MF Global’s Collapse Exposes Prop-Trading Risk That Volcker Wants to Curb

Bloomberg, By Christine Harper, Michael J. Moore and Silla Brush - Nov 1, 2011 

Jon Corzine’s failure “is OK because MF Global is not such a large institution

 that it’s going to bring down the entire financial system with it,” Neil Barofsky,

 a former special inspector for the U.S. Treasury’s Troubled Asset Relief

 Program, said on Bloomberg Television’s “InsideTrack.”

Photographer: Richard Perry/The New York Times/Redux

Jon Corzine’s risk appetite helped destroy his firm. It also provided an object lesson for Paul Volcker’s campaign against proprietary trading on Wall Street.

Nineteen months after former New Jersey Governor Corzine became chairman and chief executive officer, MF Global Holdings Ltd. (MF) yesterday filed for bankruptcy. Corzine’s decision to boost risk-taking, including a $6.3 billion wager with the firm’s own money on European government debt, triggered the collapse.

Volcker, a former Federal Reserve chairman, pushed to curb wagering by financial firms that have federal guarantees or are so entrenched in markets that they’re deemed too big to fail. Regulators and the industry are wrestling over the fine print in the so-called Volcker rule, which takes effect in 2012. Now, three years after Lehman Brothers Holdings Inc. (LEHMQ) failed, MF Global’s implosion and a probe into whether client money is missing may buttress the argument for tighter trading limits.

“In the wake of 2008, when we all should have learned a lesson, Jon Corzine told me himself that it was a relatively staid, not risk-oriented firm and he needed to ratchet up the risk,” William Cohan, author of “Money and Power: How Goldman Sachs Came to Rule the World,” said on Bloomberg Television. “Well, he does that and it blows up in his face and for the first time he can’t unwind the trade. Honestly I’m still shocked and it should not have happened.”

MF Global, with 2,894 employees and $2.5 billion in capital as of Sept. 30, wouldn’t have been affected by the rule, unlike larger rivals such as Goldman Sachs Group Inc. (GS) or JPMorgan Chase & Co. (JPM)

‘Bad Bets’

Corzine’s failure “is OK because MF Global is not such a large institution that it’s going to bring down the entire financial system with it,” Neil Barofsky, a former special inspector for the U.S. Treasury’s Troubled Asset Relief Program, said on Bloomberg Television’s “InsideTrack.” “If this is Goldman, if this is JPMorgan, if this is any of those institutions, we’re going to have to go in and bail them out and we’re going to bear the brunt of their bad bets, not the shareholders and possibly the debt holders.”

Corzine, 64, learned the strategy of making big trading bets during his 24 years at New York-based Goldman Sachs, which he ran from 1994 to 1999 before being forced out. It was the most profitable securities firm in Wall Street history before converting to a bank holding company in 2008, when smaller rival LehmanBrothers went bankrupt.

‘The Big Leagues’

“Jon Corzine made his bones at Goldman Sachs by going big,” said Cohan, a Bloomberg View columnist who interviewed Corzine for his book on Goldman Sachs. “I see this as a case of Jon Corzine ramping up the risk that MF Global was taking, trying to put it into the big leagues of investment banking, make it more like Goldman Sachs.”

While Corzine sought to recreate the Goldman Sachs that he remembered, the firm’s current management was reducing risk- taking -- in part in response to the Volcker rule. It closed Goldman Sachs Principal Strategies, a prop-trading team that bet primarily on equities, and the Global Macro Proprietary Trading desk, which wagered on bonds, currencies and commodities.

The Volcker rule also will require Goldman Sachs to reduce investments in private equity and hedge funds to no more than 3 percent of each of the funds -- or 3 percent of Goldman Sachs’s Tier 1 capital. In the latest quarter, such investments were responsible for the firm reporting its second quarterly loss since going public in 1999.

‘Implemented Quickly’

“Mr. Corzine’s activities at MF Global are exactly what the Volcker advocates wanted to protect against,” Richard Bove, a bank analyst at Rochdale Securities LLC, wrote in a note to clients. “It is exactly why they were so adamant that the regulators were not enough to stop speculative activities and a strict law had to be passed to stiffen regulator actions.”

Bank executives including Goldman Sachs Chief Financial Officer David A. Viniar and Morgan Stanley CEO James Gorman, 53, have noted their firms’ cooperation in shutting down stand-alone prop-trading businesses while warning of reduced market liquidity if the rule is interpreted too strictly.

“The Volcker rule needs to be fully implemented quickly to ensure that banks can no longer put taxpayers at risk for making the kind of proprietary trades MF Global made,” U.S. Senator Carl Levin, a Michigan Democrat who pushed for the rule, said in an e-mailed statement.

U.S. regulators are investigating whether hundreds of millions of dollars are missing from client accounts at MF Global, according to a person with knowledge of the matter. Corzine and Tiffany Galvin, an MF Global spokeswoman, didn’t respond to e-mail and phone messages requesting comment.

