Belmont Club

Plugging Every Loophole

Ezra Klein asks ‘where were the regulators when MF Global was imploding?’ Zerohedge quotes Ann Barnhardt who answers by suggesting they were busy ignoring MF Global.

I have learned over the last week that MF Global is almost certainly the mere tip of the iceberg. There is massive industry-wide exposure to European sovereign junk debt. While other firms may not be as heavily leveraged as Corzine had MFG leveraged, and it is now thought that MFG’s leverage may have been in excess of 100:1, they are still suicidally leveraged and will likely stand massive, unmeetable collateral calls in the coming days and weeks as Europe inevitably collapses. I now suspect that the reason the Chicago Mercantile Exchange did not immediately step in to backstop the MFG implosion was because they knew and know that if they backstopped MFG, they would then be expected to backstop all of the other firms in the system when the failures began to cascade – and there simply isn’t that much money in the entire system. In short, the problem is a SYSTEMIC problem, not merely isolated to one firm.

That is a serious and still isolated charge. But William Cohan of Gulf News argues that regulation played a definite role in MF Globa’s rise and ultimate fall. He tells the story of Laurie Ferber, former general counsel for MF Global who successfully lobbied for Commodities Futures Trading Commission Regulation 1.25.

In December 2000, the CFTC agreed to amend Regulation 1.25 “to permit investments in general obligations issued by any enterprise sponsored by the United States, bank certificates of deposit, commercial paper, corporate notes, general obligations of a sovereign nation, and interests in money market mutual funds” — in other words, riskier investments that could make more money for Wall Street.

Then, in February 2004 and May 2005, Regulation 1.25 was further amended and refined to the liking of Ferber and the banks. In the end, the door was opened for firms such as MF Global to do internal repos of customers’ deposits and invest the funds in the “general obligations of a sovereign nation”.

This practice, of course, may well be the centrepiece of the MF Global disaster. We now know that Corzine — who was CEO of Goldman Sachs from 1994 to 1999 — bet $6.3 billion on the distressed long-term bonds of countries such as Italy and Spain, although it’s unclear if clients’ funds were used. Bart Chilton, a CFTC commissioner, told Bloomberg News on November 10 the loss to customers’ accounts may have resulted from a “massive hide-and-seek ploy”. While the CFTC’s and the Federal Bureau of Investigation’s probes into the missing money continue, it isn’t too soon to pass judgment on how the too-close relationship between Wall Street and Washington can lead to seemingly innocuous changes in the obscure rules governing the securities industry, which, in turn, can result in financial disaster.

Robert Mintz, the former deputy chief of the Organized Crime Strike Force of the U.S. Attorney’s Office in New Jersey, said there were so many regulators and regulations out there it was like a forest designed for snakes to hide in.

One of the hallmarks of the financial crisis was the degree to which firms became so highly leveraged that a run on the bank became almost inevitable. The level that MF Global was permitted to leverage itself should have raised red flags. For example, it was reported that MF Global had liabilities of $44.4 billion against only $1.4 billion in equity at the end of June. That fact, coupled with the realization that there was no primary regulator of MF Global or brokerage firms like it, is even more disturbing. Instead, a number of regulatory agencies and industry groups each have a piece of the oversight. But with no one taking a look at the consolidated operations of the firm, it was difficult to impose strict rules regarding leverage.

While this investigation is just beginning and will likely take months to complete, what we already know is troubling enough. The story of regulators fixing the problem after the failure of a financial firm sounds all too familiar. Moreover, it seems that the patchwork of regulations and regulators may have allowed the full extent of these problems to remain undetected.

While this investigation is just beginning and will likely take months to complete, what we already know is troubling enough. The story of regulators fixing the problem after the failure of a financial firm sounds all too familiar. Moreover, it seems that the patchwork of regulations and regulators may have allowed the full extent of these problems to remain undetected.

A thicket of regulations, so comforting to Occupy Wall Street, might be the perfect place for noxious financial instruments to lie in wait. The question is whether the undetectability of MF Global’s problems was a bug or a feature is an interesting one. One of the reasons MF Global got away with its high level of risk was that it was designed to fly under the radar — custombuilt to live in the data shadows. Frank Keating at Bloomberg News says that due diligence identifies what can’t be detected all the time. In practice the Volcker Rule “forces bankers to work their way through a labyrinth of rules and definitions to see if their investments qualify for an exception to the ban”. By the time they’re done with the compliance process everybody knows where the forbidden fruit is, which in turn becomes the “investment opportunity” of somebody else — those who feel they can attract clients willing to take the risk.

I can affirm that financial companies outside the U.S. are watching the Volcker Rule implementation very carefully, but have no plans to copy it. They are poised to pick up the businesses and customers that it would cause U.S. banks to abandon.

Every system will create these high risk opportunity areas. The solution, Keating says, is to let people pay for failure and resolutely refuse to bail out anybody. “Every financial business — bank or non-bank — should succeed or fail by how efficiently and successfully it meets its customers’ needs. Good regulation should reinforce that market discipline, not mute it. … empathy for the employees of MF Global Holdings Ltd. and the investors who owned its shares also is compatible with gratitude that no government agency came to the rescue.”

That implies that one answer to preventing more MF Globals is not a forest of new regulations but to resolutely ensure that whoever misjudges his business goes bankrupt; and that whoever is guilty is tossed in jail for a long time.  If so, there’s an investment opportunity in jail construction and room to fill a lot of soon to be empty places in Washington and New York.

Now open thread: why should any financial institution be “too big to fail?”

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