Two Lessons from MF Global

November 2nd, 2011 at 8:38 am

The unraveling of MF Global provides a stark reminder of why we need to implement the Dodd-Frank financial reform legislation, a policy that every R candidate for president has promised to repeal.

Two things to look at here.  First, I’ve been on this rant re the importance of capital reserves.  There are a lot of moving parts to financial regulation, but at the end of the day, investors will find ways to make bets that are unregulated and systemically risky.  And what we (should have) learned in the late 2000s was the extent to which leverage amplifies such risks.

MF was leveraged 44 to 1, according to the link above (leverage ratios below 20 used to be the norm).

If financial institutions have enough of a capital cushion to absorb such losses, it serves as built in insurance against the next new form of “innovative” finance that gets ahead of the regulators.

Second, there’s interesting moral hazard in the MF case.  The firm, and its benighted chief, former Gov Corzine, appears to have been betting on a bailout.  And it probably wasn’t a crazy bet, except for the timing, which was what sunk the firm.  (I know it’s 20-20 hindsight, but betting on the alacrity of the European policy makers’ timing in their debt crisis was really a very risky bet.)

The firm surmised that the banks exposed to troubled sovereign debt would get bailed out, and thus leveraged up to buy a lot of that debt at a steep discount.  Had the bailout come sooner, MF and their investors would have made a lot of money—at the expense of European taxpayers.  A classic case of socializing losses and privatizing gains.

It’s not obvious how to prevent this.  Dodd-Frank has oversight provisions designed to spot trouble in systemically connected institutions before bailouts are necessary, but there’s every reason to believe that we’ll be back here again someday.   I suspect some would say, “no bailouts ever.”  That’s not realistic.

The answer is to provide regulators with the information to track leverage, exposure, and the risk profile of the global system.   Dodd-Frank is surely not perfect by a long shot, but to repeal it without a better replacement—to return to the assumption that markets will self-regulate—is policy by amnesia.


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7 comments in reply to "Two Lessons from MF Global"

  1. Will Coertnik says:

    It’s totally obvious: The US should re-instate the Glass-Steagall Act without watering it down in a flurry of politcal bribery by financial institions. And the Europeans should follow suit.

  2. ReaderOfTeaLeaves says:

    To touch on Dr. B’s final paragraph, I know well educated professionals who do not understand the information in that final point. They are great, terrific people but lack the avaricious interest of some of us to try and connect a lot of dots.
    Things they do not appear to understand include:
    — a simple, quick visualization of the significance and destabilizing effects of 1:44 leverage. But if they are told Corzine was betting $1,000,000 on the assumption that he could ‘make’ $44,000,000 watch their eyes pop wide.
    — the relationship of a figure like $44,000,000 to its impacts on … A teacher’s pension fund, or the number of school districts in the state that could be funded this year for that sum.
    — or the number of college courses, scholarships, etc that $44,000,000 would fund.

    In other words, I don’t see enough bright, hard working people I know transferring the large, abstract numbers to what Ed researchers call “working knowledge” because they can’t visualize these huge numbers to recognize relationships and conceptual models.

    That also appears to leave them vulnerable to seductive claims that Corzine “earned” that moola ( or lost it) via what I call gambling. He took a bet, and he lost. What was he betting on? Was he betting on the ability that a government could force more austerity on its people?

    In other words, these people invest.
    They respect investment * as a concept*.
    But they would not approve of using ” investment via financial engineering” to indenture and impoverish others. At least, I don’t think they would.

    As near as I can figure, they have to have someone ( often Stewart or Colbert) explain why some forms of money are “I’ll got”, and therefore socially destructive… Eventually for their own lives. And because they don’t have “working knowledge” for a huge sum like $44,000,000 they don’t realize just how socially destructive this activity is. But if you told them that Corzine was betting enough $$ to run a university and 10 suburban school districts this year, just watch their eyes bug out.

    Dr. B, you are doing what my beloved, ancient, Greatest Generation aunties would have called ‘the Lord’s work’. Thank you.

  3. perplexed says:

    Paul Krugman posted a link to the IMF conferences held recently in Iceland and MIT’s Simon Johnson’s remarks on the role of the banks in deceiving the public (without even to having to violate any regulations) about the real risks behind this leverage is something all interested in this TBTF problem should hear.

    If MF were a TBTF institution as they had hoped they’d be, the “free public insurance” would have kicked in and the costs of the failure passed on to the public. We need to require these businesses to purchase insurance and end this public subsidy of the oligarchs. The insurance companies will demand full disclosure and the costs of the insurance will spell the end of the TBTF’s; their business model depends on the free public insurance taxpayers provide. We can no longer afford this scam.

    Given his expertise, its rather amazing how little media attention Johnson gets; apparently the owner/oligarchs don’t like what he has to say. His book “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown” is a must read to understand this subject. We ignore him at our peril.

    • markg8 says:

      AIG insured all those dumb credit default swaps and look what happened to it. The financial industry needs to go back to being the boring old financial sector instead of finding new ways to suck the lifeblood out of civilization.

      • perplexed says:

        AIG under-priced the risk but collected the “premiums.” They weren’t required to project the losses and set aside reserves as an insurance company is. The American public ended up insuring the losses; most of which went to Corzine’s old employer, GS.

        I still don’t think we have any accounting of how many “synthetic” mortgages are still out there and who is holding them. With 1/4 to 1/3 of mortgages underwater, there could be a huge exposure as many “synthetics” can be created on the same underling mortgages.

        Forcing the banks to buy insurance would require them to involve a third party who would demand full disclosure. Treating it as insurance would require that there is capital reserved to cover losses, in addition to the bank’s capital. When the TBTF’s have to pay the “actuarial based” premiums instead of getting the insurance free from the public, the “profits” will disappear and they’ll have to find a new scam.

  4. Jim Gonyea says:

    One thing that I think gets missed in the MF Global scenario is that when Corzine took over he found a stodgy conservative trading company making low profits. He wanted the company to take on more risk in hopes of turning it into another Goldman Sachs. How many times has this scenario played out. A new CEO takes over a perfectly healthy company and tries to “make his mark” on the company and destroys what made it a healthy company and ends in bankruptcy and disaster.