Sunday, December 18, 2011

The incompetent and unscrupulous: Confidence in the age of MF Global

Those who are incompetent require our correction. The incompetent need to know how to succeed. Maybe this takes education. Maybe it takes better judgement. Maybe it takes a thoroughgoing review of their errors. While the incompetent may elicit our scorn, they do not merit our moral indignation.

That is reserved for the unscrupulous. The unscrupulous are sometimes incompetent. But often they are quite competent at taking our money under false pretenses.

What the recent MF Global bankruptcy--the eighth largest in U.S. history--tells us is that the world's financial system may be moving headlong into a collision of incompetence with unscrupulousness. (Full disclosure: I had a small account with MF Global and so have had a ringside seat, so to speak, in the bankruptcy proceedings.) I do not mean to say that before now there was no unscrupulous behavior in the financial system. What I mean to say is that it does not matter how competent someone believes a firm is at investing or handling money; if the firm is perceived as dishonest, that's it!

So far the revival of stock and commodity markets around the globe via enormously stimulative budget and monetary policy has assured most people with invested money that the authorities are, in fact, competent to manage downturns, even severe ones. Markets may not be back to their previous highs, but they are a far cry from the devastation of late 2008 and early 2009.

Now the competence of those authorities is being questioned as Europe appears mired in a long battle to save the euro as the currency of its 17-country Eurozone. The question is: Should the average investor--the buy-and-hold investor--stick it out once more and trust in the authorities to make things all better? That is a monumental question.

But soon that question will be competing with an even uglier one? Can I count on the institutions which hold my money and investments--primarily brokerages and banks--to deal honestly and fairly with me? Can I count of them not to steal my money?

As the questions of competence and trust converge, the financial system seems increasingly imperilled. If authorities do everything right, but investors believe they can no longer trust their brokers and banks not to steal their assets, the competence of the authorities in monetary and fiscal policy will simply not matter. And, if investors should simultaneously lose faith in the ability of authorities to handle the roiling financial crisis in Europe and lose trust in their brokers and banks to safeguard their money, we should be prepared for a wipeout that will make 2008 look like a day in the park.

This is the scenario lurking behind the MF Global collapse. Clearly, MF Global was incompetent at managing its risks including the risk that its lenders such as banks and hedge funds would withdraw funding for its positions. (Firms such as MF Global borrow money short-term to buy long-term assets and profit from the difference between the interest payments on short-term funding and the stream of revenues from long-term assets. The short-term funding must be periodically renewed. If this seems risky, it is.) The lenders stopped lending not necessarily because they believed MF Global to be unscrupulous, but because they believed the firm was no longer competent to manage the risks associated with its portfolio of highly leveraged investments. Fearing losses on their loans, they didn't roll over their financing.

Then came act two. MF Global misappropriated protected customer funds to support its precarious positions, especially those in European government bonds which seemed increasingly dicey this fall. Perhaps the firm felt it would be able to pay customers back once the fuss died down, and no one would be the wiser. But the fact that MF Global managers carefully covered their tracks in making the transfers tells us what we need to know. They believed what they were doing was illegal.

Here is the problem that regulators face. Prior to the MF Global collapse they had been able to say that no holder of a regulated futures account had ever suffered a loss of deposits (collateral or cash). Naturally, people lose money on futures positions every day. But that's a far cry from having money which has been deposited to support those positions simply stolen. That makes it impossible to collect money even if you win your bets, since the money that is supposed to be transferred to you from the people on the losing side of the trade just isn't there.

Futures accounts are not insured for such losses for the simple reason that the regulators wisely decreed that customer money and firm money have to be separated, and customer money simply cannot be used for the firm's own trading without customer consent. There was no consent, and there would have had to have been collateral posted or contractual obligations agreed to had there been any consent.

Worse still, the CME Group, owner of many U.S. futures exchanges, was the auditor for MF Global and thereby responsible for making sure customer money was properly segregated and actually in the right accounts every day. One would think that the owner of the exchanges would have a special interest in making sure one of the world's largest futures brokerages--with which the exchanges do business every day in huge volume--is handling customer money properly.

The result of the CME's poor supervision was a huge seize-up in futures trading as a significant portion of the world's largest players in the futures markets found their money frozen, waiting for someone to sort out the mess. Nearly six weeks after the collapse customers are only now getting a portion of their cash back, around two-thirds of it. The rest will have to wait for a claims process, and there is currently no guarantee that the remaining third will be paid back.

Now, if you are a futures trader and especially if you trade on behalf of clients, would you want to continue to trust the current U.S. regulatory system to safeguard your money? Why not go to say, Canada, where regulators appear to take their jobs more seriously and trade there? After all, Canadian customers of MF Global didn't lose a penny.

That's what the domestic futures exchanges and brokerage firms are facing. A gradual and perhaps persistent loss of business to someplace where traders feel assured about the safety of their funds. And, many small traders are simply giving up trading futures at all, believing the regulatory authorities are incompetent and the brokerages too crooked to deal with.

Now, I'm imagining such an outlook migrating to people holding stocks, bonds, and mutual funds at brokerages and mutual fund companies. I'm even imagining that outlook infecting regular checking and savings account holders at banks. It may already be happening in Europe in countries such as Italy and Greece where wealthy people seem to be shifting their money to safer banks in Germany or even outside of the Eurozone altogether.

These types of fears have a way of taking on a life of their own and spreading all of a sudden across the globe. I've mentioned before that Nicole Foss, writer for the financial commentary site The Automatic Earth, has said that liquidity and confidence are the same thing. If I lose confidence that my investments and cash in brokerage accounts and bank accounts are safe for whatever reason, then I will sell my holdings and withdraw my funds moving them to where I think they will be safe. If enough people do this, liquidity dries up as everyone heads for the exits at the same time. There are not nearly enough buyers to handle the sell orders in various markets. And, if people withdraw money from banks, the banks must quickly find some other source of liquidity than customer deposits. Such liquidity problems are already appearing at banks in Europe. And through it all, it will not matter whether investor fears are actually justified.

As the prosecutions of financial malfeasance rise, as the revelations of double dealing and outright theft abound, as the ability of European, American and Asian authorities to calm markets is eroded, the intersection of incompetence and unscrupulousness is poised to fling the global financial system into the dark unknown. These kinds of complete meltdowns have occurred in individual countries with disastrous results; Argentina comes to mind. But a grand failure of this sort on a global scale was only really hinted at in 2008. That's how bad it could be next time.

No comments: