The MF Global Collapse: What Went Wrong
You might have noticed some smoke rising from the floor of the Chicago Mercantile Exchange in the past couple days. Lynn Marek reports for Crain's today: "Trading Pits in Turmoil as MF Global Collapse Rattles CME Exchanges":
"This is chaos, this is not even organized chaos."
While the wreckage can be seen on the floor of the CME, the news is happening in New York, and at the center the head of MF Global, a Wall Street titan and former senator and governor who came from a tiny Illinois farm town. While it's a complex and still-developing story of a firm that hired a star and went supernova, it's an interesting, if not particularly novel, look into the arcane world of the Street and how quickly things can go wrong there.
Long story short: Jon Corzine was born to a farmer/insurance agent dad and public schoolteacher mom in unincorporated Wiley Station in central Illinois, outside of Taylorsville, the "Christmas Capital of Illinois." He went to the University of Illinois, where he was a union member and hod carrier, and then the University of Chicago:
When I came out of the military, I started a family, and I needed a job. I had always enjoyed studying economics. I went to night school at the University of Chicago. The core curriculum was heavily finance-oriented, and I grew to like what I was doing, and I thought that being a bond trader, if you will, would bring together all those things that I was learning in school, but also my interest in current events and how things fit in the cloth of a society. And it actually was true: You were constantly looking for the marginal issue that was going to move markets as a bond trader. It tended to be more macroeconomic, and I liked it. I got a job at Goldman Sachs, got lucky, did pretty well, and it kept me focused on things that I liked.
Corzine is being somewhat modest when he says that he "got lucky"; his rise from Wiley Station to night school at the U. of C. (while attending it he worked at Continental Illinois, which would later go belly up in the then-largest bankruptcy in American history) to Goldman Sachs partner at the age of 33 is impressive. But he did pick a good time to hit the Street, an "extraordinary time" in his words:
Oh, it was the deficit funding in the U.S. There was no question about it. We went from $20 billion deficits in the '70s, which everybody thought was crisis, to $300 billion deficits at different times. ... So [the expansion came out of] both the heavy push of deficit funding, financing by the federal government here in the United States, and this whole interconnectedness that was coming about, which is the globalization issue.
So Corzine makes it in New York just as Wall Street is awash in deficit financing driven by another small-town Illinois kid made good, Dutch Reagan. A lot of money means a lot of inefficiencies: "the marginal issue that was going to move markets as a bond trader."
But a funny thing happened on the way to becoming the CEO of Goldman Sachs.
As the Wall Street Journal blandly noted, "Like its Wall Street peers, Goldman was hurt when the yen rose against the U.S. dollar and interest rates rose around the world. [The firm had been betting heavily against the yen's rise and was carring huge bond inventories that plummeted in value when interest rates shot up.]
Corzine knew what to do: Buy more! "The worse it appears," he said, "the better the reality. The probability is strong that if we hang on, and even increase our position, this can be a real winner." Corzine wasn't listening to doubts or doubters. But Jon, strong as that may be in theory, in the real world we could run out of capital or run out of liquidity or run out of time before your "sure thing" comes home and pays off. As losses piled up in the fourth quarter, liquidity wasn't threatened but the firm's capital fell nearly to the minimum required by the SEC.
Worth noting here one of the jokes about the University of Chicago: the unofficial motto, "That's great in practice, but how does it work in theory?"
What happened? No one could really stop him:
Friedman was trying to get Corzine to cut back the trading positions. “He just won’t do it,” Friedman told Hurst. “He says it’s a great trade.” Part of the problem for Friedman was that, without Rubin, he was not expert enough in fixed income to know for sure whether to overrule Corzine. In any event, 1992 and 1993 had been such amazingly profitable years in fixed income that Corzine would have been difficult to overrule anyway.
Later that unfortunate year, Corzine was promoted to CEO, though he was essentially co-CEO with fellow Illinois farm boy Henry Paulson—in part because, as prior CEO Steve Friedman told William D. Cohan (ibid.), "Corzine was accepted by most people as a part of the solution. Remarkably, though, even by people who felt that way, it was ‘But you have to have someone strong paired with him.’ I recollect no one other than Corzine being comfortable with Corzine alone."
You know, because he almost blew up the company.
Shortly after Corzine co-took over the company, a similarly naughty firm ended up in a flaming bag of excrement on his doorstep: Long Term Capital Management, which collapsed for reasons much like those that just killed MF Global. Corzine, prodded by the Fed, helped rescue LTCM, which by a business-school classmate of Corzine's who thought he had a great theory too:
LTCM focused on earning money off of inefficient bond prices and pairs trading. The bond strategy, which involved short selling over-priced bonds, only allowed the fund to earn a very small margin on each bond—as little as 1 percent, or $10 off of every $1,000 bond. Thus, in order to achieve real profits, LTCM had to engage in extremely high volume trades. However, to facilitate these large volume trades, LTCM would have to borrow heavily, resulting in highly leveraged positions.
