15 February 2012

Barry Ritholtz Has the Main Theme Right, But Gets a Few Specifics Wrong About MF Global

For the record, I am an admirer of Barry Ritholtz, and have been so for quite a long time. He is smart, honest, and what the old folks used to call a mensch.

In a recent piece titled MF Global Reveals You Are a Bank Counter-Party he makes a very strong case that financial institutions that trade for their own accounts place everyone who has money with their firm at counter-party risk.

He uses this to reinforce his opinion, with which I heartily agree, that when private speculation becomes mingled with public funds and government guarantees, a moral hazard results that quite often leads, some might say almost inevitably, to fraud, the mispricing of risk, and bailouts.

"The esteemed former Fed Chairman, Paul Volcker, introduced a very simple regulatory concept that bears his name: The Volcker Rule. It was part of the Dodd-Frank regulatory reforms passed after the financial crisis of 2008-09.

There has been enormous pushback against what should be a simple piece of prophylactic rules on proprietary trading by depository banks (see this Jamie Dimon commentary as an example). Why? The profits of speculation goes to banks, driving bonuses and compensation; but the ultimate risk of loss lay with the FDIC and taxpayer. If the banks blow up, someone else besides the banker pays."

But in making his case, that the MF Global situation proves this rule even though they were not a bank, he characterizes some of the things regarding the MF Global scandal in a way that could be misconstrued, and has been misconstrued in that way by some of the main stream financial media.

Here is what Barry said:
"Recall the basic facts of MFG: Management engaged in leveraged speculations with monies — whether it was their own or clients became irrelevant as the losses were so great as to wipe out much more capital than the bank actually had. Billions in losses meant MFG was insolvent and was wound down. On the winning sides of those trades were folks like JPM and George Soros. It is neither their duty nor obligation to verify whose money is on the other side of the trade — the clearing firms make sure the trade settles.

Those trade settlements are the only possible outcome. Why? Imagine a burglar robs a house of cash, goes to a casino and loses the money playing Roulette. The Casino settles that bet, it clears — and the burgled homeowner can never recover the money. Exchanges work the same way. They simply cannot validate the capital sources of every transaction. In the case of MFG, he money wasn’t even burgled — it was simply entrusted (sic) to an entity that became so insolvent thru excess speculation that even money in “Segregated accounts” was highly compromised." (emphasis mine)

There are at least three things that are wrong with that version of the story.   I had to struggle a bit to  understand what Barry was really saying. More on that later.

First, it was NOT irrelevant whether MF Global was using customer money or their own to finance their trades. That is a matter of regulatory law as recently expressed in Rule 190, and the CFTC has made it very clear that brokerage firms cannot use customer funds in whatever manner they please despite the presumption of regulatory creep that is a favorite ploy amongst the Wall Street wiseguys.

What Barry implies is that this is a nicety, and I would say it most certainly is not. To use customer funds in this manner is a violation of fiduciary trust, known in lesser circles as stealing.   MF Global thought they could take the money and put it back with no one being the wiser, but they were caught up in the discovery of events.   This is not much different than taking company money to pay your private debts, and then failing to return them before the loss is discovered.

There is a difference between a creditor and shareholder in a financial institution like a brokerage and a customer, who has their own private assets on deposit, with specific protections outlined by the exchange and government regulators.   Just because someone is not indicted does not make a thing legal or morally acceptable.  

Using Barry's casino analogy, Soros may have been a player at the tables, albeit a highly informed one,  but JPM had a hand in running the money which was financing the casino action as well as playing at the tables, was advancing MF money, and was then leaning on them for payment while MF Global was taking the funds from the customers' safe deposit boxes at the hotel.

Second, the manner in which the bankruptcy is being handled is a grave injustice. In this case a Chapter 7 bankruptcy was appropriate, and not a Chapter 11 which is not appropriate for a brokerage like MF Global.   That was a tortured interpretation promoted by the powerful creditors led by JPM.

And as the CFTC stated, the customers whose account assets were stolen have a superior claim to the remaining assets, including clawbacks from recipients of funds in the last weeks of business.  This does not even speak to the possibiility of a fraudulent conveyance that favored a few relative insiders.

The customers ought not to be in same situation as all the other parties involved in this scandal.   I believe quite strongly that if JPM was not one of the major creditors, and had not taken such an aggressive stance with the bankruptcy and the regulators at the SEC, this situation would have turned out quite differently as it had done in the past with other failed brokerages.

Thirdly, to characterize JPM as 'just another customer' on the other side of the trade with the clearing organization between them is to utterly ignore and misrepresent JPM's role as MF Global's bank. JPM demanded and received collateral for their credit line of $1.2 billion in the last week before the bankruptcy. They contributed to the bankruptcy of the firm as they delaying payments of asset sales that MF Global had engaged in to raise cash. 

And one can only speculate on the depth of their knowledge on the size and nature of MF Global's trades.   If we are to accept that things like segregated accounts mean nothing then why would we believe in confidentiality of customer positions and their finances?

To say that JPM had no fiduciary responsibility to determine the source of the funds, when they knew beforehand that the company was in serious trouble, is quite incorrect.   They even covered that with a figleaf memo.

JPM has lawyered up in this case, and as Chris Whalen suggests is sitting on the money along with a few other entities.
"But please, to our friends in the Big Media, could we stop saying that we don't know the location of the missing $1.6 billion of client funds from MF Global? The money is safe and sound at JPM and other counterparties. As with Goldman Sachs et al and American International Group, the banks have been bailed out at the cost of somebody else. And the various agencies of the federal government are complicit in the fraud...

The effort by former New Jersey governor and MF Global CEO Jon Corzine to save his firm by stealing customer funds seems to warrant further discussion, yet instead we have silence...

So why is it that the Large Media have such trouble reporting this story? The fact seems to be that the political powers that be in Washington are protecting JPM CEO Jamie Dimon from a possible career ending kind of stumble with respect to MF Global."

Chris Whalen, Institutional Risk Analyst
To say that the customer money was 'not burgled' but rather was 'highly compromsied' may be the current fashion of thinking about taking customer money on Wall Street, but it stinks like the fog of propaganda that has spewed forth from Wall Street and their media friends since last October.

The MF Global money was not vaporized, it is not missing, and it was not 'highly compromised.'

It was stolen, and not once but twice.

I understand what Barry is really saying. In today's environment the protections that investors and depositors think that they have is thin stuff indeed. People think that they are safeguarded by regulation and legal statements, and they think they have equal protection under the law, as compared to the corporate leviathans and political insiders like Jon Corzine.

But they do not. These fine guidelines about Chinese walls and segregated accounts are merely a fiction these days. And so we must cut to the source of the danger, and separate the risky speculation that had been the domain of hedge funds and investment banks from ordinary customer funds and government guarantees designed to maintain confidence in the public.

There is definitely merit in that end as I have said. But it is not proper to begin to accept the lawlessness on Wall Street as the 'new normal' and to overlook what has been done, and the laws that are in place even if they are unevenly enforced under this Administration.

Who is to say that Wall Street will not steal customer money and embezzle depositors funds even if Glass-Steagall is reinstated?  If there are no investigations and prosecutions for such a blatant theft as this, how can anything or anyone ever be safe?

The customer money has not vaporized, is not missing, and was not highly compromised.  It was stolen.  Twice.  They would like to go for three.  

The fog of verbal niceties and legal maneuvers to excuse it is still underway.  And the world sees.
"God has numbered the days of your reign and brings it to an end. Your possessions will be divided, and given away to others. You have been weighed on the scales, and found wanting."