MF Global: Where Was The Oversight?

The truth is starting to dribble out….

After tracing 840 transactions of $327 billion in the company’s final days, Giddens is still analyzing where some of the $1.2 billion in missing customer money “ended up,” he said in the report. Corzine’s firm failed after credit-rating downgrades, a record quarterly loss and revelations about its $6.3 billion European debt trade unnerved investors. The missing money has sparked Congressional hearings and former customers have said it undermined confidence in the futures industry.

“For three months, our investigative team has worked to understand what happened during the final days of MF Global when cash and related securities movements were not always accurately and promptly recorded due to the chaotic situation and the complexity of the transactions,” Giddens said in a statement.

Yes, it’s so chaotic that you’re moving money around without recording where it went and where it came from?  That sounds like someone who’s not balancing their checkbook eh?

The investigation to date has found that transactions regularly moved between accounts and that funds believed to be in excess of segregation requirements in the commodities segregated accounts were used to fund other daily activities of MF Global. In the past, such transfers were in amounts of less than $50 million, but as liquidity demands increased and could not be met from internal sources, much larger amounts were used, apparently with the assumption that funds would be restored by the end of the day. By Wednesday, October 26th, as the result of increasing demands for funds or collateral throughout MF Global, funds did not return as anticipated.

Ah, I see.  It’s only $50 million that was “moved” (notice that the word “stole” wasn’t used) during the day, replacing the end of the day.

This is sort of like me deciding to “move” your car when you’re sleeping, and as long as I “replace” it by 6:00 AM when you need it to go to work, it’s all ok, right?  If the cops stop me it’s not really stealing because I was going to bring it back, right?

The point here is that it appears from this report that it was common practice for the firm to use customer funds on an intraday basis, essentially like kiting checks, with the presumption that they could make it all good by the close of business.  This leads to the obvious question as to whether this is going on in other firms without detection, as it is strongly implied that this was an absolutely routine thing for the company to do, and it also appears that either CME didn’t catch it or worse they didn’t care.

What’s even worse is that as I’ve pointed out repeatedly since 2007 when I started writing The Ticker off-balance-sheet vehicles are utterly toxic as they hide risk and make it essentially impossible to accurately determine exactly what is going on at any given point in time.  The Trustee’s filed report states:

The sovereign debt investments undertaken on a repo to maturity basis allowed some immediate gains to be booked, but these were purely paper profits generating negligible cash while the underlying transactions resulted in calls for substantial additional margin.

In other words the actual amount of the risk was hidden by not having it out in the open where people could see it, as the repo-to-maturity deals appeared to be “risk free” and off balance sheet but in fact were not risk free and ultimately led to the detonation of the firm.

The heightened risk and apparent loss of confidence drove customers to close their accounts and withdraw funds, resulting in even greater demands on a relatively limited amount of available cash.

Were the firm not “temporarily” stealing customer funds for operating capital then the loss of customer accounts and withdrawal of funds would have shrunk the firm’s operating profit (since the customers would have left) but that should not have caused the company to fail.  More to the point if segregation is being maintained such a “flight” situation can’t lead to the loss of customer money.

There is one interesting chart in the report, on the second-to-last page. Have a look:

This chart appears to imply that new positions were opened in the last days, as initial margin grossly increased, more than doubling between 10/24 and 10/31.  This is not explained in the narrative thus far, but it certainly appears to require some explanation, since initial margin, as the name implies, is posted when one initiates a position.

I may be mis-reading this chart (or some entries are mis-characterized) but if I’m not it looks like it is not the variation margin that blew the firm up (from changes in value) but rather it was initial margin that got them in trouble, and the obvious question that raises is “How?”

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