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.
