Criminal Negligence at MF Global
I spent an unpleasant few hours watching Jon Corzine play a Congressional Committee like a Stradivarius. Here is a man with a stellar resume: Goldman Sachs financial genius and CEO, senator from NJ, governor of NJ; CEO of MF Global. The congressmen, bless their souls, had no idea what actually happened. Was the risk taken by MF Global excessive? Mind you, there is no agreed upon definition of "excessive." Well, the congressmen are sure that it must have been excessive risk, or else how could the firm go under?
Is the Dodd-Frank monstrosity at fault for being insufficiently strict? Nobody knows. Predictably, Democrats think so, and Republicans realize that it is just arbitrary rule-making by bureaucrats who hate anyone who earns money by investing. My own view is that Dodd-Frank is irrelevant in this case. By now, you would think that our congressmen would have educated themselves just a little bit about high finance. After you stop laughing, you might think that they had hired staffers who understood it very well. You would still be wrong. The regulators, whoever they are, obviously don't understand. Geithner and Bernanke lecture the world from a valley of ignorance and cronyism. Some of the go-to pundits on various financial shows have some idea, but they don't explain it coherently.
Here are just a few questions it would have been nice to hear from the honorable members:
- What controls were in place to prevent improper use of customer funds?
- Who had the power to override those controls?
- How could commingling occur without being spotted within 24 hours?
- Who was the senior risk manager of the firm?
- What are his or her credentials for that job?
- How much power did the risk manager have to veto transactions?
- Can you supply copies of all official risk reports to you and/or the board of directors?
- What sorts of risk reports did you routinely monitor on a daily basis?
- How was the decision made on the amount of leverage to use on any particular investment?
- Who loaned the firm money backed by risky collateral?
- Were the shareholders apprised of the risks being taken by the firm?
- Do you play golf? How often? (OK...let him take the fifth on that.)
Let's look at some actual facts. My only disclaimer is that these facts come from the second- and thirdhand reports from the media. I do not have access to any primary documents.
Broadly speaking, MF Global had two basic kinds of accounts.
- MF Global had customer trading accounts. They had a fiduciary responsibility to exercise care and diligence in protecting the integrity of those accounts. They had a legal responsibility to segregate the customers' funds from firm capital. Failure to do so would be criminal -- amounting to theft.
- MF Global also had proprietary trading accounts, using firm capital. They had investors (shareholders) in the equity of the entire firm to whom they owed a fiduciary responsibility to manage risk responsibly. There is no established rule on how much risk should be taken. It is up to the shareholders to entrust their money to the resident experts or not. Only fraud or significant misrepresentation would be actionable.
- MF Global could have run a resident hedge fund. I do not know if they did. There is little difference between that and trading with firm capital. In the hedge fund structure, the investors aren't actual shareholders in the firm, but in the hands of honest management, there is little difference. It would be a red flag if the same firm ran a hedge fund and also did proprietary trading with firm capital outside the fund. It is a good sign if principals of the firm invest in the hedge fund. The hedge fund structure provides a bit more protection than proprietary trading.
MF Global must have had well-paid risk managers, whose job it was to monitor risks daily and report to Mr. Corzine. If they did not have those risk managers, that would (or should) be criminal negligence. The only way to have taken enough risk to bankrupt the firm would have been by extensive use of leverage. Leverage means that securities valued at a multiple of firm capital were bought or sold. In order to buy that much, MF Global must have borrowed money from some other institution. Somebody loaned MF Global a lot of money, poorly collateralized by bad paper. Most reports say that collateral was European sovereign debt, but it really doesn't matter.
Every time there is a financial disaster caused or exacerbated by leverage, there are lenders who made risky loans. In 2008, Bear Stearns and Lehman Brothers were leveraged more than thirty to one. There is no agreed-upon standard for how much risk is too much, but at least the firms stood to reap a huge reward if their leveraged bets won. The same cannot be said for the creditors. They took all the risk, yet would reap no special gain if the bets were won. This is much the same situation that holders of bad mortgages face. If the collateral proves to be inadequate, the lender takes a big hit. If the collateral increases in value, the borrower gets all the benefit. That is why a large down payment is needed to equalize the risk/reward balance. The borrower forfeits the down payment if he defaults.
In the case of MF Global, the lenders were undoubtedly among the most sophisticated bankers in the world. Does that sound familiar? Remember AIG in 2008. Of course, the bailout helped AIG management. But the real beneficiaries were the creditors who had made incredibly stupid loans to AIG -- a veritable who's-who of the world's largest banks. The situation is obscured by the use of simple derivative products like credit default swaps (which are not actually swaps at all). The terms of these contracts substitute for actual loans, but they are financially equivalent to the unbalanced risk/reward profile of risky loans.
