While we were busy writing our newsletter Monday and keeping tabs on whether the markets would keep May’s performance going, the Trustee for the MF Global case released his 275 page “Investigation Report.” You can download it here.
It’s obviously a long read, though the meatiest part of the report starts on page 68, if you’re up for it. That being said, in our opinion, this report is pretty damning- almost breathtakingly so. From Corzine to O’Brien to JP Morgan to under mentioned actors like BNY Mellon, this catastrophe was not a whirlwind crisis that caught everyone off guard. Those in the know saw it coming for miles, but absolutely no one did anything to stop it.
The story that has emerged, while well known to those close to the situation, bears repeating. In 2010, when Corzine took over MF Global, he began pursuing alternative business plans, which included heavy proprietary trading efforts. MF Global’s profitability had been floundering prior to Corzine taking the helm thanks to a business model which relied on earning interest on customer balances while short term rates moved to essentially zero percent. Corzine’s trading plan was intended to shore up the profitability of the firm, but it would also require substantial amounts of liquidity. As time went on, and the proprietary trading got larger, the firm began to tap into “excess” house funds kept with segregated accounts.
These excess funds were kept there to hedge against the risk of an individual account going debit, but as the investigation dug deeper, it became clear that the tapping of these excess funds was governed by loose rules and even looser accounting guidelines, with top executives relying on a “liquidity dashboard” comprised of informal data to guide their business decisions on a day to day basis. Wires were requested from the Chicago FCM offices by the NY “trading” offices on a regular basis to meet liquidity needs, which, under a very obtuse interpretation of CFTC regulations, might have gone unnoticed, had the funds been routinely returned to customer accounts by the end of business each day; after all, FCMs were legally allowed to transfer funds as needed between accounts, as long as they could resolve everything in the reports. Those reports were also shady in some ways, relying on alternative calculation methods that made the firm’s financial standing seem stronger than it was.
Though the devolution of the firm began in late 2010, it was not until late spring of 2011 that regulators began to catch on, and even then, their requests and inquisitions were slow moving and of little consequence… except to further exacerbate existing liquidity concerns by heightening capital requirements and scrutiny of MF Global’s financials. It was not until October, when the Wall Street Journal picked up the increased regulatory pressure for a story just ahead of MF Global’s quarterly earnings call, that the situation completely spiraled out of control, especially with the revelation on said call that they had needed to unload a great deal of their assets- functionally broadcasting that they would not be profitable for some time to come.
In response, credit rating agencies began chopping away at MF Global’s credit rating, plunging them below investment grade levels. Ironically, the firm had conducted stress tests for just this type of calamity, but their projections were blown out of the water by reality, as if we needed another reminder of the failings of stress tests and VaR analysis using “normal scenarios.” News flash: when the s%^ hits the fan, it isn’t a normal scenario.
The resulting decimation in investor confidence led to a selloff in the stock, and a ‘run on the bank’ by investors. Unfortunately, the timing couldn’t have been worse, as the panic hit at the peak of liquidity issues for the firm. This peak saw them dipping into segregated accounts for wires in order to satisfy overdrafts in other accounts- overdrafts that were the result of satisfying obligations on Corzine’s surging European debt portfolio. In a world without this crisis of confidence in the firm, perhaps things would not have blown up the way they did; after all, MF Global’s fancy skirting of regulations had escaped unnoticed for that long.
However, with the “run on the banks” depleting their questionably calculated “available” capital, MF Global was out of options. No amount of sidestepping and referencing of complex financial transactions could cover what ballooned to a $900 million shortfall in customer funds, and attempts to find a buyer failed. It was the perfect storm, in many ways.
How culpable were those involved in the firm’s demise and its subsequent impact on client funds? It looks like they were very guilty. That magical October 31st shortfall in customer segregated funds? It was actually there days before. On October 26th, they reported to regulators excess capital of $633 million, but they were at negative $341 million. On October 27th, a miraculous $540 million manual adjustment to the books, as well as a forgotten $200 million in outgoing wires, kept them in the black on paper, but in reality, they were down over $413 million in client funds on that day. Not pretty.
