Capital markets are plagued with a disease called greed. Its symptoms are many, including overleverage, rogue traders and out-and-out fraud. But the end result is the same: Greed leads to a scandal, and folks lose their hard-earned money. That scandal erodes investor confidence. When confidence declines, people feel uncertain and afraid, prompting them to park their money on the sidelines. And that hurts everyone.
Greed has a cure, but the pain that accompanies this treatment is usually enough to scare off even the most intrepid caregivers.
In this column and the next few, I’m going to address the hazards of greed, and then give you some tips on how to protect yourself from the Wall Street shenanigans that greed creates.
Let’s start with leverage. It’s an familiar tune, sung by consumers, businesses and investors, who tout its primary advantage: using debt to multiply your money.
Now don’t get me wrong. Leverage can be a sweet thing. Most of us wouldn’t be able to buy our homes or cars — or even college educations for our children — without debt. But the injudicious application of leverage has caused the largest financial bubbles and their ensuing collapses in this country, including:
- The 1929 stock market crash, which erased more than $9 billion of market value in American businesses. It was brought on by leverage and triggered by margin calls on that debt.
- The 1987 stock market collapse, in which the equities fell 20% in a single day, was created by mania in the overleveraged junk-bond industry.
- The dot-com bubble, which saw the erosion of $5 trillion in market value from 2000-2002, was precipitated by unadulterated growth using venture capital and debt, with no profits in sight.
- The 2007 housing, financial and investment market collapses, created by easy credit, exotic derivatives and a hands-off regulatory environment, which led to mounting foreclosures, bank failures and a global recession.
Those are just the major financial debacles caused by overleveraging. But beyond those events are legions of mini-meltdowns that can have just as devastating an effect on people worldwide.
You may remember:
- Long-Term Capital Management, which used excessive leverage in arbitrage deals and was bailed out by the Federal Reserve in 1998, to the tune of $3.625 billion.
- Amaranth Advisors, a hedge fund that borrowed $8 for every $1 it owned to bet on natural gas futures. It collapsed in 2006, losing about $6.6 billion for its investors.
- Bernie Madoff’s $65 billion Ponzi scheme that promised above-market gains.
And now we have Jon Corzine and MF Global (PINK:MFGLQ). Corzine is a perfect example of the greed that permeates Wall Street (and Main Street), using leverage to make speculative bets in hopes of spectacular returns.
Corzine is a guy with more than a few million to his name, former co-head of Goldman Sachs (NYSE:GS), as well as a former senator and governor of New Jersey. At 63 years old, he took on another challenge — MF Global. Known as a second-rate futures dealer, MF Global hired Corzine to bring it back from near-death and make it a star.
He did, for awhile, building the company into a major global broker for financial derivatives.
Along the way, he employed a tremendous amount of leverage by using derivatives such as complex repurchase agreements in the pursuit of profits, buying more than $6.3 billion of European sovereign debt. And that overleverage was the company’s downfall, especially because it wasn’t adequately disclosed.
While hedge fund clients are generally sophisticated investors, well aware that great returns are predicated on great risks, in MF Global’s case they weren’t aware of the exact risks. Auditors had warned the board of directors of the significant leverage being employed — warnings that were, for the most part, apparently ignored. And when regulators demanded disclosure, the ratings agencies (which apparently also were well aware of the problems) finally climbed on board and downgraded the company.
At that point, as rumors of the risks began to swirl, investors began pulling their money out of the firm, forcing a liquidity crisis. MF Global filed for bankruptcy on Oct. 31.
One More “Kick in the Shin”
What’s even worse is that while MF Global’s investors may have been sophisticated hedge fund clients, and well-aware of the typical risks that come from being overleveraged, they had one more “kick in the shin” awaiting them: the little-known rule changes that allowed MF Global to use its customers’ funds to further its own gains — accounts in which more than $1.2 billion seem to be “misplaced.”
One particular strategy that MF Global used to parlay its client funds into firm profits has added a new word to the vocabulary of most investors: “hypothecation,” or in this case, “rehypothecation.”
When I was a banker — many years ago — we routinely “hypothecated” collateral. In the case of a home loan, our borrowers basically ceded control or temporary ownership of their homes to the bank until their mortgage was satisfied.
To investment brokers, hypothecation occurs when an investor pledges his stock to borrow against it. If you miss your margin calls, your broker can take your stock as payback. Both of those scenarios make sense, don’t they? They’re routine business transactions that occur daily. When you pay your loan back, you get your collateral back.
But hypothecation has taken on new meaning as a consequence of MF Global’s rise and fall. Here’s why.
Most investors believe that client funds are sacred, never co-mingled with a firm’s funds and only to be used for purposes of investing for a client’s benefit. But that turns out not to be exactly true.
Until 2000, commodity firms (like MF Global), were allowed to use their client funds only to buy short-term U.S. Treasuries. But MF Global and other commodity firms petitioned for changes, and by 2005, client funds could be used — or rehypothecated — to invest in government-sponsored entities, bank certificates of deposit, commercial paper, corporate notes, general obligations of a sovereign nation, interests in money market mutual funds and short-term repurchase agreements.
In essence, those rule changes opened the floodgates. And MF Global took advantage, using client funds to buy repurchase agreements on the bonds of troubled sovereign nations such as Italy and Ireland — a strategy that wasn’t adequately disclosed. And you can bet the firm’s clients didn’t knowingly endorse it. Yet, it seems to be perfectly legal.
And along the way, some $1.2 billion in those customer funds have just disappeared. It’s feared that the money was used to cover MF Global’s trading losses.
Why It Matters to You
While no one has yet determined whether Corzine and MF Global did anything illegal, this is clearly another example of greed getting out of hand and regulators going along for the ride. So far, nine lawsuits have been filed against Corzine and MF Global — just the beginning, I’m sure.
That’s often the outcome when you borrow beyond your means and try to dig your way out by using, if not illegal, certainly very questionable strategies. And it’s a shining example of how investors — even sophisticated folks — can be suckered into some very bad investments by the promise of outsized riches.
And even if you weren’t a client of MF Global, its demise should matter to you.
You can bet that it’s certainly not the only company employing these strategies. The fallout from its collapse could also lead to billions of dollars lost by its trading partners, as well as their clients. It’s hard to believe other companies won’t be caught up in similar scenarios. Only time will tell.
All the more reason to be aware that on Wall Street, “what you don’t know can hurt you.”
For my next column, Rogue Traders: Not as Rare as You Think.