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One Year After MF Global: Are We Better Off?

October 22, 2012

 

MF Global 1 year later: Are we better off?

A year after MF Global declared bankruptcy and left the futures industry in a state of disarray, where are we? Do we really understand what transpired? Have we made the reforms necessary to prevent it from happening again? Here, we take a look at how the story played out, the reforms we've instituted to date, and the steps we need to take moving forward, both as an industry and as individual investors, to avoid a campy sequel.

This time of year, our homes and streets are swathed with cotton cobwebs, goblins and ghouls as we indulge in the chills and thrills of the latest horror movies and ghost stories of the year. The monsters beneath our bed come to life in polyester costumes and garish face paint, and macabre goes mainstream. It's a time where, instead of running from our fears, we embrace them - if only momentarily - for a rush of adrenaline and a few good laughs.

Except, last Halloween, the worst fears of the futures industry played out in agonizing slow motion without the superficial sheen of the holiday season. Amidst the candy corn and taffy apples came a sharp blow to investor confidence. The demon plaguing our central cast of characters did not don a cape nor boast a set of horns; he wore a suit and scraggly beard. Victims did not lose their lives, but some lost their livelihoods.

It has been a year since MF Global began a maddening descent into bankruptcy and scandal, but for many of us, it feels as though it was just yesterday. The story has, by and large, faded from the headlines, but the lessons of the past remain poignant today, and there is still much work to be done. We take a moment here to look back over the past year and look at what happened, how things have changed since, and what challenges await us on the horizon.

The Collapse

The harrowing tale of MF Global's demise is one with more twists, turns and intrigue than a good Grisham novel - a story that will one day make someone in Hollywood very wealthy, indeed. Fortune delved into the devilish details about four months ago, and their exposé is certainly worth a read. But here's the short version:

MF Global was one of the larger Futures Commission Merchants catering to retail and managed business. While they seemed tiny compared to a Goldman Sachs, they held considerable sway in the futures industry, and were generally well-respected. A little over a year before the story truly began, a Goldman Sachs veteran and former politician - Jon Corzine - took the helm. He saw the firm languishing a world of near-zero interest rates - the former bread and butter of the FCM industry - and decided that what the company needed was a little bit of his Goldman flavor.

Enter the risky bets on European debt.

In an effort to bolster profits for the company, Corzine began betting on an improving economic climate in Europe by buying distressed nations' bonds. However, in order to make the firm look healthier on paper, he purchased them via what was called a repo-to-maturity trade, which meant that the bonds did not show as a liability on their balance sheets. Instead, they were valued at their projected future profits. MF Global, suddenly, was looking good.

Or were they? The thing was, with these trades, there was always a chance that things would get worse in Europe before they got better. Corzine, as some have said, was well-known for weathering the storm as he chased profits, and apparently hoped he'd be able to do the same here, meeting margin calls as needed until payday came around. As time went on, though, regulators began to question the health of the company beyond the accounting tricks on their books, and pushed them to reveal the bets they had placed on Europe. Shareholders began to panic, scrambling for the door and pushing the value of MF Global stock into a rapid downward spiral.

The firm was running out of options. They needed to find a savior, and fast, but the public watched in horror as each and every suitor bowed out of a potential buyout. On Halloween, MF Global filed for bankruptcy. The futures industry had seen FCM bankruptcies before, so by itself the move, while unsettling, didn't necessarily mean the of the world. It was not the bankruptcy announcement that rocked all of us - it was the follow-up announcement that about $900 million in client money was missing.

$1.6 Billion Missing

It would take months of political drama to even scrape the surface of what had really happened, but through the efforts of the initially-maligned Trustee James Giddens and the futures industry advocacy group The Commodity Customer Coalition (CCC), a clearer picture began to emerge. It seemed as though, in order to meet margin calls on some of Corzine's trades, and in order to meet financial obligations with JP Morgan, MF Global, under Corzine's direction, began to dip into client money. The idea was that they would be able to replenish the funds rapidly, but as the requirements grew larger and larger, such moves became riskier and riskier. The massive sell-off in their stock caught MF Global off guard, which meant there was no chance of a cover up.

As of today, according to James Koutoulas of the CCC, the bulk of MF Global clients have received 80% of their money back, though those trading on foreign exchanges have only received a paltry 5%. What about the rest of the money? The $1.6 billion is still "missing," which is a funny way to put it, as we know where it is - it's just not available to clients. Of that amount, around $700 million is in dispute in the UK, while another $900 million appears to have been used to meet margin calls issued to MF Global by JP Morgan.

