The Audacity of Bonuses at MF Global

In the spirit of George Orwell’s Animal Farm commandment: “all animals are equal, but some animals are more equal then others” comes the galling news that bankruptcy trustee, Louis Freeh, could approve the defunct, MF Global to pay bonuses to certain senior executives. This, despite the fact that nearly $1.6 billion of customer funds remains “missing” or otherwise partially accounted for, yet beyond the reach of those customers, perhaps forever, since before the firm declared bankruptcy on October 31, 2011.

Another commonality between the MF Global incident and Animal Farm is the abject rewriting, or re-interpretation, of rules. At the farm, the rule ‘No animal shall drink alcohol” was ultimately ‘re-remembered’ as ‘No animal shall drink alcohol to excess.’ Absent opposition to this particular fact alteration, the pigs got drunk. It wasn’t pretty.

The Orwellian nature of finance is spiraling out of control. It was acutely demonstrated during the fall 2008, merge-and-be-bailed period, and subsequently, through mainstream acceptance that “too big to fail” validates the subsidization of reckless banking practices (bail first, ask questions or consider tepid regulation later), and the European debacle.

Three wrinkles of audacity underscore the potential MF Global bonus approvals. First, there is the moral responsibility layer. MF Global, classified as a broker-dealer wasn’t specifically subject to the investment-advisor fiduciary rule that requires ‘systemic safety and soundness’’ with respect to retail customers. But, comingling customers’ funds inappropriately with the firm’s, as former chief, Jon Corzine’s European bets were blowing up, was an abject misinterpretation of the rule's intent.

Aside from that, MF Global lied about funds segregation to its customers, which constitutes fraud. The final page of the firm’s brochure touts “the strict physical separation of clients’ assets from MF Global accounts.”

Separately, MF Global broker-dealer activities were subject to SEC oversight and restrictions on its use of client funds. During any normal investigation, like say for embezzlement, funds should be frozen until issues are resolved. Releasing any bonus pay until this matter is settled is just plain wrong.

The reason for possibly allowing bonuses for MF Global chief operating officer, Bradley I. Abelow, finance chief, Henri J. Steenkamp, and general counsel, Laurie R. Ferber follows the same twisted logic pervading Wall Street: no one else can do the job as well.

These people are apparently so special that despite incompetence, negligence or potential malfeasance in diverting customers’ funds away from their rightful spots, their expertise is critical to the bankruptcy proceeding. In that realm, their ‘job performance’ will help Freeh "maximize value for creditors of the company”. Translation: it will ensure banks like JPM Chase keep their cut, since customers are not creditors. Again, plain wrong.

But forget simple matters of right and wrong for a moment. After all, this is Big Finance: what's most important is not necessarily what’s legal or illegal, but more practically, what you can get away with and what you can’t. In that regard, the sheer impotence of regulators, the Department of Justice, and the FBI are enabling factors in perpetuating financial crimes. 

In early 1933, during the Depression that followed the 1929 Stock market Crash, Democratic president, FDR and Republican Treasury Secretary, William Woodin, declared a bank holiday, during which Treasury Department agents examined banks’ (which included at the time, broker-dealers) books to determine solidity and solvency.

Today, our regulatory bodies are incapable, or simply don’t want to be bothered with, tracing money and returning it to the public customers to whom it belongs. The inability to independently examine MF Global’s books, without its executive involved, reveals the sorry state of our financial system.  In this post-Glass-Steagall-repeal world, the mixing of customer money and speculative betting – whether at a super-market bank or broker-dealer, whether involving subprime loans packages or European Sovereign debt, poses too dangerous a level of complexity. If regulatory bodies can’t, or won’t, diminish the related risk, more concrete Glass-Steagall boundaries throughout the financial framework should be resurrected.

Meanwhile, two senators have taken on the bonus-pay fight. Senator Amy Klobuchar (D., Minn.), member of the Senate Agriculture Committee investigating MF Global, wrote to Freeh that the plan is "unacceptable." Senator Jon Tester (D., Mont.), whose constituency includes a number of farmers with funds in the ‘missing’ category, called it "outrageous.”

On Sunday, Freeh's spokesperson released a statement saying the senators’ concerns were ‘noted’ and a final decision on the bonuses hadn’t been made. But to the extent that the money trails shrouding MF Global’s final moments remain more apparent to its former employees than external examiners, it’s likely the people involved in the wreckage, will be paid extra for sorting thru it. And, that’s an expensive, outrageous, shame.

Jon Corzine, MF Global, and Unaccountability

In April 2007, former New Jersey governor, 'honorable', Jon Corzine had an altercation with a Garden State Parkway guardrail. A year later, he addressed a bevy of reporters at the swanky Drumthwacket mansion and expressed appreciation for “family, friends, and the fragility of life.” During his recovery period, he advocated seatbelt safety, before returning to New Jersey's budget, extracting $500 million in austerity measures from farmers, educators, and environmentalists, and hiking tolls on New Jersey roadways.

