Thursday, November 3, 2011

A collapse in spite of regulators

For the last couple of years, financial regulators have been telling anyone who would listen that they have learned their lessons from the 2007 crisis.

The collapse of MF Global put this learning to the test.

The regulators declared that they received a high passing grade because MF Global failed without requiring a bailout and this failure did not bring the global financial system down with it.

Your humble blogger doesn't think a high passing grade is merited because in all likelihood the collapse of MF Global was preventable.  

Yes, it is a good thing that MF Global could fail without triggering a global financial crisis.  To use a Warren Buffett idiom, the regulators are seeing where the arrow lands and then drawing a bull's eye around it.

By drawing the bull's eye around where the arrow lands, the financial regulators fail to acknowledge that it would have been far, far better if MF Global had been subjected to market discipline that had prevented the failure in the first place.  

Would the market discipline of increasing the cost of funding and driving down the share price as MF Global's European debt exposure increased have stopped Mr. Corzine from buying more?  Yes. 

It might not have stopped him from purchasing the first $1 billion of exposure.  But the ongoing drop in the stock price and the jump in the cost of funding as he purchased more European sovereign debt would have forced the board of directors and the financial regulators to order him to stop buying more.

As it was, without the market exerting its unique brand of discipline that boards of directors are highly sensitive to, even though the regulators saw there was a problem, they were unable to prevent MF Global's failure.

An article in the NY Times Dealbook discusses this.
While the commodities and derivatives brokerage firm fell apart with ferocious speed, the collapse came after regulators raised warning flags for more than four months. They told MF Global it needed to raise more capital, and they asked about risky transactions involving European debt. 
Yet Mr. Corzine resisted, lobbying to persuade regulators that the firm did not need to raise capital, according to people briefed on the discussions. MF Global did improve its capital position, but it was not enough to save the firm.
This is why regulators need market participants, particularly investors, to provide their version of market discipline.  It is much harder to lobby investors not to increase the cost of your debt when they can see that the risk of your firm is increasing.  It is much harder to lobby investors not to hammer your stock price by using a higher discount rate when they can see the risk of your firm is increasing.
The details that have emerged about MF Global’s final 72 hours ... illustrate that three years after the financial crisis, Wall Street executives are still fighting regulators’ demands.
It also shows that even when the watchdogs sound the alarm, it is not necessarily enough to save a firm....
One of the first signs of trouble for MF Global came in June, when regulators reviewed its recent financial statements, according to a person with direct knowledge of the matter. In a footnote, MF Global disclosed that it had bought debt from Italy, Ireland and other troubled European nations. 
The standard for disclosure has to be all the useful, relevant information in an appropriate, timely manner.

A footnote well after the positions are purchased is not timely.

A footnote also does not suggest the MF Global disclosed all the useful, relevant information like exactly how much of each bond issued by each country it owned.

A footnote suggests a manageable level of exposure as oppose to having bet the firm. 
The disclosure alarmed the Financial Industry Regulatory Authority, Wall Street’s self-regulator, which worried that MF Global lacked enough capital to support the trades. 
Finra called MF Global, pushing it to raise its capital levels, but Mr. Corzine fought back, according to the person with knowledge of the matter. 
Frustrated, Mr. Corzine decided to go over Finra’s head to the Securities and Exchange Commission, the person said. In July, Mr. Corzine traveled to Washington to state his case to S.E.C. officials at their offices near Union Station in Washington. Mr. Corzine chalked up their concerns to undue jitters over Europe’s ballooning debt crisis, the person said. 
The S.E.C. and Finra wouldn’t bend, and in August, the firm increased its capital cushion....
The move offered only short-term relief. By mid-October, MF Global’s European gamble was being widely discussed on a nervous Wall Street. 
You can easily imagine the nervousness in the absence of the detailed information needed to assess the situation and the risk that MF Global was taking.
Rumors spread that Moody’s Investors Service was considering a cut to MF Global’s credit rating. Finra resumed regular talks with the firm, questioning whether anxious customers, investors and trading partners would drain the firm’s liquidity. 
Late on Oct. 24, Moody’s did move to cut its rating on the firm, to just one notch above junk status, citing in part the European bond holdings. 
That proved to be a watershed moment: the downgrade led MF Global’s trading partners to demand extra collateral, draining the firm’s cash supply. 
Under mounting pressure from Washington and Wall Street, MF Global moved up its scheduled quarterly earnings announcement by two days, reporting on Oct. 25 that it had recorded a $186 million loss, its fourth loss in six quarters. The share price of MF Global went into free fall, tumbling 67 percent over the course of that week. The firm also started drawing on its credit lines. 

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