The Downfall of MF Global: Implications for Banks Too Big To Fail

Here is an alphabet-soup of regulatory agencies that let MF Global, a financial services company that specialized in futures-trading, engage in much, too much, risk: SEC, CME, CFTC and FINRA. On one level, regulators will never be able to stop practitioners from making risky or simply bad decisions; a business system populated only by firms above average is by definition impossible. As long as their managers have any freedom of movement at all, some firms, including some in the financial sector, will inevitably fail. The question I want to pose is whether this means that firms too big to fail (TBTF) should be allowed to exist at all. In short, although MF Global itself was not TBTF, the risk Corzine (who had been chairman of Goldman Sachs) permitted suggests that human nature might be insufficiently disposed to support mammoth concentrations of private capital whose fall could mean the collapse of the financial system itself. Ultimately, I suppose, human nature can only go so far, organizationally speaking.

MF Global admitted to $630 million in missing customer funds. Although accounting errors and bank-cushions could account for the discrepancy, MF Global used customer funds to loan itself money. To be able to do so, the former U.S. Senator and Governor of New Jersey, Jon Corzine, met personally as head of MF Global with federal regulators to get them to relax their proposed rule that would have forbid such a loan. According to the New York Times, financing by borrowing customer funds is not unheard of on Wall Street, but is “carries substantial risk.”

Corzine’s influence with the regulatory agencies may have been similar to the role that Madoff’s status played in his dealings with the SEC. It would seem that regulators are readily “captured” by high status alone—never mind relying on the regulated firms for information and possibly even being influenced by political contributions via elected officials acting on the behalf of big donors. Given the riskiness in borrowing customer funds without the traditional banking oversight of lending, the regulatory “status lapse” syndrome is dangerous—particularly if a firm TBTF is involved. In other words, might we be rolling the dice in Dodd Frank by relying so much on regulators? The possible mix of duplicity and risky multi-billion dollar bets at MF Global should drive home this point.

People at an exchange that cleared trades for MF Global have indicated that Corzine’s firm might have moved money out of customer accounts “in a manner . . . designed to avoid detection” as the firm headed toward collapse. CME Group, the parent company of the Chicago and New York Mercantile Exchanges, indicated that it appears that MF Global dipped into customer accounts after CME finished an onsite review of the securities firm during the last week of October, 2011. The CME statement read in part, “It now appears that the firm made subsequent transfers of customer segregated funds in a manner that may have been designed to avoid detection insofar as MF Global did not disclose or report such transfers to the [Commodity Futures Trading Commission] or CME until early morning on Monday, October 31, 2011.” CME served as a clearing house for trades that were made through MF Global, according to the Wall Street Journal.

Meanwhile, questions regarding MF Global’s $6.3 billion bet on E.U. state debt and the scrutiny by regulators were mounting, according to the Journal. That any bet would be for such a sum ought to raise a red flag for the firm making the bet. Although MF Global was not TBTF, the managers’ willingness to take on such risk suggests that the mentality to take on extraordinary risk carries on in the financial industry. This finding may render the very existence of financial firms deemed too big to fail as something we might want to revisit through legislation. In other words, if bets worth billions of dollars on European government debt were going on through the E.U. debt crisis, the risk alone (to say nothing of the utter stupidity) may suggest that financial-sector firms that are too big to fail are also too big to exist—especially if regulatory scrutiny is insufficient. The risk and the numbers may have reached a dangerous level, given how human nature treats risk (and the limits of human cognition).

Paul Volcker admitted on Charlie Rose in late October 2011 that he never thought he would talk in terms of trillions of dollars, but there it is, that day had arrived and with it, the horrendous risk of banks being too big to fail. Whereas Citigroup had $1.63 trillion in total assets at the end of June 2006, the bank had $1.94 trillion at the end of the third quarter 2011. Comparable figures for Bank of America are $1.45 trillion and $2.22 trillion. JP Morgan Chase: $1.33 trillion and $2.29 trillion. Wells Fargo: $500 billion and $1.3 trillion. Where is the lesson on TBTF from September 2008? It is as if the credit crisis and fall of Lehman Brothers had not happened. Thomas Hoenig, former Kansas City Fed chairman, said in a speech in February 2011, “We must break up the largest banks.” He said the government could do so by restricting the activities of government-backed banks “and significantly narrowing the scope of institutions that are now more powerful and more of a threat to our capitalist system than prior to the crisis.” According to the Wall Street Journal, regulators “can ultimately force a firm to sell off parts of itself if they don’t believe a firm could be wound down without threatening others.” Although Hoenig said he is not against BIG, just too big to fail, so it is possible that the biggest banks could show that “they are manageable, that their risk will not impact the taxpayer in the future,” I contend that the mere existence of concentrations of $1.94, $2.22, $2.29 and $1.3 trillion is inherently dangerous to the financial system and the greater economy. If even one of those should go under all at once, assuming losses are involved, investors, business managers, bankers and even consumers would surely hear a subtle fiscal “thud” and react aversely, even if in a self-fulfilling prophesy. If Wall Street bankers did not learn a lesson from September 2008, however, that “thud” could be far more than psychological. The example of MF Global may suggest that the bankers on Wall Street did indeed continue on in being all too willing to make risky multi-billion-dollar bets, having “slept through” the shrieking “wake-up call” of the financial crisis of 2008. The resumption of the extravagant bonus culture strongly suggests that the bankers still had an incentive to bet big with little regard for risk.

Treating the mega bank as too big to exist as a mega bank does not depend on regulatory scrutiny, which can be subject to the “status syndrome”; rather, once a firm hits the pre-established threshold, the regulators would simply come in and orderly “smash the atom” such that smaller firms result (with different owners, managers and employees—unlike the case of the companies coming out of Standard Oil, which had the same ownership and whose executives were even allowed to continue working in the same building!).

I think perhaps we presume too much regarding human nature, given the edifices we build ever higher and higher, as if in testament to the self-idolatry of our presumption that we cannot be wrong. Lest we come too close to the sun and turn our cities into deserts, we might want to fly our chariots a bit closer to the ground.

                                                

Sources:

Jean Eaglesham, Aaron Luchetti, and Jacob Bunge, “Regulators Enter the MF Fray,” The Wall Street Journal, November 3, 2011. 

Azam Ahmed and Ben Protess, “As Regulators Pressed Changes, Corzine Pushed Back, and Won,” The New York Times, November 4, 2011. 

Victoria McGrane, “Banks’ Critic Poised to Be Head of FDIC,” The Wall Street Journal, November 18, 2011. 

Institutional Conflicts of Interest: Business and Public Policy

Typically people react emotionally much more severely to an exploited conflict of interest when a person gains a personal benefit such as through a bribe. If company, or even an office or department thereof, stands to benefit inordinately, American society typically looks the other way on the institutional conflict of interest rather than taking it apart. This may just be human nature. However, the troubling institutional arrangements within an organization or between them may be tolerated because of the erroneous assumption that conflicts of interest are unethical only when they are exploited. Accordingly, the book provides a solid grasp of the structure and essence of the conflict of interest in order to make the case that it is inherently unethical. Examples of institutional conflicts of interest readily come from business, with particular attention to corporate governance and the financial sector, as well as from how business and government relate, such as through regulation The reader should come away with a sense of just how pervasive and ethically problematic institutional conflict of interests are. 

The book, Institutional Conflicts of Interest: Business and Public Policy, is available in print and as an ebook at Amazon.com

American Consumers Using Gas-Savings to Reduce Debt: Frugality or Responsibility?

The steep drop in the price of oil in July 2015 was a concern for traders. Drillers and other energy companies comprise a significant portion of the S&P 500 index. “The upside to falling oil is that all the money that drivers are saving at the gas pump should mean more spending by them at stores — and a faster-growing U.S. economy. But Americans are choosing to pay off debt instead of going shopping.”[1] Is this a bad thing? In reckoning it as such, Wall Street analysts are missing the big picture, even financially.

