MF Global: Unethical, But Perhaps Not Illegal

Investors everywhere were shocked to see that MF Global seems to have lost over a billion dollars of their customers capital.  In most cases, this capital was cash customers thought was sequestered as collateral for their trading accounts.  MF Global took its customers money and used that money as collateral in making risky, leveraged bets on European sovereign debt, bets that fell apart as debt prices fell and MF Global faced margin calls on its bets that it did not have the liquidity to cover.

Certainly it strikes most folks as unethical to lose the assets in your customers' brokerage accounts making bets for the house.  But it turns out, it may have been entirely legal.  This article is quite good, and helps explain what was going on, what this "hypothecation" thing is (basically a fancy term for leveraging up assets by using them as collateral on loans), and why it may have been legal.

In short, the article discusses two regulatory changes that seemed to be important.  The first was a 2000 (ie Clinton era, for those who still think these regulatory screwups are attributable to a single Party) relaxation in how brokerages could invest customers' collateral in their trading accounts.  The second was a loophole where brokerages created subsidiaries in countries with no controls on how client money was re-used (in this case mostly the UK) and used those subsidiaries to reinvest money even in US brokerage accounts.

The increase in leverage was staggering.  Already, cash in most commodities trading accounts is leveraged - customers might have only 30% of the value of their trading positions as collateral on their margin account.  Then the brokerage houses took this collateral and used it as collateral on new loans.  Those receiving the collateral on the other end often did the same.

MF Global would be bad if it were fraud.  But it is even worse if MF Global is doing legally what every other brokerage house is still doing.

Here is the minimum one should do:  Diversify brokerage accounts.  We diversify between bonds and stocks and other investments, but many people have everything in one account with one company.  I am not sure anyone can be trusted any more.  My mutual funds are now spread across three firms and, if I grow my brokerage account for individual stocks and investments (right now it is tiny) I will split that as well.


  1. Pakkinpoppa:

    That was the gist I got, was through some regulatory loophole, that missing couple Billion was, sorry Charlie, not "theft" but merely a case of, well... a loophole.
    It'd still suck to have an account there and basically be "frogged".

    Unethical? Of course. Illegal? Maybe not.

    Anybody else feel like exiting the casino, or at the very minimum, placing your accounts in multiple firms so if one goes belly aren't suddenly looking at being broke at retirement?

  2. Daedalus Mugged:

    I think you are missing part of the story. Part of what MF Global did was in the unethical but possibly legal angle, specifically the hypothecation of customer excess reserves. MF Global could have legally used them unlevered in their home currency. That is MF Global could have bought US Treasuries with US dollar accounts and kept the interest. Treasuries don't pay squat (thanks Bernanke!) so MFG stretched for yield.

    They probably stretched the law by hypothecating to a subsidiary without controls on hypothecation (US has haircuts, London does not) and switching currencies, and levered them up and bet on Italy. That is a is well beyond the intent of the law, but may be a legal loophole.

    However, MFG went beyond that. They apparently pledged customer assets (fully paid for, lien free, gold and silver bars owned and stored in COMEX warehouses) against a last minute loan, which they defaulted. That is clearly illegal. They can legally hypothecate excess reserves, they do not have the legal ability to put liens on unencumbered customer assests. And that is what they did. It seems JPM has seized over 3mm ounces of silver owned by MFG customers and an unknown amount of gold.

    That is no more legal than an identity thief taking out a mortgage on your paid off house, not making the monthly payment, the bank foreclosing on your paid off house. When you clearly establish that the mortgage was a fraud, the foreclosure illegitimate, and the catch the identity thief, it turns out the judge (ie the trustee) has long ties to both the bank and the identity thief, and declares the whole thing too confusing to resolve and better just to leave things where they the bank has your house, and you have nothing.

    Losing some of my cash balance, sucks but possibly legal. Losing my fully paid off, specific serial number bars that I have been paying storage fees on? Criminal. All the way.

  3. Pakkinpoppa:

    You put it better than I did, but again... from what I understand, the loophole in the law means that customers assets were used as collateral and not segregated, and since MF lost the farm, that included the customer's collateral used as such to leverage purchases.

    I'm not agreeing with the, well, basically outright theft of, say, Mr. Celente's and others metal that they'd paid for any more than the hypothetical scenario of the identity thief taking out the mortgage on your house and you losing it.

  4. Doug:

    "As a member of the United States Senate, Corzine co-authored the Sarbanes-Oxley Act, a piece of legislation designed to crack down on corporate malfeasance crafted in the wake of accounting scandals surrounding Enron, Tyco, WorldCom, and other major corporations."

    It is my understanding that Sarbanes-Oxley requires the CEO to sign a company's annual report and say "I understand everything in here and approve of this report." Then Corzine stood before the House committee and said that he had no idea where the money went, despite the requirements of Sarbanes-Oxley? The bill that he co-authored? And then there's all this talk that he could easily walk because he cleverly avoided taking any responsibility without saying anything of substance?

    What am I missing? How's the failure of Enron any different than MFG's?

  5. blokeinfrance:

    You invest your own money, you might gain or you might lose the lot.
    You give it to someone else to manage, ditto.
    Kids have been learning this in Sunday School for 2,000 years.
    Now if the investment manager is skimming the pot, that is something else. (Although according to Luke, you should forgive him anyway.)
    Investors in MFglobal were unaware that their investments were leveraged? Come on. Are we talking widows and orphans here?

