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Jon Corzine told
the House Agriculture Committee, "I simply do not know where the money
is, or why the accounts have not been reconciled to date." The public is
outraged that the former CEO of bankrupt global financial-derivatives broker
and prime dealer in US Treasury securities MF Global doesn't know where the
missing $1.2 billion in client funds went.
Corzine is the member a few
exclusive clubs: he is a Goldman Sachs alum, former US senator, and former
New Jersey governor. After the incumbent Corzine was beat by Chris Christie
in the 2009 New Jersey gubernatorial race, the MF board probably rejoiced,
believing the guy to fix their problems was suddenly available. Now he's in
the club of taking a mere 20 months to create the eighth largest bankruptcy
in history.
As a stand-alone entity, MF Global
was born in 2007 when it was spun off from UK hedge-fund giant, Man Group. MF
booked revenues of $4 billion that year from interest earned by using its
customers' funds, an operation that sounds like fractionized banking: short-term
embezzlement used to make profits.
For banks, the practice was sealed
in English common law in 1811 in the court case of Carr vs. Carr, where
Master of the Rolls Sir William Grant ruled that debts mentioned in a will
included bank accounts since the money had been deposited into the bank and
wasn't earmarked in a sealed bag. The deposit was thus a loan rather than a
bailment.
The same Judge Grant ruled the same
way five years later in Devaynes vs. Noble, despite
an attorney's argument that "a banker is rather a bailee
of his customer's funds than his debtor … because the money in …
[his] hands is rather a deposit than a debt, and may therefore be instantly
demanded and taken up."
In 1848, in Foley vs. Hill and
Others, Lord Cottenham ruled,
Money, when paid into a bank, ceases altogether to be the money of the
principal; it is then the money of the banker, who is bound to an equivalent
by paying a similar sum to that deposited with him when he is asked for
it.… The money placed in the custody of a banker to do with it as he
pleases.
It's been clear sailing for bankers
ever since. No questions asked.
At the same time, people are
surprised that a commodity brokerage firm would misplace client assets. As
Christopher Elias explains
for Thomson Reuters,
MF Global's bankruptcy revelations concerning
missing client money suggest that funds were not inadvertently misplaced or
gobbled up in MF's dying hours, but were instead appropriated as part of a
mass Wall St manipulation of brokerage rules that allowed for the wholesale
acquisition and sale of client funds through re-hypothecation. A loophole
appears to have allowed MF Global, and many others, to use its own clients'
funds to finance an enormous $6.2 billion Eurozone repo bet.
Free bankers are always insisting
that fractional-reserve banking is A-OK, as long as bankers inform depositors
up front that the bank will be using their customers' money to make loans and
investments.
That is exactly the case with MF
Global. The company's customer agreements included the following clause:
7. Consent To Loan Or Pledge You hereby grant us the right, in accordance
with Applicable Law, to borrow, pledge, repledge,
transfer, hypothecate, rehypothecate, loan,
or invest any of the Collateral, including, without limitation, utilizing the
Collateral to purchase or sell securities pursuant to repurchase agreements
[repos] or reverse repurchase agreements with any party, in each case without
notice to you, and we shall have no obligation to retain a like amount of
similar Collateral in our possession and control.
Back in 2007, customer funds held
by MF as collateral against commodities trades could be invested in two-year
Treasuries earning north of 4.5 percent. But in the wake of the '08 meltdown,
the Bernanke Fed has flattened yields to be counted in basis points. With
these low rates MF Global revenues fell to $517 million in 2010.
The old bond trader Corzine thought
he could juice up MF's earnings with a little financial razzle-dazzle.
Thinking outside the box (and off the balance sheet), Corzine moved $16.5
billion in assets into repos. A repo involves putting up assets as collateral,
assets to be repurchased later, and borrowing money against those assets. MF
used an off-balance-sheet repo called a "repo-to-maturity" where
the loan and the collateral in the transaction have the same maturity. US
accounting rules consider the transaction a sale and the assets can be moved
off the balance sheet.
Most of these assets were bonds
from Italy, Spain, Belgium, Portugal, and Ireland, all paying healthy coupon
rates that would easily cover the repo interest rate and provide a nice
profit. MF Global would have virtually no skin in the game (their customers
provided it) and be earning a nice interest-rate spread.
Although things have been rocky in euroland, the collateral value of the short-term bonds
appeared safe with the guarantee provided by the European Financial Stability
Facility (EFSF).
With the $16.5 billion in assets
moved off its balance sheet, MF Global then ramped up a net-long
sovereign-debt position of $6.2 billion on its balance sheet, exposure that
was five times the company's net worth.
While the EFSF guarantee would
insure against the default of the sovereign debt if the bonds were held to
maturity, MF was still at risk to make margin calls, if the bonds dropped in
price day-to-day. Elias writes,
Like Wall Street cocaine, leveraging amplifies the ups and downs of an
investment; increasing the returns but also amplifying the costs. With MF Global's leverage reaching 40 to 1 by the time of its
collapse, it didn't need a Eurozone default to trigger its downfall —
all it needed was for these amplified costs to outstrip its asset base.
So while MF Global's
eurozone bets had not defaulted, the company's
liquidity was drained making margin calls and trying to meet short-term-debt
obligations as the euro-crisis news flow out of Europe vacillated.