Gasoline at a station in January 2015. (ABC News)

To go on a shopping spree when in significant consumer debt is, I submit, foolish and perhaps even reckless. The mentality erroneously treats debt as permanent rather than something to be paid back. In this respect, the U.S. Government has been a terrible role model, as Bill Clinton dedicated only half of the surpluses in the late 1990s to paying down the debt. After his presidency, the wars and occupations in Iraq and Afghanistan added more than $4 trillion to the government’s debt.

To urge consumers in debt to spend what they save on gas implies the same mentality. Tim Courtney at Exencial Wealth Advisors, for example, says "Household finances are growing more healthy ... but you want to see a pick-up in spending, too."[2] I submit that such additional spending at the expense of reducing debt is detrimental to a person’s financial position. Not only is the debt not reduced, but also the habit of spending while ignoring the debt is reinforced. Consumers regaining their pre-debt position is good for Wall Street, moreover, because the financially solid position puts the consumers in a better position to spend beyond the short term.

Even so, using discretionary income to reduce household debt is said to be frugality. The following passage from The Associated Press is a case in point, and even makes explicit the interests behind the perspective. “The new frugality helps explain why the biggest long-term driver of stock prices — corporate earnings — have been so disappointing lately. In the second quarter [of 2015], companies in the S&P 500 grew earnings per share just 0.07 percent from a year ago, according to research firm S&P Capital IQ.”[3] That which is behind disappointment can be expected to be treated harshly rhetorically. Hence, responsible efforts to reduce debt is “frugality,” which has the negative connotation of cheapness.

I submit that debtless consumers are worth more societally than are continuously increasing corporate earnings (and consumer debt). The Associated Press could have reported that consumers were being responsible while over-reaching corporate expectations were taking a hit. How the media decide to report a story does indeed have an impact not only on consumers and company managers, but also the society as a whole—even in how it votes. In the case of the U.S., especially relative to the E.U., business interests can be said to have a disproportionate influence societally.

---

[1] Bernard Condon and Ken Sweet, “Why Stocks Are Tumbling 6 Years into the Bull Market,” The Associated Press, August 23, 2015.

[2] Ibid.

[3] Ibid.

Credit-Card Companies in a Conflict of Interest

On April 12, 2012, Hawaii sued Bank of America, Chase, Citi, Barclays, Capital One, Discover, HSBC, and their subsidiaries, “claiming that the banks ‘slammed’ Hawaii credit card customers, charging them for products customers didn't need and that the companies never provided.”[1] The Hawaiian government alleges that the banks used “‘predatory tactics to sign up customers for services they either don’t want or don't qualify for,’ and the companies charged their customers ‘without their knowledge or consent,’ according to a press release issued by the Hawaii attorney general's office.”[2] According to the Attorney General, David Louie, “You don't know that you're enrolling, but they say, 'Oh you just enrolled,' okay, and now they've put a charge on your credit card.”[3]  The banks’ telemarketing departments may have charged customers an average of $150 in the form of small charges.

The full essay is at Institutional Conflicts of Interest, available in print and as an ebook at Amazon.

1. Bonnie Kavoussi, “Hawaii Sues Bank of America, Chase, Citi, Others For DeceptiveCredit Card Marketing,” The Huffington Post, April 13, 2012.

2. Ibid.

3. Ibid.

Refinancing Mortgages: Only for the Rich?

According to the U.S. Government, prices of homes with government-backed mortgages fell 5.9% in the second quarter of 2011 from a year earlier. This was the biggest decline since 2009, which was on the heels of the credit crisis of late 2008. In 2011, more than one in five homeowners with mortgages owed more than their homes are worth. That translates to at least 10.9 million families, almost none of whom could refinance. While the Treasury Department and Federal Reserve were able to pump hundreds of billions of dollars into American banks, federal programs to assist homeowners had been regarded as ineffective.. [1] Out of the $45.6 billion in TARP funds (the total being $800 billion) set aside to help struggling homeowners, only $22.9 billion had been spent by August 2011. Fewer than 1.7 million loans had been modified under federal programs as of 2011. Just over 760,000 permanent mortgage modifications had been initiated under the government programs while at least 5.5 million mortgages were in delinquency or foreclosure. Andrea Risotto, a spokesperson at Treasury, said that the unused portion of the TARP funds for homeowners would be used to reduce the deficit.[2]

