The 3 Most Important Lessons From the Collapse of MF Global

Just days after Jon Corzine took over as CEO of MF Global (OTC: MFGLQ), he told a visitor, "Don't ask me any hard questions. I hadn't heard of this company a week ago." Now, over a year and a half later, he still isn't able to answer any hard questions.

At three congressional hearings so far, Jon Corzine has said repeatedly that he has no idea what happened to the approximately $1.2 billion in missing customer funds. Throughout his testimony, he hasn't been able to remember very many details, and he has often apologized for not knowing how varying parts of the business work. At one point he even admitted that he wasn't "an expert on the complicated rules and regulations governing the various different operating businesses that comprised MF Global," and that he "had little expertise or experience in those operational aspects of the business."

Predictably, Congress has not been able to get many answers out of Corzine and his lieutenants about the missing funds. This investigation is still ongoing, and we will learn much more in the coming months. At this point, however, there are quite a few things we do know for certain.

Facts are stubborn things
We know that the segregation of customer funds is supposed to be sacrosanct at a futures commission merchant -- or FCM -- so a violation of that rule is a serious problem, whether it's a result of fraud or substandard operating policies and procedures. Even if it is eventually determined that no illegal activity occurred, we're still left with a spectacular dereliction of duty on the part of the MF Global Board of Directors and management team.

We also know that MF Global's CEO was acting like a chief trader and was able to make trading decisions outside of normal risk controls. With leverage of approximately 35-to-1 -- once you add the European debt exposure to the firm's stated assets -- Corzine's company wasn't able to survive when it faced a liquidity crisis brought on by a downgrade from the credit ratings agencies. And that downgrade was partly a result of the firm's exposure to European sovereign debt.

Corzine has tried to defend the European sovereign debt trades by arguing that "none of the foreign debt securities that MF Global used in the RTM [repo-to-maturity] trades has defaulted or been restructured." Whether this is true is irrelevant. These trades set off a chain of events that resulted in MF Global's bankruptcy and the subsequent loss of customer funds. All the rationalizing in the world cannot change that inconvenient fact.

So far, MF Global customers have been ill-served by the bankruptcy process. Thousands of farmers, ranchers, and independent traders don't have access to money they believed was securely housed in segregated accounts. This is unacceptable and should never be allowed to happen again.

Areas for reform
We don't have all of the facts yet, but already there are a few areas policymakers should focus on in order to prevent something like this from occurring in the future. Here are three possible things to consider:

1. Review the accounting rules for derivatives in general and repos in particular.
As we noted earlier in our series, MF Global took proprietary positions in European sovereign debt using "repo-to-maturity" transactions, which allowed it to move these high-risk bonds off its balance sheet. This, of course, allowed MF Global to portray its financial position as stronger than it actually was. Writing about this maneuver recently, Sheila Bair, the former chairperson of the FDIC, asked, "Why don't accountants fix this stuff?"

We've been asking ourselves the same question, and feel we need a change here. As Alex Dumortier wrote, "If you retain the market risk, the default risk, and the credit risk (and a few others), you own the bonds -- full stop." And if you own the bonds, it needs to be reflected on the balance sheet.

2. Consider an insurance system for futures customers.
A lot of the MF Global customers we spoke with felt that there should be some sort of FDIC-like fund for protecting futures customers from collapses like this one. In the past, futures customers have relied on the hallowed principle of "segregated accounts." Now that faith in that principle has been shattered, additional protection is needed.

We are hopeful that progress will be made here. Commissioner Bart Chilton, of the Commodity Futures Trading Commission, appears to support a FDIC-style system, saying recently that it "would help protect investors' money from misuse." Right now, there is just too much uncertainty for customers of MF Global. We should do whatever we can to ensure that future customers of other FCMs are not subjected to a similar process.

3. Boards of directors need to be more engaged in the risk management process.
In an earlier piece, Alex Dumortier also argued that MF Global's board of directors bears the most responsibility for the collapse after Corzine. By allowing Corzine to wear two hats -- CEO and trader -- "the odds of the firm failing increased exponentially."

One MF Global executive, in hindsight, believed that having different oversight procedures for Corzine and the ordinary traders was a "bad recipe." The board, with Corzine as its chairman, was the only entity that could limit Corzine's trades. As Alex writes, "Once that was the case, no amount of risk committees or sophisticated analytics could help."

