The roots of MF Global can be traced back to 1783, with a sugar trading business in England started by James Mann. It evolved into a commodities trading business, and by the 1980s was a financial services firm. And the firm that has been around for over two hundred years crumbled in less than two under John Corzine’s watch.
MF Global’s bankruptcy is the eighth largest ever…and the largest since Lehman Brother’s in 2008. The firm filed Chapter 11 on October 31st, listing $41 billion in assets, $26 million in cash, and $39.7 billion in debt. But the number that really mattered was buried on page 78 of the firm’s most recent annual report… “other sovereign obligations – $6.3” billion.
That $6.3 billion was the firm’s exposure to the sovereign debt of troubled European countries like Italy and Spain. But in September, when FINRA “demanded” that the firm announce that it held a “long position” in euro zone sovereign debt and that it raise capital, few seemed to take notice. The markets took notice on October 25th, when the firm met FINRA’s demand and disclosed its exposure…and the fact that it lost $200 million in the 3rd quarter. By the end of the week, all three ratings agencies downgraded the firm’s debt to junk. Those downgrades resulted in increased margin calls that drained cash.
But the size of the firm’s exposure to debt-laden euro zone countries is just part of the problem. The other problem is its accounting.
The firm used accounting to underplay its trading risks. To finance its bond purchases, the firm used something called “repo-to-maturity”. Basically, this is an agreement that allowed MF Global to borrow money to buy the bonds, using the bonds themselves as collateral. The firm then made money on the spread between the interest rate it paid and the coupon payment it received on the bonds. The financing would mature the same day as the bonds matured…so the firm was essentially locking in the spread as a profit for the duration of the debt…assuming everything went according to plan.
From an accounting perspective, the “repo-to-maturity” allowed MF Global to move its billions in euro zone exposure off the balance sheet. The transactions were treated like a sale, so even though the firm still bore the risk of the euro zone debt, it wasn’t reflected on paper.
There were a couple of risks with the plan. There was the risk that any of the distressed euro zone countries could default on their bonds. And there was the risk that MF Global would be required to put up more capital if its creditors got nervous as the value of the sovereign bonds decreased… that would amount to a serious liquidity problem.
When John Corzine came to MF Global in March 2010 (after losing his post as New Jersey governor to Chris Christie), he had it in his mind to transform the firm into an investment bank like Goldman Sachs (where he previously served as chairman)… a firm that puts its own money on the line. He said that he wanted to make the firm global and take more risks. He did. And now MF Global is the largest U.S. casualty of the euro zone crisis so far. And more than that, according to The Wall Street Journal, it is “proof that Wall Street’s creative destruction process works”.