So it is perhaps not a surprise that even though mortgage interest rates were around 4%, the Obama administration was hedging in 2011 on whether to direct Fannie and Freddie to allow the existing mortgages guaranteed by those agencies to be refinanced. David Wessel observed that whereas taxpayers bore all the downsides of nationalizing the two housing guarantors, the two firms and their regulators consistently resisted helping taxpayers over their heads on their mortgages.[3]

Even though the mortgage servicers and banks had been at the very least complicit in the liar’s loans of many of the sub-prime mortgages, the Obama administration was not sure even as late as mid 2011 whether homeowners behind in their payments should be able to refinance. According to the New York Times, despite “record low interest rates, many homeowners have been unable to refinance their loans either because they owe more than their houses are now worth or because their credit is tarnished.” Yet it was “unclear . . . whether people who are delinquent on their mortgages would be eligible or whether lenders would administer it.”[4] So it would appear that only homeowners who don’t need the refinancing will be able to get it.

The priorities showing through both with TARP and the refinancing ideas being floated in 2011 may have reflected the anti-borrower bias Countrywide and other mortgage originators, whose meagerly educated sales force and managers believed that the struggling sub-prime borrowers were lazy and dishonest idiots who do not deserve a break from the “sacred contracts” (even if constructed as a liar’s loan—meaning a lender lying about the borrower’s income to secure a double commission).[5] 

In other words, the imbalance concerning the treatment of the banks and the borrowers by the U.S. Government is consistent with the bankers’ selective attention to culpability. Most likely, the sub-prime crisis had multiple contributing sources. Were the government’s responses to reflect this, both the financial institutions and the borrowers would be given some leeway so as to obviate a collapse of the entire economy. Both the major banks and the struggling homeowners would be attended to because the crisis was larger than any one of them. For the government’s priorities to reflect one of them suggests disproportionate influence, which ultimately is detrimental to the republic itself.

1. Shaila Dewan and Louise Story, “U.S. May Back Refinance Plan for Mortgages,” the New York Times, August 25, 2011. 
2. Ibid.
4. Ibid.

5. David Wessel, “Tracking Missteps Behind World’s Economic Slump,” Wall Street Journal, August 25, 2011. 
3. Ibid.

Jamie Dimon of JPMorganChase Exploits an Institutional Conflict of Interest

U.S. Treasury Secretary, Tim Geithner, said on July 18, 2011 that he was not concerned about dire warnings from Jamie Dimon, CEO of JP Morgan Chase, a bank that was too big to fail and thus evinced systemic risk. Jamie Dimon, CEO of JPMorgan Chase, said the government regulations may have been suffocating the economic recovery. While it was nice of Jamie Dimon to be so civic-minded as to want to protect the recovery, his real objective was likely to increase his bank’s profitability through relaxed financial regulations in the U.S. If so, his ulterior motive was not in line with the economy overall, much less with society and the common good.

The full essay is at Institutional Conflicts of Interest, available in print and as an ebook at Amazon.

Voluntary Greek-Debt Maturity Extensions: A Rush for the Exits?

As the E.U. was working out more loans for Greece in summer 2011, rating agencies looking at the state’s debt indicated that default would be pronounced should the decision of bond-holders to continue to hold Greek bonds be anything less than voluntary. Germany had been pushing for something less than voluntary so taxpayers would not have to bear so much of the risk and cost. France, doing the bidding of its banks, effectively used the rating agencies’ default-guidelines to insist that additional E.U. loans do not require then-current bond-holders to agree to later maturities. Given the extent of Greece’s debt-load relative to the state’s GDP, a private sector bond-holder, such as a bank, would naturally loose little time in getting out of holding Greek debt, even given the high interest rates (which reflect the risk).  

