What Really Killed MF Global

No one doubts that former New Jersey governor Jon Corzine helped destroy MF Global (OTC: MFGLQ). But if you think that his strategy to transform the futures and commodities broker into an investment bank was stupid, you're wrong.

Don't believe us? Look at the data:

Company

Operating Income Margin

Net Income Margin

Return on Equity

MF Global 7.9% 3.2% NM
INTL FCStone (Nasdaq: INTL  ) 5.8% 3.7% 1.5%
Penson Worldwide (Nasdaq: PNSN  ) 14.4% 8.4% 10.3%

Source: S&P Capital IQ. MF Global data for March fiscal years ending 2006 to 2008. MF Global return on equity has been excluded because it was a public company for only one reporting period covered; pre-IPO shareholders' equity does not reflect the capital requirements of the stand-alone company. FCStone data for September fiscal years ending 2005 to 2007. Penson Worldwide data for December fiscal years ending 2005 to 2007.

Now look at the same figures for some of the major investment banks:

Company

Operating Income Margin

Net Income Margin

Return on Equity

Goldman Sachs (NYSE: GS  ) 36.6% 24.3% 24.7%
Morgan Stanley (NYSE: MS  ) 22.1% 19.4% 14%
JPMorgan Chase (NYSE: JPM  ) 34.3% 21.4% 11%

Source: S&P Capital IQ.

Why wouldn't Corzine want what his former firm, Goldman Sachs, had? Any sane evaluation of the environment in which MF Global was operating shows that brokers were getting pinched by cutthroat competition. Corzine's best bet for growing earnings was to return to the investment banking model he grew up with.

Here's how he explained the rationale at a Sandler O'Neill investment conference in June 2010: "I think we have missed a significant opportunity to deepen our relationships with our clients because we're not in the principal risk-taking activity in a market-making sense, not in a proprietary book sense, but in a market-making sense with respect to our clients."

He followed up a year later at the same Sandler O'Neill conference, saying:

We have been transitioning over these 14 months into a broker dealer, and we have every intent on [becoming] an investment bank in due course. ... I think actually this diversification is showing that we are actually building multiple streams of income, which actually makes us less risky. That's one man's opinion.

Bet big or go home
There's no mistaking Corzine's thinking. He believed remaking MF Global into a principal-risk-taking investment bank in the image of Goldman Sachs would be safer. Former MF Global employees we've spoken with agree the firm had little choice but to diversify, though for the sake of profit rather than risk reduction.

Reporting by The Wall Street Journal corroborates this view. In a piece published earlier today, the newspaper quotes anonymous sources who point out that Corzine viewed big bets from a principal trading desk as the key to returning MF Global to profitability following years of losses.

But unlike larger peers, MF Global under Corzine lacked a series of checks on the CEO's bets. Only the board had oversight. Chief Risk Officer Michael Stockman, meanwhile, played the role of helping Corzine present his trading strategy to the board, the Journal reports.

Could it be he was swayed by the math behind the new business model? Corzine described the profit opportunity in detail at the June 2010 Sandler confab:

You look at principal transactions [that] are only 14% and we do that mostly unmatched. You find the buyer and the seller, put them together and that's a principal transaction. If we run trading books, that 14% could easily be one-third of our earnings. I think [if you] look at some of the bulge bracket firms [they put up] significantly higher numbers, [there is] plenty of room for growth there.

In other words, based on what he knew about the trading operations of big investment banks, Corzine rightly saw a potential windfall within MF Global's grasp. He crafted a strategy to take advantage.

Executed by execution
Yet even good strategy coupled with poor execution will always produce poor results, and that seems to be what happened here.

Again, consider oversight. The systems and culture for properly balancing risk and reward at an investment bank take time to develop, and judging by the Journal's reporting, MF Global never took the steps needed to create the sorts of controls common to larger peers -- including Corzine's former employer, Goldman Sachs.

Corzine had to know this was an issue. He spoke publicly of the need for tight controls at MF Global after joining the firm in March 2010: "Making certain that you don't have the kind of car crash that this organization experienced back three or four years ago is essential by having tight controls, tight compliance, and making it part of the culture. And that's the kind of people we're hiring, and that's the kind of culture we're building."