MF Global was able to leverage up
its euroland bets by way of the rehypothecation
of their clients' collateral. Hypothecation is pledging collateral for a
loan. Like the mortgage on your house.
Customers of MF posted cash, gold,
or securities as collateral to backstop their commodity futures and
derivatives trading. MF would then take those customer assets to back its own
trades and borrowing. Mr. Elias explains, "The practice of
re-hypothecation runs into the trillions of dollars and is perfectly legal.
It is justified by brokers on the basis that it is a capital efficient way of
financing their operations much to the chagrin of hedge funds."
Under US rules, a prime broker is
allowed to rehypothecate assets to the value of 140
percent of the client's liability to the broker. The rules are more liberal
in the United Kingdom, where there is no limit and in many cases UK brokers rehypothecate 100 percent of collateral value placed in
their custody.
Elias writes that by 2007, rehypothecation was half the shadow banking system.
Prior to Lehman Brothers collapse, the International Monetary Fund (IMF)
calculated that U.S. banks were receiving $4 trillion worth of funding by
re-hypothecation, much of which was sourced from the UK. With assets being
re-hypothecated many times over (known as "churn"), the original
collateral being used may have been as little as $1 trillion — a
quarter of the financial footprint created through re-hypothecation.
All of this churning has created
rivers of liquidity, much of it with no asset backing. And what assets do
provide backing aren't the quality they used to be.
The repo rules were liberalized in the Clinton era. So instead of AAA
government paper being required, AA sovereign debt works just fine, after
all, as James B. Stewart writes
for the New York Times:
The law also allows commodities firms like MF Global to use segregated
customer funds as a source of low-cost financing for their own operations,
but they are required to replace any customer assets taken from segregated
accounts with supposedly ultrasafe collateral of
the same value, typically United States Treasuries, municipal obligations and
obligations whose payments of principal and interest are guaranteed by the government.
(emphasis added)
Of course all this rehypothecating creates mountains of counterparty risk,
all dependent on dubious collateral that has been pledged multiple times. The
equivalent of having four mortgages on a house, each having been sold to other
parties who have been told their mortgage is in first position. When the
property value starts dropping or the borrower doesn't pay, only one lender
will get there first and legal fistfights ensue.
This rehypothecation
activity may be the biggest credit bubble of all time, according to Elias.
J.P. Morgan alone has rehypothecated over half a
trillion dollars in 2011, Morgan Stanley $410 billion, Goldman Sachs $28
billion, and the list goes on.
Americans have been told US banks
have little exposure to European sovereign debt, but according to the Bank
for International Settlements (BIS), US banks hold $181 billion in the
sovereign debt of Greece, Ireland, Italy, Portugal, and Spain. And while
Germany is considered the belle of the Continental ball, Grant's Interest
Rate Observer reports that Deutsche Bank is levered at 43:1 and the Bundesbank has doubled its leverage since 2007 when it
was geared at 75:1 — these days the central bank is levered at 153:1.
Extreme leverage is a problem if
the slightest thing goes wrong — anywhere. When the cost of swapping
euros for dollars soared at the end of last month, a coordinated central-bank
cavalry charged out of nowhere, cutting swap rates and establishing temporary
bilateral-liquidity swap arrangements. Nobody but financial news junkies
seemed to know or care.
The truth about the financial crash
wasn't known until Bloomberg chased its request for information all
the way to the Supreme Court to obtain documents that shed light on how much
dough the Federal Reserve really provided the banks during the 2008
meltdown.
For instance, it turns out Wachovia
shareholders got lucky as the bank was floated a secret loan from the Fed of
$50 billion to keep the doors open while a sale could be arranged with Wells
Fargo for $7 a share rather than shareholders having to take the buck-a-share
offer from the wounded Citibank.
"This deal enables us to keep
Wachovia intact and preserve the value of an integrated company, without
government support," Wachovia's chief executive Robert Steel said
at the time.
Right, no government support at
all.
Instead of being among the bailed
out, Corzine and MF Global are now joining Lehman, IndyMac, Colonial, and all
the small-fry banks lacking the friends in high places needed to keep them
afloat. In the fractional-reserve world, markets don't decide the winners and
losers; government does.
Stewart writes for the NYT,
"SIPC will replace up to $500,000 of securities and cash (but not
futures contracts) missing from customer accounts at member firms," and
the notion of even covering futures accounts has been
floated on CNBC by Senator Debbie Stabenow, just as the FDIC
replaces deposits up to $250,000. But covering the losses of clients and
depositors is hardly the reflection of sound capitalism and the honoring of
property rights.
"If no business firm can be
insured," Murray Rothbard wrote,
then an industry consisting of hundreds of
insolvent firms is surely the last institution about which anyone can mention
"insurance" with a straight face. "Deposit insurance" is
simply a fraudulent racket, and a cruel one at that, since it may plunder the
life savings and the money stock of the entire public.
So it's unlikely Jon Corzine knows
where the $1.2 billion in customer money went any more than the president of
a failed bank would know exactly where the customer deposits went.
The bigger issue is that, day by
day, Mr. Corzine looks to be merely a canary in the fractional-reserve coal
mine.
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