Investors need to pay very close attention to the risk management procedures of financial companies. Ideally, the chief risk officer would report directly to the board. And it should be a huge red flag if a CEO is also making trades out of his own account. The financial crisis of 2008 and the collapse of MF Global teach us that risk management matters -- a lot. Investors must pay close attention to a company's risk management procedures as part of their research.

This story is still unfolding, and we will continue to follow it in the coming months. Journalism is the rough draft of history, and our nine-part series is an early attempt to tell this extremely important, but very unfortunate tale.

John Reeves does not own shares in any of the companies mentioned in this story. You can follow him on Twitter @TMFBane. 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 (35) | Recommend This Article (64)

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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 19, 2011, at 5:27 PM, richie54 wrote:

    They should make this guy the next Postmaster General.

  • Report this Comment On December 19, 2011, at 5:28 PM, JNaughton wrote:

    "there should be some sort of FDIC-like fund for protecting futures customers"

    Seriously? The FDIC is backstopping trillions of dollars of deposits with an insurance fund that is several billions in the red, so that's a solution?

    The FDIC insurance is a market signal to people that they don't have to be concerned with how badly the bank managing their CD's or deposits is being run or what kind of risks they're taking. Just go for the highest return and if they go bust, the cost of will be transferred to everyone else. What could possibly go wrong?

    How about instead, we tell people that they're risking their own money so they better watch who's got it and what they're doing with it, along with some immediate perp walks for Corzine, the board, their auditors, and the regulators who didn't stop it, and some very fast court cases including stiff prison sentences. A few judicious instances of tarring and feathering wouldn't bother me either.

    Just spitballing here.

    FDIC. Sheesh.

  • Report this Comment On December 19, 2011, at 5:30 PM, kijngti wrote:

    So who were MF Global's Auditors and where were they in this. Isn't that the place to look for the smoking gun?

  • Report this Comment On December 19, 2011, at 5:31 PM, nerd1951 wrote:

    I think the most important lesson we can learn from the collapse of MF Global is that our financial regulatory agencies are broken. Self-regulated industries really aren't regulated at all.

    We've had numerous opportunities to learn this lesson but big finance lobbying and revolving door from regulators keeps us from doing anything about it.

  • Report this Comment On December 19, 2011, at 6:02 PM, don448 wrote:

    All the necessary controls are already in place. Bureaucratic bumbling and good-ol-boy policing allowed this theft to take place. Do you really think Corzines buddies will punish him? I'll bet he walks without losing a bit of his own money.

  • Report this Comment On December 19, 2011, at 6:09 PM, xetn wrote:

    I believe this article states the case very well:

    http://www.caseyresearch.com/articles/abcs-re-hypothecation-...

  • Report this Comment On December 19, 2011, at 6:16 PM, gkirkmf wrote:

    @ JNaughton

    Amen brother... I second your " Sheesh"

  • Report this Comment On December 19, 2011, at 6:32 PM, TMFKopp wrote:

    @JNaughton

    "Seriously? The FDIC is backstopping trillions of dollars of deposits with an insurance fund that is several billions in the red, so that's a solution?"

    FDIC-esque. Some sort of insurance fund. It could be government-related like the FDIC or it could be a more private-market solution like the SIPC, which backs the securities industry.

    I'll note that most of the farmers that we talked to strongly advocated for a private-market insurance solution rather than a government-sponsored one.

    I know there are a lot of minimal-government types that find it attractive to say "you just have to do diligence and figure out where your money is going to be safe." And there is some truth and wisdom to that. But at the same time, it's a problem when that reduces the efficiency of the industry and the participants. So for those that don't like government solutions, an insurance fund is still an option -- assuming its organized and funded by industry participants.

    Matt

  • Report this Comment On December 19, 2011, at 7:09 PM, CraftyFellow wrote:

    The entire derivatives market is a house of cards. Take Silver on the CME. In one month this year, the actual silver produced in the world to paper silver being traded was a 1:500 ratio. Now Bloomberg is reporting that investors that had paid MF Global to physically store their physical silver bars will only get about 70% of their stored metal returned to them in the bankruptcy... How does that get insured?