The quote seems to refer to a $141.5 million loss incurred in February 2008, when a so-called rogue trader named Evan Dooley made a bad bet on wheat futures. Was Corzine's thinly vetted bet on European debt really so different? Systematic oversight appears to have been lacking in both instances.

A cold cup of comfort
Corzine's desire to turn MF Global into an investment bank made sense on several levels. But he was rash about the process. Checks and balances were pushed aside when he became CEO, big-money trader, and risk manager.

It's as if hubris on a Greek scale allowed Corzine to believe he could make the shift happen more quickly than history and his own experience as an investment banker would suggest. Yet the board, regulators, auditors, and fellow executives did nothing to stop it. Shame on Corzine, but shame on them, too.

Our team here at The Motley Fool is continuing to dig deep into the MF Global mess. If you'd like to share any information, you can email us at tips@fool.com or call our tip line at 703-254-1546.

Also, if you want to stay up to date on the emerging story at MF Global and participate in efforts to enact Wall Street reform, shoot a blank email to imoscovitz@fool.com.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He didn't own shares in any of the companies mentioned in this article at the time of publication. Fool contributor Matt Koppenheffer didn't own shares in any of the companies mentioned at the time of publication.

The Motley Fool owns shares of JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of The Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 01, 2011, at 4:10 PM, Hawmps wrote:

    "We have been transitioning over these 14 months into a broker dealer, and we have every intent on [becoming] an investment bank in due course. ... I think actually this diversification is showing that we are actually building multiple streams of income, which actually makes us less risky. That's one man's opinion."

    When people use the word "actually" it really makes my ears perk up; like whoever is doing the talking is [actually] trying to sell me on something they don't entirely believe to be true. He said "actually" 3 times in this sentence... that's a bright red flag to me, and not the run with the bulls kind... more like the run away and hide kind.

  • Report this Comment On December 01, 2011, at 11:35 PM, sasflo wrote:

    This comparison is worthless. INTL in the same context as PNSN and MF Global? You have to be kidding!

    Compounding the nonsense is the additional comparison with GS, MS and JPM.

    How this is supposed to help make sensible investment decisions is beyond me.

  • Report this Comment On December 02, 2011, at 10:56 AM, WeWereWallStreet wrote:

    Talk about skipping Greenwood's Behavioral Finance class.

    What killed MF Global was Corzine's bad karma. We document it here: www.WeWereWallStreet.com/Corzine-what-goes-round.html

    He wasn't even hanging out on long-term bets. He just got what was coming to him.

    It'll be interesting to see if the missing $$$ shows up.

  • Report this Comment On December 02, 2011, at 11:13 AM, GrumpyOldGuy wrote:

    MF is the culmination of what Corzine has been working towards his whole life. The man has never paid the price for his poor performance and he thought he never would.

    He has basically failed at everything he tried but his connections kept him going. Now he pays the piper.

  • Report this Comment On December 02, 2011, at 11:27 AM, BseeingU wrote:

    The real reason Corzine went on a takeover

    binge of retail firms like Lind-Waldock, etc., was to be able to get his hands on the billions of dollars in supposedly segregated customer accounts.

  • Report this Comment On December 02, 2011, at 12:07 PM, Millsteen wrote:

    Why hasn't Corzine been civilly and criminally indicted for the missing money?

  • Report this Comment On December 02, 2011, at 12:10 PM, TMFKopp wrote:

    @sasflo

    "This comparison is worthless."

    Want to provide some more color to your proclamation? INTL is one of the U.S.'s largest FCMs. The businesses aren't carbon copies of each other (few are), but the basic idea is that the banks that take more firm-principal risk can end up being far more profitable.

    I'm not implying that that's necessarily right or ideal -- a well run, safe company that makes thin profit margins can still be a very fine business. But when the two models -- and their profitability -- are stacked side by side, it's easy to see why Corzine would have wanted to transform MF Global.