Who is going to take a hit on all this? There are those at MF Global that look really, really bad, with email trails serving as proof positive of internal recognition of the problems in play. Some quotables included:
- June 20th, 2011, Internal Audit Report
“…monitoring and forecasting is manual and limited. Reporting capabilities to evaluate liquidity needs for transactions that are booked but not yet settled have not been fully developed.”
- July 19th, 2011, email from Chris Serwinski, North American CFO (recipient not noted)
“[i]t did not sound like they were just looking for the firm invested amount in excess but more such that the customers funds not required from a secured regulatory computation would be tapped into.”
- July 26th, 2011, email from Edith O’Brien, Assistant Treasurer, to David Dunne, Global Treasurer, and Matthew Bresgen, Senior Vice President in Treasury
“Christine [Serwinski] was not pleased about the late hour borrow or the size. The borrow is $100mm and the Seg excess is currently $127mm.”
- July 27th, 2011, email from Serwinski to Henri Steenkamp, Global CFO and prior Chief Accounting Officer, Dunne and Besgen
“FCM client assets may be put at risk even if for overnight . . . Utilizing the FCM client asset [base] should not be a BD working capital source strategy to be relied upon.”
- August 11, 2011, email from O’Brien to MF Global Hong Kong
“Henri [Steenkamp] says and to me today . . . ‘we have plenty of cash.’ I was rendered speechless wanted to say ‘Really, then why is it I need to spend hours every day shuffling cash and loans from entity to entity?’”
- September 16, 2011, email from O’Brien to Joseph Cranston, Treasury staff
“[The FCM has] lower than usual ‘seg excess’ which is the liquidity figure $25 million versus $70 million average.”
- October 6th, 2011, email from Steenkamp to Corzine
“Jon . . . we need to address the sustained [liquidity] stress. In summary, we have three pools of liquidity for Inc. – (1) finco cash which is real and permanent, (2) FCM excess cash which is temporary and volatile, [and] depends on how customers post margin, and (3) the situation of our broker-dealer that is currently unable to fund itself, and more worrying continues to need more cash than we have [from] finco, thereby having us dip into FCM excess every day. This should be temporary but is becoming permanent, and the FCM cash is not reliable. Why is the BD unable to fund itself? Part of it is the permanent pool of liquidity needed for RTM’s, but we also see continued haircut increases in fixed income, increased funding needed PSG and box size being permanently large.”
- October 14th, email from Vinyay Mahajan, Global Treasurer as of August 2011, to Steenkamp and Michael Stockman, Chief Risk Officer
“[T]he B/D is leaning on FINCO and FCM’s cash pool. We now require $16mm of the FCM’s buffer as well. This for the U.S. going into the and no buffer leaves us with $24mm of liquidity weekend.”
- October 26th, 2011, 6:24 PM email from O’Brien to Gills, Lyons, and Simmons in Operations
“I need to know how much is being returned [from customer funds]– from where to where”
- October 26th, 2011, 6:25 PM email from O’Brien to Gills, Lyons, and Simmons
“I NEED TO KNOW NOW – TO PRE-ADVISE FUNDING AND AVOID A SEG ISSUE.”
- October 27th, 2011, email from O’Brien to Regulatory Group requested segregated statements
“after completed – before distributed. We had significant moving parts.”
- October 27th, 2011 email from O’Brien to Serwinski
“Lent is a strong word-I would state-Fail to return intraday funding compounded by Funding B/D Customer Wires.”
Those are a lot of names, but let’s nail down the big ones. Corzine is in hot water here. He was in charge of the European bets- expanding the portfolio through July of 2011 to levels not seen anywhere else on Wall Street. The only reason he didn’t go through with the expansion? They were out of assets to leverage. Take a look at their exposure as a percent of equity in the table below, showing it was 460% of their equity (on a single trade/bet).