  • Report this Comment On December 19, 2011, at 7:18 PM, clevelandrudge wrote:

    Since we're seconding tonight, I second the comments of nerd1951. And what we really need is campaign finance reform to fix the all-too-porous wall between Congress members and staffers and the giant lobbying firms. The investment those firms make on behalf of their clients must represent the best investment opportunity available anywhere. The only problem is that it's not available to you and me, Fools.

  • Report this Comment On December 19, 2011, at 7:28 PM, mike2153 wrote:

    So Corzine's either a fool hired for his political connections or a really bad liar. If he's just a puppet, who are the guys pulling the strings? Money doesn't just disappear (like Republican integrity). Track it down and sieze it back. Nail the people pulling the strings and/or Corzine.

  • Report this Comment On December 19, 2011, at 7:49 PM, TMFBane wrote:

    @mike2153, I think you've raised a central issue in all of this. Is Corzine as clueless and out of touch as he seems? Or is he a pathological liar who is deceiving the United States Congress? Or something else?

    Right now, I'd choose "something else." One of the most interesting pieces I've read on this is by Felix Salmon who described Corzine as a "rogue trader." You can read it here:

    http://blogs.reuters.com/felix-salmon/2011/12/12/jon-corzine...

    Essentially, Corzine exhibits all of the signs of an obsessional trader. My hunch is that he didn't care much for the futures side of the business, and felt he could add value by pursuing his talent as a trader (specifically in sovereign debt, which he considers a speciality). His increasingly large and leveraged bets without proper risk controls eventually ruined the firm.

    I'm really enjoying the comments, everyone.

    @kijngt, we agree that the auditors are a key area to investigate, and will be pursuing that thread in future articles.

    @JNaughton, you make a very persuasive case, but I agree with Matt that an insurance system would do more good than harm. The current system with this sort of disruption is ultimately unworkable.

    @nerd1951, it's hard to disagree that our regulatory system is extremely flawed. The CFTC is overwhelmed, and the self-regulatory organizations have not acquitted themselves well. So, I guess I'd "third" your comment.

    Thanks for all of the great comments!

  • Report this Comment On December 19, 2011, at 8:31 PM, Merton123 wrote:

    Don't open a brokerage account with a business that engages in Futures trading. Open a brokerage account with Vanguard, Fidelity, Charles Schwab, Edward D Jones, and your risks are minimal that the broker will steal your money.

    You notice I didn't include Merril Lynch because they underwrite securities and are probably engaged in similiar business activities that MF Global was engaged - eventhough they do have a stellar business reputation.

  • Report this Comment On December 19, 2011, at 9:19 PM, snowmon wrote:

    With all the incredibly stupid and costly regulations out there, it would appear that it may be perfectly legal to use the cash in client accounts to make the bets that were made. Repeal all of Sarbanes-Oxley and Dodd-Frank, and write a simple rule- "thou shalt not gamble with thy customer's money".

    That, and let ALL such organizations fail, so matter how big (AIG, Bear Stearns, ...). Let the scum clear- new institutions will form (or existing will expand) into the vacuum.

    The last thing we need is yet another crushing Sarbox/Dodd_Frank out of this debacle.

  • Report this Comment On December 19, 2011, at 9:38 PM, Toklat2 wrote:

    @JNaughton, You took the words out of my mouth, except I'd stress the Chinese solution in some of the worst situations. The Chinese execute people like Madoff.

  • Report this Comment On December 19, 2011, at 10:15 PM, XLouisiana wrote:

    It's either "We have seen the enemy and he is us" or "Wacka-wacka," I'm not sure which? Not only the fall of MF Global is worrying, but the reaction by the CFTC, the SEC and the the “Merc” as well. Actions (or lack of) by the Merc after MF Global's collapse were unprecedented. Check out this scare:

    http://www.financialsense.com/contributors/2011/12/02/ann-ba...

  • Report this Comment On December 19, 2011, at 10:30 PM, Ragingmoose wrote:

    We better buy and sell stocks ourselves with a discount broker than pay any outstanding mandarin to ''take care'' of our cash.

    Wy should I pay someone to loose my money. I can loose it by myself and learn the hard way to be a winner.

    Read the newsletter (like Motley Fool) and make your homework !

  • Report this Comment On December 19, 2011, at 10:32 PM, devoish wrote:

    xetn,

    good link.