    Matt

  • Report this Comment On December 02, 2011, at 12:10 PM, c0ffeen0te wrote:

    You cannot look at the returns that the Goldmans et al are generating and say "I want that" without an understanding of the enormous risks they are taking. Their bonus structure incents them to take unfathomable risks. Worst case scenario may only have a .1% chance of happening which means basically it will happen every three years (once in a thousand days). In the meantime these people get rich and as we know, when the black swan event arrives we bail them out.

    Hubris is what took out MF Global and will claim many more victims no doubt unless we as a country decide to make banking boring again.

  • Report this Comment On December 02, 2011, at 1:06 PM, WikiCPA wrote:

    ^Corzine was head of Goldman Sachs Intl prior to this position, I think he understood the risk.

  • Report this Comment On December 02, 2011, at 2:44 PM, TMFTomGardner wrote:

    c0feen0te, I hope you plan to post a lot more in the years ahead. You should also be a financial writer. I agree with what you've written, yes.

  • Report this Comment On December 02, 2011, at 3:26 PM, slpmn wrote:

    Actually, the major investment banks don't make the bulk of their profits from taking "unfathomable" risks. They like to say what they do is based on taking risks, but that's largely because 1) it makes it sound like a sexy business and 2) it partially justifies their massive personal compensation (i.e. their compensation is about risk/return).

    How they make the bulk of their profits is by trading and M&A, neither of which are particularly risky, done properly. In both cases, they're basically just skimming money off of transactions as compensation for being the middle man. In M&A, it's somewhat justified because it just isn't practical to set up some kind of efficient low cost exchange for whole business transactions. In bond and derivitive trading, however, there's just no reason that can't be done more effieciently and without paying the middle man so much.

    For example, look at what happened with stock trading over the last 30 years. Brokers used to actually make lots of money from commissions on small trades. That was essentially elminated through internet trading and the magic of easily accessible bid/ask spreads. Contrast that with bond trading in which institutions still have to call a human, place their order, and wait while their guy finds the right bond for them, then charges a nice fee for the service. It's why bond traders make so much money - they're skimming profits off of trillions of dollars in transactions.

    Inefficient markets explain why investment banking is so profitable. Blow-ups like rogue traders or the mortgage meltdown are special cases that really have nothing to do with the money machine that fuels investment banks.

  • Report this Comment On December 02, 2011, at 4:17 PM, TMFKopp wrote:

    @slpmn

    To some extent you're right and you bring up some good points.

    For instance, in all of the talk of turning MF Global into an "investment bank" as far as I know Corzine never had plans to do traditional investment banking -- that is capital raising and M&A advisory. And you're right that the big banks get meaningful profits from IB services. However, it's not huge in most cases -- Goldman, for instance, got slightly less than 10% of its pretax profit from true IB services.

    Of course this "oversight" by Corzine makes perfect sense. He came up on the trading (FICC) side of Goldman and never really got along with the white-shoe folks from the banking side. In fact, it was Hank Paulson and others who had come up from the banking side of Goldman that pushed Corzine out. So I can't see him as jumping at the possibility of bringing in those darn banker types :)

    As for the trading though, the big differences from what you're outlining are twofold:

    1) Some of the big profits come from trading in products that the bank creates itself and aren't traded on established exchanges. When it's a customized product or such a small market that it's not exchange traded, it makes sense that the middleman might get paid well.

    2) The banks like Goldman, Morgan, etc take positions and have trading books -- when they talk about their "trading" division, it's not simply about matching up buyers and sellers. That's one of the big opportunities that Corzine was looking at. MF Global was making markets and creating liquidity, but its traders were not taking proprietary positions and maintaining trading books. Because of the mounting pressure on straight trading commissions due to competition, the prop trading made trading overall far more profitable.

    Matt

  • Report this Comment On December 02, 2011, at 5:42 PM, NOTvuffett wrote:

    This is not about a failed business model, this is about commingling of funds. It is criminal.

    -1

  • Report this Comment On December 02, 2011, at 6:16 PM, TMFKopp wrote:
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