Why would anyone, especially a Minnesota farmer, risk their farm or grain business on what would happen in the European bond market?
The answer is that they would not, but the MF Global debacle, in which the company collapsed and some $1.2 billion of customer money – including that of many Minnesotans – is missing, shows that in today’s financial system this can happen without the clients’ knowledge.
MF Global was headed by Jon Corzine, a former top executive at Goldman Sachs, a former governor and former U.S. senator from New Jersey and an oft-cited possible Treasury Department head. His role in the debacle shows Wall Street had, as French pundit Talleyrand said of the Bourbon dynasty, “learned nothing and forgotten nothing.”
Corzine has been subpoenaed to appear today before the House Agriculture Committee, which reportedly has been flooded with calls for help and questions about what went wrong.
Some background is in order.
Virtually all grain and feed dealers and many large farms use futures contracts or options to reduce price risk on the grain they buy or sell. Most deal with some local or regional commodities broker. Most such firms, however, do not trade on the actual futures exchanges in Chicago or elsewhere. Instead, they go through a larger “clearing broker” that is a member of these exchanges.
This “introducing broker-clearing firm” relationship is just like the system for stock trading that prevailed from 1870 until a few decades ago.
When clients at small stock brokerages in cities like Baton Rouge, Billings, Boise or Bismarck wanted to buy shares of U.S. Steel, for example, the local brokerage firm would telegraph the order to a larger New York firm that was a member of the New York Stock Exchange. This “wire house” would actually purchase the stock.
(Investors in larger cities – like Minneapolis, St. Louis or San Francisco – had the option of dealing with major regional brokers, such as Piper Jaffrey, that were large enough to have their own seats on stock exchanges and thus could execute their own trades.)
Any futures transaction, even one to reduce risk for a farmer or feed company, requires a deposit of “margin money” to guarantee the bargain will be kept. And, depending on which way prices move between the date the contract is entered and when it is closed out, additional margin may have to be deposited.
Even for bread-and-butter grain dealers or for large hog farms, the total amount tied up in a futures margin may run into the hundreds of thousands of dollars. And the margin is held by the wholesale clearing broker that actually deals with the exchange.
MF Global had long been such a clearing firm. It was neither an investment bank, underwriting issues of new stocks and bonds, nor a hedge fund. However, when Corzine took over as CEO in early 2010, it began to transform itself from a commodities firm into a Goldman Sachs wannabe.
Any brokerage firm, whether for stocks, bonds or futures or at the retail or wholesale level, is legally banned from mingling client funds with the firm’s own money. However, margin-account money does not have to be held in cash. It may be invested in safe securities like Treasury bills.
MF Global broke the intent of the law, but it may have taken advantage of a regulatory loophole that allowed the brokerage side of the firm to lend money to its proprietary hedge fund side via a derivative security called a repurchase agreement. This would not appear on MF Global’s balance sheet the way a direct loan would.
Neither would Minnesota elevators and hog feeders have any idea that their money, legally held in escrow, was being used to bet that relationships between prices and interest rates of bonds issued by European governments would return to some expected pattern or that they could lose money if Corzine’s bet did not pay off.
History supported them. Informed sources in the local grain trade could recall no instance of a clearing firm going broke and losing clients’ margin money in several decades. Even veteran executives in major futures firms have been flabbergasted by the debacle.
If this undermines confidence in grain price hedging tools, both farmers and local grain dealers may return to carrying more risk themselves than is really necessary or economically efficient.
The financial sector blew up in 2008 because firms created financial instruments the risks of which they did not understand, and that fostered opaqueness rather than transparency even while creating false confidence in naive savants like Alan Greenspan.
The explosion was devastating because of the high degree of leverage major players embraced. Small-scale customers had no idea of the risks they were being sold. Regulators were three steps behind.
MF Global demonstrates this still is true. Wall Street apparently learned few lessons from its losses three years ago and forgot none of its financial manipulations designed to hide vital information from customers and regulators. As a result, the public and the global economy remain in peril.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.