JP Morgan has been the subject of increasingly harsh criticisms on the latter missing amount. Essentially, despite the fact they were holding the client accounts from where this money was transferred, and despite the fact that MF Global refused to sign an assurance that the money they were posting did not belong to clients, JP Morgan accepted the MF Global transfers. Why is this an issue? Under a component of the bankruptcy code known as "Safe Harbor Laws," counterparties in a bankruptcy may not have payments made clawed back to meet obligations in the bankruptcy proceedings, as long as they can demonstrate that they had no knowledge of wrong-doing prior to payment. One would think that the margin posted to JP Morgan would clearly not qualify for protection under Safe Harbor provisions, but that's where things stand today.

The Department of Justice has yet to take action against Jon Corzine, despite emails which indicated these actions were taken at his behest. The CCC has stated that they have other options waiting on the backburner, but many at this point are wondering if MF Global victims will ever see real justice.

What Reforms Have Been Made to Date

The thousand words or so above is grossly insufficient when it comes to capturing the depth and breadth of this scandal, and its impact on, not only the former clients of MF Global, but the industry as a whole. For decades, it was assumed that client money, held in a segregated account, was sacred. And following MF Global there was a renewed push to ensure that the segregated account structure was iron clad.

But just as we were all coming up for breath and starting to put proposals in place for better protections, we were dealt another blow as PFGBest went down in fraud-fueled flames.

In many ways, it's been the nightmare from which you can't wake up, with the actions of two men causing investors to doubt the integrity of hundreds of hard working professionals across the futures industry.  Fortunately, we are far from a legion of Freddy Kruegers in this industry, and these two scandals (plus the dedication and hard work of the folks trying to do the right thing) have led to a series of industry changes designed to make sure this kind of thing never happens again:


The Work that Remains

These are all changes we're happy to see, and should make you feel more comfortable investing in the futures industry. That being said, we would be remiss in our dedication to protecting our clients to say the war is won. There are a variety of battles we still need to win:

What About Individual Investors?

It's been a year since MF Global started a radical reorientation of how those within and outside of the futures industry view this investment realm. Confidence has been shaken; there's no doubt about that. However, as many sophisticated investors have realized, the actions of a few do not necessarily reflect the intentions of the many, and should not scare them away from seeking out non-correlated investments, like managed futures, for their investment portfolios. That being said, it is not unreasonable to view the Corzines and Wasendorfs of the world as fat tail events, and as any good investor knows, it's good to take steps to prevent such events from wreaking havoc on your world. What can you, as an investor do, to protect yourself in an imperfect investing climate?

The first thing to do is be particular in selecting which FCM you work with. As we wrote in late July:

Beyond that, another consideration is how you keep the money with an FCM. If, despite using stricter criteria in selecting your FCM, you are still concerned about the safety of your money, you might consider using a "sweep" method in managing the cash you have on hand. Instead of depositing all funds into your FCM account, you would only keep what is absolutely necessary with the FCM, sweeping out the excess on a daily, weekly, or monthly basis. This would mean that, should the unthinkable happen, only a small amount of your investment would be frozen or at risk. To be fair, this is an imperfect solution. It requires regular monitoring of your account, fees associated with the movement of money, and a potentially vast array of headaches and paperwork. However, if it provides you with enhanced peace of mind, it may be worth the costs.

Conclusion

In the days, weeks and months that have followed MF Global, those in the industry have had to call everything they believed into question. Was client money really safe anymore? Were they doing the right thing by clients? Could they be doing anything differently? These conversations are the right ones to be having during times like these, and they'll keep on going for months to come.

But what is there to say to those who have watched this horror flick play out since last October? Perhaps the best way to think about it is in the context of the film genre. Take, for instance, the Halloween franchise. Michael Myers, to many people, was terrifying. He inflicted pain and suffering without conscience. We’ve seen there are people in finance cut from the same cloth, but that doesn't mean that everyone falls into that category, and you should stay locked up in your house for the rest of your life. You lock your doors at night, you park in well-lit places, and you take steps to make sure you're safe.

Corzine and Wasendorf are our Halloween villains, and investors today are faced with a choice similar to that of a moviegoer. You can choose to be afraid of the things that go bump in the night, or you can choose to make smart, defensive investment choices in order to gain access to the asset classes you need for diversification. For us, it's a simple question to resolve. We'll reserve our fears for the next slasher blockbuster, and hope you will too.

 

IMPORTANT RISK DISCLOSURE


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IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.