all over again. The European debt crisis is nipping our incipient recovery in the bud. There’s talk of a growing battle over the nation’s debt ceiling. And now there are new revelations of former U.S. Senator and New Jersey Governor Jon Corzine’s shenanigans at the once-little-known financial firm MF Global.
Your disgust at the reemergence of those first two issues is not unwarranted, but the post mortems out this week – in the form of a 275-page report from MF global Trustee James Giddens and a 12,500 word feature from Fortune magazine – at least provide for some entertaining reading while the world economy withers around us. For those who don’t have time to pour through the full reports, here are four takeaways from the latest disclosures:
1. MF Global was in shambles before Jon Corzine even got there. MF Global was spun off by its previous parent, Man Group, in 2007 and found itself almost immediately in financial straits. In 2008, a rogue trader name Evan Dooley lost the firm $141 million on ill-advised wheat futures trades. According to the Giddens’ report:
“When the loss was announced, the ratings agencies downgraded MF Global, and even though customer funds were not implicated, a number of [MF Global] customers lost confidence and withdrew their accounts.”
Following this incident, MF Global beefed up their risk management procedures and staff. But around the same time the financial crisis struck, causing the Federal Reserve to slash interest rates. With that move MF Global’s only profitable business – earning interest on brokerage customer’s margin deposits – vanished. According to the Fortune report:
“For the many years when interest rates were high, the firm made a healthy overall profit thanks to “net interest income”—the spread between the meager rate it paid customers on their balances and what it earned from investing all that cash. After rates dropped to zero beginning in 2008, it regularly lost money.”
2. But that doesn’t mean there isn’t plenty of blame to be laid at Corzine’s feet. The financial services industry and its regulators are so reviled today that it’s nearly impossible to think of a professional in the field widely believed to be competent. The latest revelations at MF Global do nothing to help the industry’s cause. The reports paint a picture of Corzine as a CEO who was obsessed with trading and neglected other parts of the firm that could have used his attention. According to the Trustee’s report, “Mr. Corzine was very hands-on with respect to sovereign debt trades. He communicated with . . . personnel directly regarding the trades, instructing them when to enter and exit various positions.”
Of course there are reasons why CEO’s shouldn’t be traders. Traders need oversight, and there was nobody to tell Corzine “no,” when he went all in on European debt. And CEOs need to be disinterested enough to be good stewards of all segments of the business, and Corzine clearly was not.
3. Our financial system remains dysfunctional. It’s clear from this report that MF Global was operating based on perverse incentives. When Corzine arrived at the firm, his main objective was to boost short-term profitability of the firm in order to stave off credit downgrades, which would give his long-term reforms time to take hold. This is where his aggressive investment in European debt came in. Corzine believed (correctly, so far!) that the European Union wouldn’t allow it’s larger members to default on their obligations, and so he ordered large bets to be placed on euro zone bonds. But the firm structured the trades in a complex way that allowed the firm to get around accounting rules that would have required it to take temporary losses on those investments (which would have defeated the point). These structures proved to be far more illiquid than simply investing in the bonds themselves and were a factor in MF Global’s eventual downfall.
I understand that there are defensible reasons for such accounting rules and counterparties’ reliance on credit ratings agencies to assess risk. But it’s plain to see from the example of MF Global that our financial system, through these rules and institutions, sometimes inhibits firms from doing what’s best for their long-term health in the simplest and safest way possible. Whether you believe the solution is more, less or simply better regulation, something must be done.
4. There’s still a chance for real accountability. It is still unclear how $1.6 billion in customer funds were used to fund MF Global’s liquidity needs during the final days of its downfall. Some of it was surely due to human error and poor accounting systems. But the cause ultimately isn’t as important as the effect. Misappropriating customer funds is inexcusable and illegal, and those in charge should be held accountable. The trustee’s report leaves open the door to Corzine and his deputies being held accountable for their negligence. Giddens writes, “The Trustee is already consulting with commodities’ customers’ class action counsel about actions against officers and directors and other employees. The Trustee believes that claims, including claims for breach of fiduciary duty and negligence, may be asserted against Jon Corzine, . . . among others.”
This sort of action is necessary not only because it’s suitable to hold these people accountable, but to ensure that managers will think twice about doing this sort of thing again.