  6. Hal (GT):

    If it ain't criminal it had better soon be.

  7. Daedalus Mugged:

    Bloke in France, you seem to be missing a lot of the story. Point by point.

    "You invest your own money, you might gain or you might lose the lot." No one is complaining about the performance of their investment choices, people are concerned about decisions they did not make affecting them.

    "You give it to someone else to manage, ditto."
    MFG did not manage people's money, they were a brokerage shop, customers made their own decisions.

    "Investors in MFglobal were unaware that their investments were leveraged? Come on. Are we talking widows and orphans here?" In some cases, yes. But some investments were levered, some was cash, and some were unlevered. An open future contract is inherently levered. A physically settled future contract (paid in full) is inherently unlevered. Cash is supposed to be cash. It is not customer leverage that blew up their positions. As a matter of fact, so far, the more levered you are, the more of your money you have gotten out of the estate. 80% for levered open positions, 60% for all cash, and 0% for unlevered assets. Those with the unlevered positions (fully paid for assets, no lien) are the ones who have gotten nothing out of the estate. It is not customer leverage that was the problem.

    Can I place a bet with a lien on your house? That is what Corzine and MFG did.

  8. epobirs:

    Then it follows to ask, why is it legal?

    I'm still amazed at the destruction wrought with Credit Default Swaps. These instruments let you take out insurance on investments with no connection to yourself. If you walked into an insurance company and tried to take out insurance on the life or assets of a complete stranger, you'd likely be hearing from the cops soon after. But on Wall St.? No problem!

    But the suckers keep lining up to get in the game.

  9. Val:

    Can assets be hypothecated without permission of the owner?

  10. Smock Puppet, Frequent Fantasy Flyer:

    >>> but many people have everything in one account with one company.

    I believe this should be called the "Enron Lesson", and it ought to be moderately DUH after those events.

    Perhaps it's not, but there are those who learn from experience, and those who don't.

    Then there's the Bismarck strategy:

    "Fools say they learn by experience. I prefer to learn by others' experience."

  11. Smock Puppet, Frequent Fantasy Flyer:

    >>> When you clearly establish that the mortgage was a fraud, the foreclosure illegitimate, and the catch the identity thief, it turns out the judge (ie the trustee) has long ties to both the bank and the identity thief, and declares the whole thing too confusing to resolve and better just to leave things where they stand…ie the bank has your house, and you have nothing.

    This sounds like a case from the 1980s in NYC, delineated by PJO'R in "Parliament of Whores", IIRC.

    There was some run-down tenement building, which was bought for tax dollars or something by some shyster, who then offered the existing tenants a kind of sweat-for-equity deal. After the place was all fixed up, there was some bogus dealings and the official owner sold the property without giving them any compensation at all, using some kind of tax-law swindle. They took it to court, and lost. Then it turned out the tax court judge was somehow in cahoots with the shyster of an owner of the property. I seem to recall the poor tenants never got anything back from their efforts. I personally hope the judge and the crooked SOB got an ounce of lead applied at a high speed.

    Such pr***s deserve nothing less.

  12. Smock Puppet, Frequent Fantasy Flyer:

    >>> But the suckers keep lining up to get in the game.

    Dude, two words: Social Security.

    That most of the occupants of the Capitol in DC haven't been lynched yet regarding this says all you need to know about suckers.

    As it is, it's becoming a game of musical chairs. Who will be lynched when the music stops?

  13. Bram:

    Legal or not - Corzine did attest to those reports. Whoever wrote their D&O insurance (I'm sure it's layered) is going to have a full limit loss.

    Once the civil suit plaintiffs run through the insurance money, they are going to go after Corzine personally. He will lose everything he has - which gives me a nice warm feeling.

  14. NormD:


    The customers DID consent. The referenced article notes that the MF client agreement says:

    “7. Consent To Loan Or PledgeYou hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate, loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.”

  15. Ian Random:

    Isn't it SIPC that insures balances at brokerages? I thought there was another one. Anyone, I hear it isn't so easy to get them to pay.

  16. Val:

    Ian, SIPC only covers 500K, of which 100K can be cash. It does not insure against market loss, and only covers certain types of accounts. It is not FDIC, which protects principal (cash only) up to its limit (currently 250K).

    From what NormD (thanks NormD!)says above, these people were almost certainly involved in investments not covered by SIPC. Some firms carry additional private insurances, but I doubt they had anything like that, either. The more I hear, the more I think these people should have been aware of what they were involved in and the risks associated with it. However, everyone expects bailouts of some type or another these days, and so take risks with little thought for the, well, 'risk'.

  17. tomw:

    OK, I'll play dummy. Do other 'financial institutions' maintain similar powers over account balances{"Collateral"}? Does that mean that my 100 shares of Magellan can be pledged by Fidelity as collateral for them to borrow to buy shares in BogusCorp? Or was this just limited to MJ?
    Personally, I think such financial doubletalk is enough reason to get out of Wall Street completely. They bet the future on bogus mortgages, took the profits, and went home, leaving the US citizen holding the bag. They THEN took the TARP funds, amongst other sources, to shore up the accounts they had turned to merde. AND took bonuses for their action. Yeah, invest with confidence... that you'll be taken to the cleaners three ways before the Banksters give up one dime of their ill-gotten gains. Rant over.