On the one-year anniversary of his accident, his chief-of-staff, Bradley I. Abelow declared,  “Corzine has returned to his former self as a thorough and exacting boss.” (Italics mine.)

Fast forward to the current MF Global flameout. Abelow shifted to Corzine’s Chief Operating Officer. And not only did Corzine ratchet up the ante on ways to really piss off farmers, but after several days of engaging in verbal dodge ball with Congress, this ‘thorough and exacting boss’ maintained his Forest Gump type cloak of secrecy regarding the stolen $1.2 billion of his customers’ segregated money.

After days of political-reality TV, we knew nothing more about its evaporation. Corzine and his stewards, Abelow and Chief Financial Officer, Henri Steenkamp, executed a perfect chorus of  ‘I don’t recalls’, ‘I didn’t intends’ and ‘the butler did its’.

For the most part, testimony from the various regulators didn’t shed additional light on the ‘missing’ funds either (everyone’s extremely sorry and deep in search mode) but they did reveal extreme, pass-the-blame incompetence, in the spirit of AIG.

Acronym alert. SEC director, Robert Cook testified that MF Global Holding Company (like AIG) had no official consolidated supervisor regulating it; one of its subsidiaries, MF Global UK Limited, fell under the UK Financial Services Authority (FSA.) The other one, MF Global Inc. (MFGI) was registered under the Commodity Futures Trade Commission (CFTC) as a FCM (futures commission merchant) and also, under the SEC as a broker-dealer. It was the Chicago Board of Options Exchange (CBOE) supposedly overseeing MFGI’s broker-dealer activities, while its futures activities fell under the CFTC, National Futures Association and the Chicago Mercantile Exchange (CME). Somewhere in the mix lurked the private self-regulatory body, the Financial Industry Regulatory Authority (FINRA). Really, how many inept regulatory bodies does it take to screw customers out of $1.2 billion?

But, here’s how we know Corzine was lying – besides the nervous body movements.

During the summer of 2011, the CBOE and FINRA told MF Global Inc. that it didn’t have enough capital behind its repo-to-maturity (RTM) positions in European sovereign bonds – the positions Corzine put on. By mid-August, the SEC got involved and met with Corzine and other MF Globalites. They then had to file a net capital deficiency notice on August 25^th for $150 million.

During  the week of October, 17^th – MF Global Holding had to increase capital again at MFGI - for the same positions. The next week, on October 25^th, it released abysmal quarterly earnings, and got downgraded to almost junk status. The stock plummeted and customers were heading for the hills, the fastest ones getting their money out, others getting locked out. The SEC set up camp at MF Global headquarters in Manhattan on October 27^th to “monitor the situation” and “engage with senior management regarding the steps that were being taken by the firm” regarding possibilities like selling the firm, selling the customer business, or selling the RTM positions.

On Sunday afternoon, October 30, a perspective buyer for MFGI’s customer business emerged: Interactive Brokers (whose judgment I question, so watch out for them). In the wee hours of Monday morning, October 31, – the ‘missing’ funds were detected.  Interactive Brokers balked. Bankruptcy proceedings begun at  9 AM.

The CME’s testimony stated that just past mid-night on October 31,^st Christine Serwinski, the chief financial officer of MF Global's North American division, and Edith O’Brien, a treasurer, told Mike Procajlo, an exchange auditor that about $700 million in customer money was transferred on October 27th, 28th and possibly October 26 from the broker-dealer side of the business to ‘meeting liquidity issues.’ The CME hadn’t noticed this while reviewing the firm’s books prior to bankruptcy. Another $175  million was used by MF Global UK.

The CFTC disclosed that MF Global’s general counsel, Laurie Ferber notified them Monday evening, October 31st about “a significant shortfall in its segregated funds account”.  Neither the SEC, nor the CME had picked up on this beforehand.

As a broker-dealer registered with the SEC, MFGI was not just subject to CFTC rules, but also to the SEC's customer protection rule that prohibits use of customer funds or securities to support proprietary trading or expenses. It also prohibits customer funds or assets from being pledged as collateral for the firm’s own trades or to raise funds, plus requires a reserve account  be maintained that is bigger than their holdings – just in case.

The CFTC has a more lax rule, called Reg 1.25, weakened courtesy of MF Global, JPM Chase, and others that enables segregated customer funds to be used for investing in foreign sovereign bonds (investing – not posting as margin or acting as collateral). But as Janet Tavakoli pointed out in her excellent MF Global analysis; the ‘missing’ customer funds were not in the currency of the foreign sovereign bonds, as per the rule’s stipulation. Plus, none of the required replacement assets were held against those funds. Indeed, there is no element of Reg 1.25, the reg cited as a potential legal loophole by various media, that allows segregated customer funds to be used for risky purposes – like saving a firm from destruction long enough to sell it. Translation – the ‘missing’ funds were stolen against rules, from their rightful segregated customer accounts. Corzine claimed no knowledge of this.