The irony is that homeowners who get mortgages they cannot afford are usually considered victims, not villains. No, the villains in home mortgages are purportedly the greedy lenders who provided the loans. But MF Global, which also borrowed too much money, is looked at as the bad guy. You won't hear the lenders who lose money in the MF global bankruptcy characterized as villains. They will be seen as victims. That is what happened in 2008. The truth is that these lenders are enablers, like doctors who provide dangerous drugs to placate patients.
How can one expect a regulator to understand more about the riskiness of various investments than the most sophisticated investors in the world? This is why regulations usually fail in the end. The free market provides the best regulation there is. It is reasonable to sympathize with naïve home-buyers at the mercy of sleazy mortgage-brokers, but lose no sleep over losses by the lenders. That is why bailouts are so irresponsible. They protect the people who took stupid risks at the expense of people who did not knowingly do so.
This is not to say that financial institutions should be unregulated. One of the most important regulations involves the segregation of customer accounts from firm accounts. How did that work out for MF Global? A good reform would be to remove the inherent conflict of interest that arises when a person or entity manages its own money side-by-side with client funds. Everyone knows not to commingle such funds, but the only real protection lies in not even having anything to commingle. Hedge funds have come in for a lot of bad publicity, which misses the point. There is no conflict of interest in a hedge fund. Managers do well only if clients do well. You never have the insane situation where a firm's traders bet against the firm's customers.
To that end, I propose a single all-encompassing regulation. A firm may trade for itself like a hedge fund or it may have customer accounts, but never both. Investment banking is a noble pursuit. It is the sine qua non of capitalism. Let investment bankers get fabulously wealthy by matching up investors with entrepreneurs. At the same time, allow proprietary trading firms to act as entrepreneurs. Let them find investors who believe in their investment skills, and charge them a performance-based fee for making them money. Both professions serve an important purpose in a capitalist financial system. Just keep them separate from each other.
This doesn't solve all the problems. There is no substitute for due diligence by investors and lenders. However, it does remove a conflict of interest, and it prevents improper commingling. A closely related issue is the conflict of acting as principal and agent in any transaction. Be an agent or a principal, but never both.
The old Glass-Steagall Act did separate investment banking from "ordinary" banking. That is the wrong place to draw the line. However, ordinary banks have many special privileges by law, plus FDIC-insured accounts. They are not truly private corporations. That's right. Would you like to be allowed to print money? Just open up a bank and apply to be a primary dealer in U.S. Treasuries. Don't bother unless you were Geithner's sister's roommate at Wellesley, or have some other suitable credentials. See if you can get the right to borrow at below-market rates from the Fed. Be sure you have a hundred million or so to help pay for the kids of some well-connected lawyers to send their kids to Princeton. The system is so corrupt that untangling it would be a hard job for Hercules. Not corrupt in the eyes of the law, mind you, but cronyism doesn't begin to cover it. This is a parody of capitalism. If the Soros puppets from Occupy Wall Street get their way, the only change would be that the jobs currently held by private citizens would be filled by commissars.
The 2,500 pages of Dodd-Frank should be torn up and replaced by a few simple rules that apply to all bankers, big and small. Instead of favoring the mega-banks, the Fed, and the Treasury, the new rules should bestow favorable status on mini-banks -- you know, the ones with less than $50 billion or so in assets. If the big boys can survive the competition, good for them; if not, let them downsize.
There is still the question of the missing money at MF Global. One can speculate on exactly how it was lost. Perhaps it was on legitimate losing trades, but that seems unlikely. The money wouldn't be missing in that case. It is absurd to claim that the money is just gone and will never be found.
Customer money could not possibly have been unintentionally commingled with firm capital. It would take a conscious action by a very senior manager, probably Mr. Corzine himself, to override the normal controls in place to prevent any accidental outflows from a customer account into the firm account. Only legitimate, properly documented transactions could take place. Since there can never be a valid reason to violate correct procedures, it would have to be either theft or criminal negligence.
Get a competent auditor in there and go over every customer transaction in reverse-chronological order until the money shows up. The money may indeed be gone forever if it was stolen or lost in bad trades, but it should be easy to trace how it left the customer accounts. Maybe the bankruptcy trustees will actually do that. History suggests that they will just milk as many assets from the rotting corpse as they can get away with, while judges sit by, smiling on them benignly. The carcass of Lehman Brothers continues to fester after three years.
And yet, I am bullish on America. Go figure!