This part might sound familiar:
In particular, LTCM had invested heavily in the Russian bond market, where concerns of currency devaluation had pushed the yield on short term bonds to a 120 percent annual rate. The partners were convinced that this perceived risk in the market was unjustified, as the thought that Russia simply would not allow its currency to fail. However, on August 17, 1998, the fears of all the investors in the market were borne out—Russia, contrary to its many public promises to the contrary, devalued its currency and defaulted on its government debt.
Jump forward 13 years, and Jon Corzine—after one-term stints as a senator from and governor of New Jersey—is back on Wall Street, running the "sleepy brokerage firm" MF Global, brought in to rescue it after it landed in the red. Roger Lowenstein, author of When Genius Failed, the classic book on Long Term Capital Management, writes:
MF Global was leveraged 30 to 1, shades of LTCM. And of MF Global’s roughly $40 billion in assets, more than $6 billion were in volatile European sovereign debts. Corzine was the author of the firm’s strategy of risking its own capital. He wanted a firm like Meriwether’s, and he got one. Corzine also approved the strategy of loading up on European debt. According to the Wall Street Journal, he told a company executive that “Europe wouldn’t let these countries go down.” Just as, 13 years ago, traders believed that Russia wouldn’t default.
OK, so Jon Corzine put Goldman Sachs at risk by betting on interest rates spreads that didn't go the way he predicted, and lost piles of money. Having survived that, he turns around and helps bail out a company that did the same damn thing. One would think that Corzine would have learned something about leverage and risk: that in the very basic data set of how many times he was intimately involved with massive failures of firms that overleveraged themselves betting on government debt, a clear pattern would emerge.
Then again, that also would have been a terrible bet.
If you really want to know the gritty details of what brought down MF Global, the Financial Times has an analysis of its bad bets. A consensus is emerging that they weren't bad bets... or at least didn't seem like bad bets. Felix Salmon has a reasonably clear explanation, but let me see if I can dumb it down further.
1. MF Global buys European bonds. Obviously Europe is a mess, but c'mon, it can't be that risky. It's Europe! Nothing ever goes wrong there! And it's hedged, just in case.
2. MF Global borrows money with the bonds as collateral. It costs less to borrow than MF Global makes on the bonds.
Imagine that, instead of buying European bonds, MF Global had loaned money to people betting the Cubs won't win the World Series next year. That's a pretty good bet, since the odds are low. Then the Cubs get Theo Epstein, who everyone loves. All of a sudden the Cubs look a bit better for next year. Now let's say they sign Prince Fielder. Now the odds go up and all hell breaks loose, not because MF Global lost the bet, but because it's not as good a bet as it was a few months ago and they have to have more money lying around to cover it in case it goes sour:
What happened here is that MF Global’s regulators worried the firm didn’t have enough capital to meet likely margin calls and demanded it raise more capital and disclose more about the size of its positions. These disclosures worried the ratings agencies, which downgraded the company. Which made the creditors demand more collateral.
Which is a problem, given how heavily MF Global was leveraged. As Salmon writes:
As the MF Global slide notes, “MF Global retains obligation to post margin”. If the people lending money to MF Global started getting worried, they could require MF Global to put up more money.
And that seems to be exactly what happened. When questions started being raised about MF Global’s ability to continue as a going concern, its counterparties probably started asking for more collateral if they were locked into repo trades to maturity in 2012.
But MF Global, leveraged to the eyeballs, didn’t have that kind of extra money lying around.
So then the quality of MF Global's bet doesn't matter; the hedge doesn't matter; all that matters is whether MF Global has enough money, now. Which it didn't. Francine McKenna, a Chicago journalist specializing in accounting, argues that maybe someone should have said something:
On first blush MF Global’s problems, and Corzine’s mea culpa, may look like bolts out of the blue. But those who are in the business of watching over the company should have seen storm clouds brewing long ago. Back in June 2008, MF Global was still somewhat optimistic but guarded about its business prospects. A year later, it was spelling out the double whammy it faced from low interest rates and trading volumes in its annual report.
All that, of course, was even before Corzine showed up and began turning MF Global into a glorified casino.
We wonder what is meant by this pronouncement and what evidence must be present to conclude that a going concern opinion is appropriate. Might that include four years (2008-2011) of massive losses, as occurred at MF Global? Might that include severely negative free cash flows for three of the last four years?
In other words, maybe MF Global's mucking around with European debt was an okay idea for a company with lots and lots of assets to risk and plenty of money coming in from other concerns—like Corzine had with Goldman Sachs—but a rickety old company like MF Global wasn't it. Corzine pushed it too hard, and it broke.
Now the big question is whether MF Global used money from customer brokerage accounts to stop the bleeding. After a CME audit! Or they may just not know where in the hell their money is. The FBI is interested in helping them find it.
It's a remarkable story, and usually I'd use a word like "unprecedented" to describe it. But it's clearly precedented; it's the third time Corzine has had to clean up a mess like this in his career. If it's surprising at all, it's surprising in its lack of suprise, in the weird shock-unsurprise mobius strip that Wall Street's become.
Photograph: John Picken (CC by 2.0)