The systemic risk revealed by MF Global’s collapse

Watching the MF Global saga unfold, I had to wonder: “How was it possible for a broker dealer to tap segregated client monies to speculate in risky assets and lose billions?”

MF Global’s story, as you will soon understand it, raises serious concerns for any investor. That the activities that led to MF Global’s collapse were possibly legal (!) is stunning. The details are complex, but follow them through to the end and you will see all of the problems of our system — political corruption, excess leverage, focus on short-term profit at the expense of survival — in one sordid affair.

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The MF Global story contains six elements that I found astonishing:

1. What MF Global did with client monies was “technically” legal (though it probably violated the spirit of the law).

2. Britain’s leverage loopholes provided a back door for U.S. firms such as Lehman Brothers and MF Global to “re-hypothecate” client assets — and leverage up.

3. As a result of MF Global’s lobbying, key rules were deregulated. This allowed the firm to use client money to buy risky sovereign debt.

4. In 2010, someone from the Commodities Futures Trading Commission recognized these prior deregulations had dramatically ramped clients’ exposure to risk and proposed changing those rules. Jon Corzine, MF Global’s chief executive, successfully prevented the tightening of these regulations. Had the regulations been tightened, it would have prevented the kind of bets that lost MF Global’s segregated client monies.

5. None of MF Global’s Canadian clients lost any money thanks to tighter regulations there.

6. Little noticed in this affair is (once again) the gross incompetency of the ratings agencies. Had they not been maintaining “A” ratings on Spain and Italy, MF Global could not have made its disastrous bets there.

First, let me explain hypothecation. The classic example of this occurs when you take a mortgage to buy a house. You are pledging collateral (the house) to secure a debt (the mortgage). Your collateral is “hypothetically” controlled by the bank, as the lender has the right to take possession if you default on your mortgage payments.

To equity traders, hypothecation occurs when their broker uses client stock holdings as collateral for trading or leverage. To oversimplify, buying equity with leverage involves pledging shares (collateral) to a third party (broker) in order to borrow against them. You still own the stock, but the broker can sell it if you fail to make payments when necessary. (This is the basis of a margin call and forced liquidation.)

Back to MF Global. The rules covering what a commodity firm can do regarding hypothecation are governed by two regulations. Equity and commodity brokers have, for as long as I can remember, been able to tap into client monies to make short-term purchases of U.S. Treasuries. William Cohan, author of “Money and Power: How Goldman Sachs Came to Rule the World” and “House of Cards,” the story of Bear Stearns’s demise, quoted the rule as allowing “obligations of the United States and obligations fully guaranteed as to principal and interest by the United States (U.S. government securities), and general obligations of any State or of any political subdivision thereof (municipal securities).” In other words, safe, liquid, AAA-rated investments.