‘Up in Smoke’

A version of the Volcker rule released by regulators last month already has been criticized by banks and analysts. Brad Hintz, an analyst at Sanford C. Bernstein & Co., said the rule may shave 25 percent from fixed-income trading desks’ revenue. The Office of the Comptroller of the Currency estimated that it will cost banks $917 million for raising more capital and an additional $50 million in compliance and legal expenses.

Arthur Levitt, a former Securities and Exchange Commission chairman and adviser to Goldman Sachs, said Wall Street lobbyists will fight to postpone and weaken the regulations.

“This is going to be a long slog, and much of that rule that you see today is going to go up in smoke,” Levitt, a Bloomberg LP board member, said on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt on Oct. 13. Levitt said he was speaking for himself and not expressing the views of Goldman Sachs.

Avert Failure

MF Global’s board had met through the weekend in New York to consider options including a sale to avert failure, according to a person with direct knowledge of the situation. Following a record loss announced last week, MF Global was suspended yesterday from doing new business with the New York Federal Reserve, according to a statement on the regulator’s website. Trading in MF Global’s stock also was halted.

MF Global shares declined 67 percent last week and its bonds started trading at distressed levels amid its disclosures of bets on European sovereign-debt. MF Global held talks with five potential buyers for all or parts of the company, including banks, private-equity firms and brokers, said the person, who asked not to be identified because the talks were private.

Early yesterday, MF Global told regulators it didn’t have a deal “and reported possible deficiencies in customer futures segregated accounts held at the firm,” the Commodity Futures Trading Commission and SEC said in a joint statement. The regulators said they decided a bankruptcy led by the Securities Investor Protection Corp. would be the best way to safeguard customer accounts and assets.

‘A Risk-Taker’

“MF was highly leveraged and I think Corzine came in trying to do what he did at Goldman Sachs,” Levitt said yesterday on “Bloomberg Surveillance.” “He was a risk-taker, and the markets went against him.”

Stand-alone proprietary-trading groups at six bank holding companies -- Bank of America Corp., JPMorgan, Citigroup Inc., Wells Fargo & Co. (WFC), Goldman Sachs and Morgan Stanley -- had a net loss of about $221 million from June 2006 through the end of 2010, according to a July 13 Government Accountability Office report.

The business of betting money for banks’ own accounts produced positive net revenue in 13 of the 18 quarters examined, totaling $15.6 billion, and generated losses of $15.8 billion in the other five quarters, according to the report. The study didn’t address prop trading conducted in other groups besides the stand-alone desks.

‘Exceptions and Loopholes’

Regulators including the SEC, Federal Reserve, OCC and Federal Deposit Insurance Corp., issued a 298-page proposal of the Volcker rule on Oct. 11. The agencies are seeking public comment on the draft and may make changes before it takes effect July 21.

The Volcker rule, as written in the Dodd Frank Act, had “so many different exemptions and exceptions and loopholes that it almost became nearly impossible for the regulators to fashion a rule that can live up to its original intent,” said Barofsky, a Bloomberg Television contributing editor.

Among the exceptions are trading of U.S. government and government agency obligations and anything that assists a firm in making markets for clients or hedging those positions. While Wall Street lobbyists have helped to water down the bill, the Treasury Department didn’t fight hard enough for it after the Volcker rule was added to the Obama administration’s original financial-reform proposal, Barofsky said.

‘Late Add-on’

“Remember, this was sort of a late add-on to what was originally proposed in regulatory reform and I don’t think that their heart was necessarily in the legislative process,” Barofsky said. “So you see all these exemptions that really are going to enable a lot of different types of trading to go forward even under the Volcker rule.”

Deputy Treasury Secretary Neal Wolin supported the rule when he testified with Volker, an Obama administration adviser, during a February 2010 hearing before the Senate Banking Committee. Barofsky didn’t work on the Volcker rule during his tenure as special inspector for TARP.

“The Volcker rule is an important component of the reform of America’s financial system and a provision that would not have been in the legislation but for the strong advocacy of the president and the Treasury Department,” Colleen Murray, a department spokeswoman, said in an e-mailed statement.

The bankruptcy also may influence debates related to other parts of financial-industry rulemaking. MF Global, alongside hedge funds and brokers, had succeeded in urging the CFTC to open access to derivatives clearinghouses for firms with less net capital than Wall Street’s largest swaps dealers.

The CFTC completed a rule on Oct. 18 that would require clearinghouses to open access to firms with at least $50 million in net capital. Clearinghouses would still be able to scale a member’s participation depending on how much capital a company holds above $50 million. Wall Street’s largest derivatives- dealers have said members need experience and adequate resources to manage defaults.

To contact the reporters on this story: Christine Harper in New York at charper@bloomberg.net; Michael J. Moore in New York at mmoore55@bloomberg.net; Silla Brush in Washington at sbrush@bloomberg.net

To contact the editors responsible for this story: David Scheer at dscheer@bloomberg.net; Lawrence Roberts at lroberts13@bloomberg.net

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