By Bethany McLean The opinions expressed are her own.
On Monday morning, MF Global, the global brokerage for commodities and derivatives, filed for bankruptcy. The firm's roots go back over two centuries, but in less than two years under CEO Jon Corzine, whose stellar resume includes serving as the chairman of Goldman Sachs, as New Jersey’s U.S. Senator, and as New Jersey's governor, MF Global collapsed, after buying an enormous amount of European sovereign debt. The instant wisdom is that he made a big bet as part of his plan to transform MF Global into a firm like Goldman Sachs, which executes trades on behalf of its clients, and also puts its own money at stake. Although the size of the wager has received a great deal of scrutiny, the accounting and the disclosure surrounding it have not–and may have played a role in the firm's demise.
In the 24 hours since the filing, more ugly questions have piled up, with the New York Times reporting that hundreds of millions of dollars of customer money have gone missing, and the AP saying that a federal official says that MF Global has admitted to using clients' money as its problems mounted. Whether this was intentional or sloppy remains to be seen; MF Global didn't respond to a request for comment by press time.
At the root of MF Global's current predicament was a simple problem: the profits in its core business had declined rapidly. That core business was straightforward, even pedestrian; what the firm calls in filings a "significant portion" of total revenue came from the interest it generated by investing the cash clients had in their accounts in higher yielding assets and capturing the spread between that return and what was paid out to clients. As interest rates declined sharply in recent years, so did MF Global's net interest income, from $1.8 billion in its fiscal 2007 second quarter to just $113 million four years later. MF Global's stock, which sold for over $30 a share in late 2007, couldn't climb above $10 by 2009.
Enter Corzine in the spring of 2010, who had just lost his job as New Jersey's governor to Chris Christie. He was brought in by his old pal and former Goldman partner Chris Flowers, whose firm had invested in MF Global. Fairly quickly, Corzine accumulated a massive net long sovereign debt position that eventually totaled $6.3 billion, or five times the company's tangible common equity as of the end of its fiscal second quarter. I'm told Corzine's move was highly controversial within the firm. But no one overruled him, maybe because after all, he was Jon Corzine. In a mark of just how much Corzine mattered to the market, in early August, MF Global filed a preliminary prospectus for a bond deal, in which the firm promised to pay investors an extra 1% if Corzine was appointed to a "federal position by the President of the United States" and left MF Global.
Buying European sovereign debt may not have been just a bet that the bonds of Italy, Spain, Belgium, Portugal and Ireland would prove attractive. An additional allure may have been the way MF Global paid for the purchases, and thereby, the way the accounting worked. MF Global financed these purchases, as its filings note, using something called "repo-to-maturity." That means the bonds themselves were used as the collateral for a loan, and MF Global earned the spread between the rate on the bonds, and the rate it paid its repo counterparty, presumably another Wall Street firm. The bonds matured on the same day the financing did.
The key part is that for accounting purposes, MF Global's filings say the transaction was treated as a sale. That means the assets and liabilities were moved off MF Global's balance sheet, even though MF Global still bore the risk that the issuer would default; that means the exposure to sovereign debt was not included in MF Global's calculation of value-at-risk, according to its filings. And that also means MF Global recognized a gain (or loss) on the transaction at the time of the sale. The filings do not say how much of the gain was recognized upfront. But if it were a substantial portion, then these transactions would have frontloaded the firm's earnings. That, in turn, may have helped cover the fact that MF Global's core business was struggling.
MF Global's public filings also don't say how much this contributed to earnings. But one indication of the size of the repo-to-maturity deals comes in this small excerpt from MF Global's most recent 10K, under the heading of "Off balance sheet arrangements and risk": "At March 31, 2011, securities purchased under agreements to resell and securities sold under agreements to repurchase of $1,495.7 million and $14,520.3 million, respectively, at contract value, were de-recognized." ("De-recognized" means moved off the balance sheet.) Of that $14.5 billion, 52.6% was collateralized with sovereign debt. One way to get a sense of the ramp-up of “repo to maturity” transactions is to compare the figures to those as of March 31, 2010: The securities sold under agreements to repurchase increased by some $9 billion.
Once the regulators and rating agencies began to zero in on all of this, it didn't matter that the trade itself may not have been that risky. (The debt all matured by the end of 2012, and MF Global, of course, had financing in place until it matured.) But it was European sovereign debt, after all, and the trade was huge"”and it appears that part of the concern may have been the accounting, and certainly the lack of disclosure. On September 1, MF Global said in a filing that the Financial Industry Regulatory Authority (FINRA) was requiring it to "modify its capital treatment" of the European sovereign debt trades. According to an affidavit filed by MF Global's president on the day of the bankruptcy, FINRA was "dissatisfied" with the September filing and "demanded" that MF Global announce that it "held a long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity." Words like "dissatisfied" and "demanded" aren't good in the context of a regulator!
