Maybe it is the complexity of the financial scenario or the small scale of assets (only $1.2 Billion), but outrage does not seem to exist for MF Global and its lead dog, Jon Corzine. Whether the disappearance of $1.2 Billion in clients’ assets is fraud or incompetence, it could impact your portfolio if you don’t watch out.
So what really happened at MF Global? MF Global is a broker-dealer, which means investors place assets with MF Global to place trades in stocks, bonds, futures, options, etc. MF Global custodies or holds the assets as well as conducts the underlying transactions for their clients. Several broker-dealers exist. You might use a discount custodian like Charles Schwab, Scottrade, TD Ameritrade, or E-Trade, or you might use a company like Merrill Lynch, Wells Fargo, and Morgan Stanley. The problem with MF Global arose because it also manages its own portfolio along with its duties as a broker-dealer. While managing its own money, MF Global screwed up. It leveraged its portfolio 34-1 and bet big on European sovereign debt. This amount of leverage is ridiculous. As an example, imagine you had $1 Million (don’t we all wish). Through the use of debt or options, you control $10 Million of assets with your initial $1 Million. If your $10 Million lost 10%, you now control $9 Million in assets, but the $1 Million you lost wiped out your initial $1 Million portfolio. You are broke. At 34 times leverage, it only takes a 3% loss to wipe out your initial capital and create a margin call (where you have to put in more money to keep your positions open).
This is what happened to MF Global. European government bonds have taken a beating over the past few months, and MF Global got a margin call. Problem is they didn’t have any money to cover the margin call. Instead, they took money from clients who were utilizing their broker-dealer services. Just imagine that you have a portfolio of stocks and bonds at your brokerage house. You expect that your assets remain your assets. These firms are regulated to ensure this happens, but it didn’t. Clearly, if MF Global merely took client funds, this is fraud. Corzine should see jail time even if he didn’t directly authorize this practice since Sarbanes-Oxley mandates the CEO have a system in place to prevent fraud.
A chance exists that this isn’t fraud. It could have been rehypothecated assets. What is this? Hypothecation happens all the time. You probably do it with a mortgage. All it means is you put an asset as collateral to borrow money. For a mortgage, you borrow the money and use the home as collateral. You still own the home, but the bank can repossess the home if you fail to repay the mortgage. Rehypothecation is where the collateral is re-used by the bank or financial institution. Using the mortgage as an example, rehypothecation would be the bank using your home as collateral for a debt it is undertaking. Could you imagine your home being foreclosed upon because an investment by the bank went sour. This is rehypothecation. It was a big problem in 2008 because many banks, including Lehman and Bear Stearns, were rehypothecating clients’ assets in the shadow banking system. This can be totally legal. Hidden away in small print in the enormous brokerage agreement you sign, a clause may exist authorizing your brokerage to rehypothecate your assets.
This could affect you, and you might have no recourse. So what should you do? First, ask your broker if the current agreement allows them to rehypothecate your assets. If so, get the agreement changed or leave the broker. Second, if your brokerage firm has an investment banking arm or invests on its own behalf, leave them immediately. If Corzine and the other cronies at MF Global are not prosecuted for this sin, then it sends a signal to the other bankers that stealing client funds is ok. This puts your hard earned capital at risk. Don’t take a risk with a firm that has its own portfolio. Take action before you find your account has been raided.