The full essay is at "Essays on the E.U. Political Economy," available at Amazon.

Long Term Capital Management: An Institutional Conflict of Interest

By 1997, “after three years of strong profits for LTCM, the opportunities were drying up. There was too much money chasing the same investments. . . . In early 1998, LTMC decided to give a large portion of its capital back to its original investors because profitable opportunities were so hard to find. At the end of 1997, LTCM had nearly $7.5 billion under management, compared to $1 billion when it started, and it now returned $2.7 billion of that to investors. The partners also figured that they could, if necessary, simply leverage their portfolio further to compensate for the loss of capital, which would compound their personal gains. Greed was at the heart of what turned out to be a disastrous decision. . . . Unable to reproduce the returns of the first three years, LTCM took increasingly more risk, abandoning its purer arbitrage for the kinds of ‘directional’ investments Soros made and LTCM had so long disdained—such as trying to forecast interest rate and currency movements. More and more of these trades were unhedged.”[1] Furthermore, “LTCM’s risk models—VAR and related statistical tools . . . –were misleading.”[2] For example, diversification was little protection if there was a run on the banks. When Russia defaulted on August 17, 1997, LTCM’s hedges against its Russian investments were worthless. Furthermore, because all fixed income assets fell sharply in value, “diversification, it turned out, did not matter. The finely calculated relationships on which LTCM was built and which the firm always believed would hold started to come apart. VAR could  not account for such an unlikely but sweeping event—an event in which everyone wanted out at the same time and almost all investments fell significantly in price. The use of VAR itself precipitated much of the selling. Commercial banks under the jurisdiction of the Basel Agreements, which . . . set capital requirements based on the level of VAR (the lower the VAR, the lower the capital required), were forced to sell assets to raise capital.”[3] LTCM lost $1.9 billion that August. Eventually, fourteen banks, organized by the Fed, put together loans of more than $3.5 billion to purchase 90 percent of the firm.” LTCM “did manage to sell down assets in an orderly fashion and by early 2000 it was essentially out of business”[4] 


The full essay is at Institutional Conflicts of Interest, available in print and as an ebook at Amazon.

1. Jeff Madrick, Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present (New York: Alfred A. Knoff, 2011), 277-81.

2. Ibid.

3. Ibid.

4. Ibid.

British Banking Regulation in the E.U.

Before the financial crisis of 2008, the British government was light on banking regulation compared to other E.U. state governments. Oddly, some Europeans imagined an “Anglo-American” connection or likeness, as the American states had been on a deregulation kick since Carter’s airline and thrift deregulatory laws in the late 1970s. Reagan and the second Bush in particular extenuated the movement, which applied to the entire U.S. common market. After the crisis, however, even as Republicans in the U.S. House of Representatives, which is commensurate to the E.U. Parliament, were still voicing support for still more deregulation as though 2008 had not happened, the regulatory tussle in the E.U. reflected the greater involvement of the state governments (i.e., the stronger federalism than the lop-sided variety in the U.S.), with the British government in particular pushing for stronger banking regulation—if not at the E.U. level, then in the state of Britain. “British officials are waging an increasingly aggressive fight to impose banking regulations as they see fit, even if they go further than rules elsewhere in the European Union,” according to The Wall Street Journal. From this quote, we can unpack two distinct though interrelating strains: a desire for tougher banking regulation and an anti-federalism wherein the state governments of the E.U. can go beyond the federal government in terms of the regulation. Both of these points are significant.

The complete essay is at Essays on Two Federal Empires.