    I heard it suggested that the relevant law that allowed MFglobal to put client money up as collateral is this one.

    http://taft.law.uc.edu/CCL/34ActRls/rule15c3-3.html

    i Except as otherwise agreed in writing by the OTC derivatives dealer and the counterparty, the dealer may repledge or otherwise use the collateral in its business;

    ii In the event of the OTC derivatives dealer's failure, the counterparty will likely be considered an unsecured creditor of the dealer as to that collateral;

    Best wishes,

    Steven

  • Report this Comment On December 19, 2011, at 10:35 PM, rplandon wrote:

    After Madoff, another broker dealer, I looked at the SIPC financials and their capital situation.

    They needed capital, that was to be raised from the SIPC members. Where do they stand today?

    What credit rating would they obtain. Supplemental insurance is a thin layer, by any measures.

    The 1.2B in segregated funds appears to have been was pledged to support MFG deals that went bad. Corzine did not know this?

  • Report this Comment On December 19, 2011, at 11:48 PM, kmarkt2 wrote:

    There is only ONE lesson that needs to be re-learnt, that is:

    Enforcement need to be merciless when dealing with brandname personalities in the likes of Madoff, Ken Lay, Kozlowski et.el.

    Forget about using Congress to enact tougher laws - its meaningless when the current set available has no enforcement or putting more insurance mechanisms.

    Better to err on conservatism then to carry a can of worms.

  • Report this Comment On December 20, 2011, at 4:53 AM, Rolin4ward wrote:

    A week or two before this story broke, an experienced investor was interviewed about how he had bought commodities and was surprisingly told, the day before the interview, that he didn't have any funds in the account. He had a gold shipment that should have covered it. The gold never arrived and further investigation revealed it had simply been taken by the bank which was wrapped up with this MF Global Bank business. He wasn't aware at the time, few did, that MF Global Bank was up to no good. They brazenly took his GOLD right out of his private account folks!

  • Report this Comment On December 20, 2011, at 9:12 AM, sept2749 wrote:

    Using clients funds in huge amounts should have been picked up by outside auditors. Unfortunately, audits rarely uncover fraud. One would and should feel otherwise but that's the way it is. There should be some form of insurance to cover customer's losses of this nature. It's a damn shame - can't trust anyone anymore!

  • Report this Comment On December 20, 2011, at 1:26 PM, vriguy wrote:

    How many of MF's top executives and directors will do jail time? Will they face hefty fines as a punishment, hefty enough to impoverish them?

    Sadly the answer to both questions is NO WAY!

    Where are the politicians who demonize the rich (Obama and co.)? and the politicians that say the markets can self-regulate if govt. gets out of the way?

    VERY VERY QUIET

    We need someone to clean these Augean stables.

  • Report this Comment On December 20, 2011, at 2:06 PM, colleran wrote:

    This may be too simple. Fix the problem by:

    Eliminating any off book debt, transactions, etc.

    Identify capital requirements of say 10% for all debt to limit leveraging.

    Make executives criminally responsible for any transactions that violate the above rules.

    Make accounting firm executives criminally responsible for allowing a company to violate the above rules.

  • Report this Comment On December 21, 2011, at 7:47 AM, brokeassbroad wrote:

    "Why don't accountants fix this stuff?" - Because they (auditors) are paid by the client and don't want to lose big accounts.

    "Make accounting firm executives criminally responsible <clip>." - Like the proverbial bus full of politicians going off a cliff, it's a good start.

  • Report this Comment On December 22, 2011, at 12:31 AM, truman1987 wrote:

    @JNaughton regarding the FDIC

    "How about instead, we tell people that they're risking their own money so they better watch who's got it and what they're doing with it . . ."

    Really? You go into your bank and ask to see how they are performing on each loan and make sure that they aren't investing your deposits in risky investments? I sincerely doubt it. You and every other bank depositor in the country depend on the FDIC to make sure that they are watching the bank and will backstop your deposit.

    The FDIC isn't in the red, although their reserves are very low, think about it, we are going through the worst banking crisis since the 30's. Of course it is low. Be glad the FDIC is there, if this were the 30's your bank, like 25% of them did, might close one day and all of your money would be gone.

    I've seen the FDIC audits from the inside. They are very tough on small community banks. I think they do their job well. It's the regulators involved in large investment banks that are useless, don't confuse the two.