Corzine chose the company’s direction. He was personally involved in the requests to JP Morgan for the wire that would cover the overdraft. But furthering that image of Wall Street CEOs being investing cowboys, Corzine apparently never had a true grip of what, exactly, was going on. He didn’t understand why customer segregated funds were going up and down (it’s called marked to market, Jon), and had to be taken through the liquidity analysis because he just wasn’t getting it. Even with the analysis being all over the board- he knew net capitalization was negative at points, and he knew customer money was missing.
O’Brien doesn’t get out unscathed. She was approving every transfer, and she knew where the money was coming from. She didn’t know where it was going or when it would come back, but she knew it was coming from segregated funds. The story that cuts to the quick of it revolves around a requested signed letter for JP Morgan in the 11th hour, ensuring that every transfer MF Global had ever made or would ever make was compliant with all pertinent regulations. She refused. They narrowed the letter to vouching for the two transfers she was at the time requesting. She still refused. She knew, flat out, that MF Global was breaking all the rules.
But this is where the blame expands to cast a much wider net. JP Morgan requested that signature, and never got it. They still conducted the transfers. As it became clear that the funds were coming from customer accounts, they never returned it. Part of this the report blames on London legal standards for protection of customer accounts, but the second transfer in the infamous duo was worse. The letter pressuring took place over the course of several days, but in the middle of it, MF Global requested a transfer of $135 million from the firm’s house account to their JPM clearing account. This caused an overdraft in the house account, which was satisfied through a transfer of $135 million from the customer segregated funds account.
More damning evidence for MF Global? Of course, but also for JP Morgan, who had put all of MF Global’s accounts on debit watch the day prior, resulting in any and all MF Global wires needing pre-approval. This means someone at JP Morgan approved the wire (theft) of customer funds to satisfy the overdraft MF Global caused.
JP Morgan isn’t alone, either. On October 31st, MF Global did attempt to wire out all customer monies (though whether that was so they could use it or protect it is anyone’s guess), but the banks flat out refused to complete the wires, sending a mere $15 million of the over $500 million being requested by MF Global- which they argued was subject to lien due to debts owed, despite it being money owed to segregated account clients. We can hear a banker saying, “Their customers probably should get their money back, but we lent this Wall Street trader money, and we should really be paid before the farmers and little guys who had accounts at MF Global.” Talk about a 1% versus 99% problem.
By the end of the report, the Trustee concludes that they could very easily see legal action taken against Corzine and Company, along with banks JP Morgan and (a newer player) BNY Mellon. While we won’t hold our breath (after all, how many of the 2008 villains have seen their day in court yet?), the report explicitly states, “[T]he Trustee has announced publicly that he is engaged in active discussions with JPM with respect to transfers that the Trustee believes may be voidable or otherwise recoverable. In the event these discussions do not result in an agreement within the next 60 days, the Trustee, if appropriate, will commence litigation.”
The Trustee makes a series of recommendations by the end of the report, and many of the changes are ones that we’ve been rallying for since the situation came to a boil last October. This includes closing transatlantic legal loopholes (the UK currently refuses to release $600 million in U.S. customer funds which were held for overseas trading), heightening monitoring and capitalization requirements, and strengthening customer fund protections. We can only wait to see if some of these recommendations will be heeded by those in power. Until then, we continue to urge those participating in the futures markets to work with firms they trust will monitor FCM health on their behalf, and to have multiple clearing relationships in place in order to protect their interests.
Here’s hoping Corzine goes down for this mess.
Gensler’s Swap Comments Hold Further Significance – May 22, 2012
Corzine Dodging Bullets? – March 26, 2012
UBS and Barclays to the Rescue- Maybe? – March 14, 2012
Will Some Good Come out of MF Madness? – March 8, 2012
MF Global Madness Catches Fire All Over Again – February 8, 2012
Great Expectations, Legal Drama, and Continued MF Global Investigations – December 15, 2011
Corzine’s Ever-Shifting Story – December 13, 2011
No Answers, More Hope– December 9th, 2011
How to Save the Futures Industry- November 16th, 2011
Continued Complications in the MF Global Mess– November 9th, 2011