MF Global's Fiasco: Loss of Controls and Conscience
MF Global can trace its roots to the sugar trading business started by James Man in England in 1783. In March 2010, Jon Corzine took over the helm with the goal of turning the company into a formidable Wall Street investment firm.
In a little over a year and a half that dream crumbled. The entire firm filed for bankruptcy on both sides of the Atlantic. A 228 year old firm has now been wiped off the map with the blink of an eye.
Why? Its senior-ranking officials made bad investment decisions, had bad risk management and operational controls. They also had no conscience.
During the last week of October 2011, rating agencies downgraded MF Global twice because of its $6.3 billion exposure to European sovereign debt, its growing financial losses and concerns about its risk management procedures. MF Global tapped its credit lines for over $1 billion, presumably to meet its margin calls. We cannot be certain what its mark to market losses were. However, as indicated in a quarterly filing with the Securities and Exchange Commission on June 30, the firm had only $1.4 billion in equity.
That figure reflects pretty poor risk management. And now MF Global is mirred in investigations by the Securities and Exchange Commission and Commodity Futures Trading Commission as to its misappropriation of customer funds.
Michael Stockman, MF Global's chief risk officer, has 25 years of experience managing risk and even co-authored an article entitled "The 100 Year Flood: an Alum's Perspective on the Subprime Mortgage Crisis" (http://www.cqsolution.com/pdf/100_YEAR-3.pdf) in which he presented plenty of insights into how to avoid the next market crisis. Yet MF still managed to fall apart because of its long exposure to European sovereign debt in a down market.
In MF Global's final 10Q filing with the SEC, the firm touted its solid risk management controls. Here is what it said: "The Company's Board-approved risk appetite and strategic objectives translate to defined risk tolerances and oversight processes and, subsequently strictly enforced delegations of authority and concomitant controls, which are designed to ensure its operation within those risk tolerances. The CRO [chief risk officer], who reports to the company's president and chief operating officer Bradley Abelow, leads the risk department and is delegated certain authorities from the board. The CRO reports and advises on market, credit, issuer and operational risk matters. The CRO and senior management promote companywide compliance to its enterprise risk management framework."
But in an interview with Risk Magazine on March 31, 2011 Stockman may have just foreshadowed his bad judgement when he said. "We are going to be actively and aggressively seeking to take risks in a broad fashion.. I suggest we are not taking enough risk."
Stockman also may have foreshadowed the bad judgement of other senior ranking officials who ignored the early warning signs. How could a firm have an exposure in distressed debt that was four times the amount of its equity? Distressed debt, by its very nature, is far riskier and more volatile than investment grade debt. A twenty percent drop in the market value of MF Global's exposure in sovereign debt would have been enough to wipe out the firm's equity.
MF would also have had to meet margin calls from the CME Group or other counterparties during the market decline from September through November of 2011. This was yet another warning sign that the firm was overleveraged in risky financial instruments.
The role of the risk management and finance departments was to ensure that the firm was within its risk and regulatory guidelines and to reduce its positions in risky investments. So how much did the risk management department actually push back to warn the firm's business and operating teams about the risk of having such a large position in distressed sovereign debt? What was the firm's internal risk profile which allowed it to carry such a high exposure and how did the risk management department react to potential capital and financial woes? We will likely find answers to those questions as the investigation evolves.
We will likely also find answers to why there was a breakdown in protecting customer assets. One of a broker-dealer's most fundamental requirements is to protect its customers' cash and securities. All licensed supervisory officials know that they cannot compromise their customers' well-being. Every day, the operations department of a regulated entity ensures that the firm has "possession or control" of a customer's assets. At least once a week, a firm's finance department also ensures that the it has sufficient "segregated cash" in a special reserve bank account for the exclusive benefit of its customers. The finance department must calculate this reserve to ensure that customer funds are not used by the firm for non-customer related business.
I was the financial principal for a broker-dealer for over 20 years. My role required that I signing off on certain reports filed with regulators such as the SEC and the Financial Industry Regulatory Authority. Each time I signed off on the reports I would review every amount listed and investigate any material anomaly. My license, my reputation, and the reputation of my firm were always paramount. Small mistakes were made over the years, but when regulators reviewed the documentation and calculations, they could rest assured that the information I provided was clear and concise. I was not unique in how I approached my responsibilities. I learned to conduct myself appropriately from my predecessors and passed all the lessons to my staff. I also worked in key operations roles and know that heads of operations take a similar approach in ensuring customer assets are protected.
Now after two months of investigations to track down the missing customer funds, the Commodity Futures Trading Commission says it knows where the money went. It's just a matter of finding out which transactions were legitimate and which were not. Scott O'Malia, a commissioner at the CFTC, says that MF Global's records were a "disaster." There is a good likelihood that, given the difficulty of following the paper trail, the alleged misappropriation of customer funds has been going on for a longer period of time than first believed. It wasn't just a day or two.
So how could MF Global's Chief Financial Officer Henry Steenkamp or the firm's head of operations David Simmons, as stewards of the firm's controls, stand by as their customers' trust to protect their assets was broken?
It will be interesting to find out, when regulators conclude their investigation, just who gave the orders to transfer customer funds to cover the firm's obligations. In Congressional hearings, Corzine has said he didn't know the illegal transfers were being made.
MF Global's customers supported the firm, but were not rewarded in kind by its senior officers and management. They didn't uphold the regulatory and ethical protections that any senior official of a regulated financial firm should consider when he or she signs the required regulatory reports every Tuesday.
Larry Wagner is a principal at C&A Consulting, a New York-based firm offering financial, technology, compliance and strategic advice to financial services firms. He has previously served as chief financial officer for Nomura Securities and ING Inc.