Thursday, November 17, 2011

More Details Emerge About MF Global Debacle

New details continue to emerge about the conditions that set in motion the collapse and bankruptcy of MF Global. It turns out that one of the items that led to the financial firm going bankrupt was a change in the rule done in December 2000 that allowed these kinds of firms to expand where they could invest their own money.
Before 2000, the rule permitted futures brokers to take money from their customers' accounts and invest it in a number of approved securities limited to "obligations of the United States and obligations fully guaranteed as to principal and interest by the United States [U.S. government securities], and general obligations of any State or of any political subdivision thereof [municipal securities.]" That is, relatively safe securities with high liquidity.

The banks, however, pushed the CFTC to expand the investment options that would allow firms to practice "internal repo." In this scheme, money is taken from customer accounts and invested short-term in a variety of securities, with the futures brokers reaping the not-insignificant financial rewards from their customers' money.

And, lo and behold, such efforts were successful. In December 2000, the CFTC agreed to amend Regulation 1.25 "to permit investments in general obligations issued by any enterprise sponsored by the United States, bank certificates of deposit, commercial paper, corporate notes, general obligations of a sovereign nation, and interests in money market mutual funds" — in other words, riskier investments that could make more money for Wall Street.

Then, in February 2004 and May 2005, Regulation 1.25 was further amended and refined to the liking of Ferber and the banks. In the end, the door was opened for firms such as MF Global to do internal repos of customers' deposits and invest the funds in the "general obligations of a sovereign nation."

This practice, of course, may well be the centerpiece of the MF Global disaster. We now know that Corzine — who was CEO of Goldman Sachs from 1994 to 1999 — bet $6.3 billion on the distressed long-term bonds of countries such as Italy and Spain, although it's unclear if clients' funds were used. Bart Chilton, a CFTC commissioner, told Bloomberg News on Nov. 10 that the loss to customers' accounts may have resulted from a "massive hide-and-seek ploy."
Time to turn back the clock on those regulations and reinstate them to the pre-2000 rule, which not only protected the customer accounts, but limited the bank/financial firm exposures to sovereign debt crises.

The push for ever greater profits from the banks blinded them to the downside and banks thought that the US government would backstop them (and for a chosen few, they were right). But that's the wrong tact for the banking/financial industry to take. There's plenty of money to be made without pushing into financial instruments that could potentially take down entire firms and destabilize the economy because of how entangled firms are with sovereign debt of foreign nations and unstable economic conditions. The pre-2000 rules made plenty of sense, and the reason they were changed was an attempt to maximize profit all while ignoring the downside risks.

Those downside risks are now being realized and it's time to reestablish the old rule.

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