By the time the market opened on Monday, October 24th, MF Global's stock had already fallen 62% from its high of almost $10 following the announcement that Corzine was joining the firm. Then, Moody's downgraded the firm’s debt, citing MF Global's "inability to generate $200 million to $300 million in annual pretax earnings and keep its leverage within acceptable range." In other words, Moody's was concerned about the real profitability of the business. The next day, MF Global reported its $6.3 billion position, per FINRA's demand, and also reported that it had lost almost $200 million in the quarter ended in September"”in large part because the firm had reduced its deferred tax assets by $119.4 million, a sign that the accountants were saying there wouldn't be a return to big profits any time soon. By the end of the week, all three rating agencies had downgraded MF Global debt to junk. Moody's wrote that its downgrade "reflects our view that MF Global's weak core profitability contributed to it taking on substantial risk in the form of its exposure to European sovereign debt." MF Global's stock finished the week down 67%.
The actual details of the run aren't clear yet, but according to the CFO's affidavit, the ratings downgrades "sparked an increase in margin calls," which drained cash. Plans to sell all or part of the business fell through, reportedly because of the discovery of the missing cash. Another part of the explanation might be that potential buyers found out just how weak the core business was.
Of course, if Corzine made the trades for an accounting play, there's a deeper question of why he would feel the need to do this. And isn't that always the question in situations like this?
PHOTO: Jon Corzine, MF Global Holdings Ltd. CEO, leaves the office complex where MF Global Holdings Ltd have an office on 52nd Street in midtown Manhattan, October 31, 2011. REUTERS/Brendan McDermid
The CME and the CFTC are the ones who really need to be investigated.
“…So I gave all my money to this outfit run by the former governor of New Jersey. Seemed like a good idea at the time.”
Any moron who lost money on Corzine’s turd-transferring exercises at MF Global deserves what they get. This is exactly why we need the Volcker Rule to stay in place. Transparency requirements work. They found him out and they will find more.
Very well written article. I am a layman when it comes to financials and I was able to follow this quite thoroughly. Welcome to Reuters! I think I will look for an app to add this to my Ipad.
I find it amazing that Americans can be so highly critical of Corzine’s billion dollar gamble using investor’s assets . . . while condoning trillion dollar gambles by our government . . . using your money and mine.
It is sickening to see trusted big heads and agencies let the boat sink and start scratching their heads. The words used in describing the transactions and activities (except that we know they were financials involving investors money – investors who had no idea what these activities by MF G would lead to)do not make any sense to even financial professionals at times and were evidently planned to be that way. May be NOBODY knew what they meant anyway. A bunch corporate chiefs and some suordinates and some from FINRA, CFTC and auditing firms (where were they while the drain was unplugged)had a great time supporting luxury business of wining and dining. What would we have done if those support jobs were not supported by these folks? Let us wise up every one. Shed the greed and ask questions up font!
Yes. Mr Corzine was once in the Government and a Billion is a small change compared to what he could have done with your money and mine. Govt provides good training may be.
Always enjoy McLean’s work. What really is astonishing is that the top echelon of Wall Street so blithely engages in what is nothing more than fraud with a fancy accounting name attached to it.
Its very obvious that accounting gimmicks led to the downfall. Hiding very leveraged very risky “bets” off the balance sheet is akin to an alcoholic hiding a bottle of vodka in their desk: Sooner or later it would be found out. The idea that this man could risk the solvency of the firm on whether or not the EU member nations could come to and implement a very controversial plan is mind numbing. MF Global’s profits had dropped,.. so what. Rates would have eventually gone back up and profits would pick up again. This was simply a case of ego and greed.
Enter Corzine in the spring of 2010–
Everything in this paragraph is a f**k you to middle America by the money keepers and the government.
The reason Why is there is a fundamental disbelieve on Wall St, et al, in Efficient Market Hypothesis. Even writing the name of the theory here is going to provoke the rant of nay sayers.
Yes, I know you beat the market, I beat the market, but neither of us do it consistently, and over time there is regression to the mean, especially when you factor in risk. If you are producing average results over time, you have a very hard time justifying the insane fees that you charge, and worse, you face the possibility that you are just an average joe. So Hubris and Greed, time tested explanations for lots of behavior.
Time and again I have gone in and looked at the returns on hedge funds, where the numbers have been available. Starting with LTCM, by the time they were toast their average return over the life of the ‘experiment’ was between 9% and 11%, about what I have gotten from an asset allocated collection of ETFs from Vanguard.
It is REALLY, REALLY hard for a guy[s] like Corzine to live with that. When these guys can’t cook the books, or do deals of dubious legality, they might as well go back to flogging load mutual funds or ‘hot stock picks’. That will not make you legendary.
Thank you Bethany McLean, for a great article. Is this another nail in the coffin of the concept of “moral hazard”? I’m sorry for all who lost their shirts in this scheme. Thank goodness for the regulators at FIRMA. Had Corzine gotten away with this I’m sure we’d be looking at the collapse of an even bigger scheme down the road.
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