If you were stranded on a desert island the past two months and upon your return to civilization tried to learn why MF Global Holdings Ltd. had collapsed, you might find that some of the standard explanations don’t make much sense.
One scenario is that a catastrophic bet on some European government bonds killed the commodities and derivatives broker. Another story line has it that investors were slow to realize MF had made such a big leveraged wager, and their concerns evolved into fear, leading to a run on the firm.
Neither version of events is satisfactory. None of the bonds went into default. The sovereign-debt trades were profitable, by all official accounts, even as the company filed for bankruptcy six weeks ago. MF disclosed the stakes as far back as May, though perhaps it should have done so sooner and with more detail. Investors usually don’t panic over losses that haven’t happened, on trades that are a matter of public record.
What caused investors to lose confidence in MF in late October? There’s a simple, sensible explanation. Six days before it filed for bankruptcy, MF reported a large quarterly loss, the details of which contained a message: Don’t expect this company ever to be profitable again. The markets responded accordingly.
MF’s main business was executing and clearing trades for clients. The company was a dinosaur. It still took most of its orders over the phone, long after the industry had shifted to electronic trading. Not surprisingly, MF reported net losses for each of the past four fiscal years. Its $186.6 million loss last quarter was its biggest.
Most of the quarter’s red ink came from writing down something called deferred-tax assets. Basically this item represented the money MF had thought it would save on taxes in the future, assuming it would be profitable. Net deferred taxes stood at $108.3 million as of March 31, according to MF’s 2011 annual report, which was the last time the company provided a detailed tax footnote.
MF wrote down that figure entirely last quarter. In essence, MF’s executives were admitting they couldn’t figure out how to make money.
There couldn’t have been a more ominous warning, especially coming from a brokerage firm that depended on public confidence for its survival. The market seems to have understood this. Over the past decade, Delta Air Lines Inc., Bethlehem Steel Corp. and General Motors Co., to name a few, all took big charges against earnings to write down the value of deferred-tax assets -- shortly before filing for bankruptcy. The day MF released its quarterly results, its stock fell 48 percent to $1.86.
The core business’s troubles help explain why Jon Corzine, who became MF’s chief executive last year, made the big bet he did. Unable to figure out how to make money, he took more risk. The sovereign-debt wager was a symptom of the bigger problem.
Moody’s Investors Service made a similar point when it cut MF’s credit rating to junk on Oct. 27. “The downgrade reflects our view that MF Global’s weak core profitability contributed to it taking on substantial risk in the form of its exposure to European sovereign debt in peripheral countries,” Moody’s said.
The downgrade, which was the second by Moody’s that week, helped accelerate MF’s downfall. Some customers and trading partners pulled their business. Others demanded greater collateral. The run had started. MF tried to sell itself, but the company that came closest to buying it backed out after learning that a lot of customer money was missing. MF filed for bankruptcy on Oct. 31.
Balance Sheet Outrage
The point isn’t to defend Corzine’s sovereign-debt trade. MF risked $6.3 billion -- more than four times its shareholder equity -- on government debt issued by Portugal, Spain, Ireland, Italy and Belgium. The way MF structured the deals, neither the bonds nor the loans it used to buy them had to appear on the company’s balance sheet. That this complied with the Financial Accounting Standards Board’s rules is an outrage in its own right. The accounting treatment masked the company’s leverage.
Still, investors didn’t seem terribly bothered after MF disclosed on Sept. 1 that the Financial Industry Regulatory Authority had told it to raise more capital because of the transactions. By then, MF already had complied with the order. It wasn’t until Oct. 25 that MF’s stock fell off a cliff, after the company disclosed its outsized quarterly loss.
The scandal here isn’t that MF died. It had been dying for years. By writing down its deferred taxes, MF telegraphed that it was on its last legs. This much Corzine got right before he resigned last month, although MF executives arguably should have written down the assets sooner, just as the credit raters probably should have been quicker to slash MF to junk.
The real crime is that $1.2 billion or more of MF customers’ money has gone missing. Corzine says he doesn’t know how, as have MF’s remaining top executives. They have given no good reason why anyone should believe them.
Asked during his congressional testimony last week whether he authorized the transfer of customer funds from their segregated accounts, the former New Jersey governor replied under oath: “I never intended to break any rules.”
Note that he never answered the question. If the feds can’t find a bunch of people to arrest over this heist, they’re no better than Corzine.
(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)
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