Corporate Analogies: Money-Making as War-Games as a Sign of Boredom

What to do when analogies go over the top. As an aspiring writer, I was chastised by more than one writing tutor for mixing analogies. The device can add color to otherwise drab prose to be sure, but too many colors at once can be daunting to even a captivated reader. Consider, for example, the following passage from Larry McDonald about the management at Lehman Brothers:

“In a way, Lehman was run by a junta of platoon officers . . . I think of them as battle-hardened, iron-souled regulars”[1] (p. 89). Richard Fuld, Lehman Brothers’ former CEO, was “our spiritual leader and battlefield commander . . . surrounded by a close coterie of cronies, with almost no contact with anyone else. . . . I suppose that was fine so long as the place was chugging along without civil war or mutiny breaking out, and continuing to coin money, which is after all the prime objective of the merchant bank.”[2] Fuld “worked within a tight palace guard, protected from the lower ranks, communicating only through his handpicked lieutenants.”[3] 

The full essay has been incorporated into On the Arrogance of False Entitlement: A Nietzschean Critique of Business Ethics and Management, which is available in print and as an ebook at Amazon. 

1. Lawrence McDonald, A Colossal Failure of Common Sense: The Inside Story of the Colapse of Lehman Brothers (2010), p. 89.

2. Ibid., p. 90.

3. Ibid.

Weening Businesses off Debt: A Difficult Recovery?

We might view the recovery from the financial crisis of 2008 as a systemic correction in which managers were weened off their reliance (i.e., addition) on debt. Of course, the key lies in holding to the correction rather than falling off the wagon. Perhaps there should be an AA for debt-ridden businesses.

The near credit-freeze that came to a head in September of 2008 meant that even in the ensuing recovery, managers at American companies would be hesitant to spend their companies’ cash reserves. $838 billion for S & P’s 500 Index in March, 2010, was up 26% from March, 2009. Accordingly, managers have been hesitant to hire. From late 2007 to late 2009, payroll employment dropped by nearly 8.4 million by July, 2010; only 11% of the lost jobs were regained.[1] 

Robert Gordon, an economist at Northwestern University, points to the shift in executive compensation more in the direction of stock options. This arrangement gives managers more incentive to cut costs more in recessions and hold off in hiring in recoveries so that profits might surge first. However, one could point to the mandatory delay stipulated in some executive’s options to buy stock as giving them an incentive to look to the longer term.  Lynn Reaser, another economist, points to the lack of available external credit even more than a year after the financial crisis of 2008. She argues that managers conserved cash because they couldn’t rely on outside financing. 

However, firms like Apple, Yahoo, and Google are debtless and doing very well, so I would question the premise that outside credit is something to be desired.  Managers betting on leverage typically allow their irrational exuberance to distort their debt-to-assets and debt-to-profit benchmarks. If managers have become more averse to debt, maintaining higher cash reserves is not a bad thing, even when little interest is made on the cash. Once the new level is achieved, then only replenishments would be needed, so the diminishment of a firm’s investing in equipment or new hires would be temporary—to build the reserves and then to keep them stocked.  Drawing on their firm’s cash reserves rather than asking a bank for a loan or selling bonds proffers more freedom and self-reliance—qualities that are valuable even though they are difficult to quantify.  

1. Robert J. Samuelson, “The Big Hiring-Freeze,” Newsweek (August 2, 2010), p. 26.

Lehman Bros: Insufficient Accountability in Corporate Governance

In an executive meeting at Lehman in the summer of 2008, Skip McGee told Richard Fuld and the other top executives that the market was demanding “that we hold ourselves accountable.”  Essentially, he was pushing for Gregory’s outster.  What strikes me is what he didn’t say–namely, something like, “the stockholders are holding us accountable!”[1]  Had he said this, Fuld might have laughed. Of course, Richard Fuld was a major stockholder, so he might have viewed it as “holding myself accountable to myself.”  Given the inherent ethical conflict of interest in such a statement, I don’t think we can rely on corporate governance as a check on excessive managerial risk-taking when executives hold a substantial share of the stock.  Therefore, in including stock options in executive compensation to align executives' incentives with medium and long-term firm performance, boards should add institutional safeguards or accountability mechanisms to corporate governance. In business-speak, there is a cost incurred that boards may not be aware of in aligning executive compensation (and firm ownership) with future profitability.

The full essay is in Essays on the Financial Crisis.

1. Grace Wong and Aaron Smith, "What Killed Lehman," CNN.com, March 15, 2010.