The disease has a name, and even a cure, but the pain that accompanies its treatment is usually enough to scare off even the most intrepid caregivers.
The disease is greed and its symptoms are many, including over-leverage, rogue traders, and out-and-out fraud. The end result is the same: Greed leads to a scandal and folks lose their hard-earned money, and that scandal erodes investor confidence around the world. And when confidence declines, people feel uncertain and afraid, and park their money on the sidelines. And that hurts everyone.
In the next few columns, I’m going to address a few of these investor hazards, and then give you some tips on how to protect yourself from some of these Wall Street shenanigans.
Let’s start with leverage. It’s an age-old tune, sung by consumers, businesses and investors, who tout its primary advantage—utilizing debt to multiply your money.
Now don’t get me wrong. Leverage can be a sweet thing. Most of us would not be able to buy our homes or cars—or even college educations for our children—without the use of debt. But, it’s the injudicious application of leverage that has caused the largest financial bubbles and their ensuing collapses in this country, including:
· The 1929 stock market collapse, which erased more than $9 billion of the market value of America’s businesses. It was brought on by leverage and triggered by margin calls on that debt
· The 1987 stock market crash, in which the stock market fell 20% in a single day, was created by mania in the over-leveraged junk bond industry.
· The dot.com bubble, which began its steep decline in 2000, and saw the erosion of $5 trillion in market value from 2000-2002, was precipitated by unadulterated growth using venture capital and debt, with no profits in sight.
· The 2007 housing, financial and investment market collapses, created by easy credit, exotic derivatives, and a hands-off regulatory environment, led to mounting foreclosures, bank failures and a global recession.
Those are just the major financial debacles of the past century that were caused by over-leveraging, and affected most consumers, businesses and investors. But those events don’t even scratch the surface of the mini-meltdowns that can have just as devastating an effect on people worldwide.
You may remember:
· Long-Term Capital Management, which used excessive leverage in arbitrage deals and was bailed out by the Federal Reserve in 1998, to the tune of $3.625 billion
· Amaranth Advisors, a hedge fund that borrowed $8 for every $1 it owned to bet on natural gas futures, collapsed in 2006, losing about $6.6 billion for its investors
· Bernie Madoff’s $65 billion scheme that leveraged new investment monies to shore up returns to his previous rounds of naïve investors looking for above-market gains.
Those are just a few of the scandals that have rocked Wall Street in the past decade and a half.
And now we have Jon Corzine and MF Global. Corzine is a perfect example of the greed that permeates Wall Street (and Main Street), using leverage to make speculative bets in hopes of spectacular returns.
Corzine is a guy with more than a few million to his name, ex co-head of Goldman Sachs, as well as a former Senator and Governor of New Jersey. At 63 years old, he took on another challenge—MF Global. By all accounts, the company was a second-rate futures dealer, and Corzine was hired to bring it back from near-death and make it a star.
He did, for awhile, building the company into a major global financial derivatives broker.
Along the way, he employed a tremendous amount of leverage by using derivatives such as complex repurchase agreements in the pursuit of profits, buying more than $6.3 billion purchases of European sovereign debt. And that over-leverage was the company’s downfall—especially because it was not adequately disclosed.
While hedge fund clients are generally sophisticated investors, well-aware that great returns are predicated on great risks, in MF Global’s case, those exact risks were certainly not properly disclosed. Auditors had warned the board of directors of the significant leverage being employed—warnings that were, for the most part, apparently ignored. And when regulators demanded disclosure, the ratings agencies, which apparently also were well aware of the problems, finally climbed on board, acknowledged the risks and downgraded the company.
At that point, as rumors of the risks began to swirl, investors began pulling their money out of the company, forcing a liquidity crisis, and MF Global filed for bankruptcy on October 31.
We can argue all day about the brilliance of Corzine’s trading strategy, but the fact remains that MF Global didn’t actually lose any money on the bet; its bankruptcy was due to a loss of investor confidence.
Now you may not be feeling sorry for MF Global’s customers since everyone knows that hedge funds are risky in and of themselves, and sometimes the risks are greater than the rewards. Consequently, MF Global will not be the last firm to close its doors due to unwise speculation and over-leverage.
But that’s not the end of the story.
What’s even worse is that while MF Global’s investors may have been sophisticated hedge fund clients, and well-aware of the typical risks that come from being over-leveraged, they had one more “kick in the shin” awaiting them—the little-known rule changes that allowed MF Global to use its customers’ funds to further its own gains—accounts in which more than $1.2 billion seem to be “misplaced”.
Corzine is playing dumb, telling Congress he “has no idea” what happened to those funds.
In particular question is a strategy that MF Global used to parlay its client funds into firm profits, that added a new word to the vocabulary of most investors—hypothecation, or in this case, rehypothecation.
When I was a banker—many years ago—we routinely “hypothecated” collateral. In the case of a mortgage loan, our borrowers basically ceded control or temporary ownership of their homes to the bank until their mortgage was satisfied.
To investment brokers, hypothecation occurs when an investor pledges his stock to his broker in order to borrow against it. If you miss your margin calls, your broker can take your stock to pay him back. Both of those scenarios make sense, don’t they? They are routine business transactions that occur daily. You pay your loan back; you get your collateral back.
But hypothecation has taken on new meaning as a consequence of MF Global’s rise and fall. And here’s why.
Most investors believe that client funds are sacred, never co-mingled with firm funds and only to be used for purposes of investing for a client’s benefit. But that turns out not to be exactly true.
Until 2000, commodity firms (like MF Global), were allowed to use their client funds only to buy U.S. Treasuries, short-term. But apparently MF Global and other commodity firms petitioned for changes and by 2005, client funds could be used—or rehypothecated—to invest in government sponsored entities, bank certificates of deposit, commercial paper, corporate notes, general obligations of a sovereign nation, interests in money market mutual funds, and short-term repurchase agreements.
In essence, those rule modifications opened the floodgates. And MF Global took advantage, using client funds to buy repurchase agreements on the bonds of troubled sovereign nations such as Italy and Ireland—a strategy that wasn’t adequately disclosed and you can bet the company’s clients didn’t knowingly endorse.
Yet, it seems to be perfectly legal. And somewhere along the way, some $1.2 billion in those customer funds have just disappeared. It’s feared that the money was used to cover the company’s trading losses.
Every day, new information is surfacing, and while no one has yet determined whether Corzine and MF Global did anything “illegal”, the fact remains that this is yet another example of greed getting out of hand and regulators going along for the ride.
So far, nine lawsuits have been filed against Corzine and MF Global—just the beginning, I’m sure.
That’s bad for its investors, employees, customers and suppliers, but, sadly, it is often the outcome when you borrow beyond your means and try to dig your way out by using, if not illegal, certainly very questionable strategies. And it’s a shining example of how investors—even sophisticated folks—can be suckered into some very bad investments by the promise of untold riches.
And while you may not have been a client of MF Global and therefore, are not affected by its demise, think again.
You can bet that MF Global is certainly not the only company employing these strategies. And we don’t yet know the fallout from its collapse—there may be billions of dollars lost by its trading partners, as well as its clients. And there’s no reason to believe that other companies won’t be caught up in similar scenarios. Only time will tell.
In the meantime, be aware that “what you don’t know can hurt you” is a prevailing theme on Wall Street, and can trap even the most sophisticated investors.
Next up, Rogue Traders: Not as Rare as you Think
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