But the reality is - the clock ran out on Corzine’s big bet and customer funds were the only way to keep it ticking until a potential sale of the firm could be confirmed. If the funds hadn’t been switched, the firms seeking margins would have taken losses. The motive was to optically alter the appearance of MF Global and exit, leaving the bag with someone else. You can’t have that clear a motive and no idea of how to achieve it. It’s implausible.

Let me put $1.2 billion into a perspective that the House committees didn’t. According to its second quarter SEC filing, MF Global had $3.7 billion of available liquidity.  The funds were equivalent to a third of that liquidity. That’s not a tiny figure. If you’re running a firm buckling under the weight of the bets you’re losing, you’re damn well aware of your liquidity lines – they are your life raft.

Besides that, MF Global’s net revenue for the second quarter was $206 million and for the six months ending September 30, 2011, it was $520 million. The ‘missing’ customer money was more than twice the firm’s net for the first half of their year.

To recap. Corzine was obsessed with the European sovereign bet. So, he fired his risk officer, Michael Roseman for questioning it,  and replaced him with a yes-man, Michael Stockman whose job description appeared to have included stroking Corzine's – er – ego, and to remain quiet about any trade concerns. He rides the trade through a succession of flailing earnings and intense market volatility, while meeting with regulators questioning its sustainability. He knows he’s got to pony up a chunk of capital in the summer to appease them and stick with it. And when finally, MF Global’s ratings were downgraded on October 25th, a bunch of calls transpire between him and NY Fed head and former Goldmanite, William Dudley before the firm goes bankrupt a week later, with nearly $1.2 billion in customer money ‘missing.’ 

We’re supposed to believe this ‘thorough and exacting’ man knew nothing about where it went? Or that his sense of entitlement and bravado was so big, he didn’t think it was wrong to take that money? Or that he wasn’t aware it was available? At all?

No. Not possible. And yet, over half a dozen regulatory bodies were oblivious to the fund heist. Finding Corzine guilty of a crime would be like asking them to indict themselves. The CFTC Enforcement division can refer criminal matters to the Department of Justice for prosecution. But the DOJ has punted on every Wall Street crime related to the 2008 subprime crisis. So what will probably happen –  is that Corzine may get a little fine from the Washington regulators. Legislators will move on to figuring out how to incorporate MF Global into stump speeches. Those that had their money stolen will battle it out in civil suits for years. And again, no lessons will be learned. No practices altered. No heads will roll.

Another MF Global / Goldman Puzzle Piece: Rule 606: Order Flow

As we await the results of a probe into MF Global and its missing clients’ funds that will no doubt be conducted with the same tactical zeal with which authorities across the country arrested over 4000 Occupy Wall Street protestors it’s interesting to note another component of the MF Global - Goldman Relationship. Beyond the past-leadership of Goldman Sachs by former MF Global head, Jon Corzine, and fact he was brought to the helm by former Goldman buddy, Christopher Flowers, there was also a nice little execution business-sharing going on between the firms. An examination of those transactions, each less than $200,000 , could be illuminating.

Under Rule 606 (formerly SEC Rule 11Ac1-6), as part of its strategy to rely on the companies it is supposed to be regulating to reveal whatever part of their hand they want to, the SEC requires a quarterly report  from brokerage firms on  their order-routing services. Specifically, the report covers ‘non-directed’ orders, or ones that customers haven’t specifically requested go through a particular vendor for execution.  The report has four sections: one each for securities listed on the New York Stock Exchange, The Nasdaq Stock Market, the American Stock Exchange and 'Other' exchange-listed options, and indicates the venues most often selected.

So, according to MFG's third quarter non-directed routing report, guess what vendor showed up prominently? Yep - Goldman Sachs Execution and Clearing LP.

Of course, not all information must be disclosed, and, as MFG notes in its report “statistics capture only a portion of MFG order flow” and “do not create a reliable basis on which to assess whether MFG or any other trading venue has satisfied its duty of best execution. “ But sill.

On the NYSE (the body taken public by former Goldman Sachs co-President, John Thain), the order flow of non-directed customer orders less than $200,000 (or 69.1% of total orders) mostly went through Goldman Sachs Execution and Clearing LP. (SGMA) The entity executed 46.4% of total non-directed orders including 58.4% of limit and 37% of ‘other’ orders.  The rest of the NYSE orders went through the Nasdaq, Knight Direct and NYSE ARCA.

On the Amex, non-directed orders of $200,000 or less comprised 23.24% of all orders, of which 31% went through Goldman, including 29.5% limit and 32.2% ‘other’ orders.

Of the orders that went thought the Nasdaq, 94.8% were under $200,000. Of those, 70.4% limit and 40.3% other, went directly through the Nasdaq. Goldman executed 12.1% of the limit, and 8.1% of the other orders.

The reports, as per the SEC being useless, don’t include the trade volume represented by these percentages, yet, for the most part, when MF Global didn’t execute directly its non-directed client orders through an exchange, it used Goldman. There may be some interesting – and co-mingled – 'missing' transactions that slipped in there. Just saying.