  • Report this Comment On December 22, 2011, at 12:38 AM, kmtominey wrote:

    The only thing that will stop this sort of illegal activity is to require by law, that one organization cannot engage in both activities. You want to speculate with proprietary trading fine, you want to be a dealer broker fine - but not under the same corporate roof.

    You want legitimate audit reports and ratings. Take control of the formal audits away from companies. Formal audits to be arranged by the CFTC or SEC as the case may be. Auditors work for and report to the SEC; fudging results to make a company look better is a federal crime. Ratings agencies subject to the same. CFTC or SEC hires, fires and pays. They send the bill to the audited firm or the issuer.

    The conflicts of interest are just too serious and these highly paid executives with the self control of poorly raised 3 year olds is going to destroy capitalism if they are not reined in sharply.

    Reinstate Glass-Steagall, the Antibucket Shop Law (getting rid of naked CDSs is a great idea), and require buyers of securities or their representatives to arrange for and pay for ratings.

  • Report this Comment On December 22, 2011, at 2:02 PM, JNaughton wrote:

    @TMFKopp:

    "FDIC-esque. Some sort of insurance fund. It could be government-related like the FDIC or it could be a more private-market solution like the SIPC, which backs the securities industry.

    I'll note that most of the farmers that we talked to strongly advocated for a private-market insurance solution rather than a government-sponsored one..."

    Let's be clear. The FDIC isn't insurance, it's a stupidity subsidy.

    Real insurance takes risk into account. No insurance company would sell me insurance if I'm 50 years old, 100 pounds overweight, smoke, drink myself to sleep, and am planning on taking up hang-gliding to blow off stress of working as a lumberjack at the same premium rate as a 20-something Mormon school teacher. And if they did, they wouldn't be allowed to exist saying a reserve of 1-2% of their insured risk was good enough, with a chunk of that reserve consisting of collection of the next few years' of premiums in advance.

    The FDIC would, though. How much more do the big boys pay in insurance premiums to offset the atomic derivative risk and MBS in their portfolios compared to the community banks (that truman 1987 is concerned about)? Nada.

    Well, that's not exactly correct if you consider all of the interest free money the walking dead TooBigToF banks have been propped up with. Kind of like charging that Mormon kid a couple of extra years of premiums in advance to loan me money for the hang-gliding lessons.

    I know local folks who got cleaned out by MFG, too. I'm not uninterested in them getting justice or protecting people in the future. But for a little timing, I could've been in the same boat.

    Adding another federal program wouldn't be an answer, it'd be the birth of a new pending disaster.

    (We could start by giving the CME the bill, who decided to stiff all of the the MFG clients instead of living up to all of the talk about the sanctity of their clients' accounts. They could use some of the tax break money my insolvent state of Illinois just voted for them so they wouldn't move!)

    Cheers,

    JNaughton

  • Report this Comment On December 23, 2011, at 4:18 PM, Ferretz wrote:

    @TMFBane:

    "Essentially, Corzine exhibits all of the signs of an obsessional trader. "

    An inability to limit the size of the risk sounds a lot like an addiction to gambling.

  • Report this Comment On December 24, 2011, at 10:08 AM, tedstips wrote:

    What a spellbinding piece,and easily read by laymen. great amount of work went into this.It should be published in book form. Congratulations to MF for this illuminating story.

  • Report this Comment On December 24, 2011, at 12:27 PM, Bienetre wrote:

    This underscored my belief that I shouldn't invest in anything that I don't understand, and made me more concerned that those who are 'looking after my money' and looking after themselves. Thanks for the story.

  • Report this Comment On December 24, 2011, at 2:33 PM, TMFBane wrote:

    @tedstips, Thanks for the kind words! We'll definitely have an easier way for readers to access the entire series. More on that soon!

  • Report this Comment On December 24, 2011, at 3:03 PM, Starfirenv wrote:

    The most important lesson here is- A bird in the hand is worth $1.2 Billion in the bush.

  • Report this Comment On December 25, 2011, at 3:29 PM, rabba wrote:

    Tax payers should not backstop hedge fund investments. You invest your money, you take the risk, you keep the profits. Instead, prosecute those who broke the laws, and pay attention where you put your money.

  • Report this Comment On January 05, 2012, at 8:49 PM, thidmark wrote:

    Two predictions:

    1. This episode will produce gobs more regulation.

    2. Another fraud like this will happen again - and soon.

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