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Three Lessons From the Collapse of MF Global

InvestorEducation / Learn to Trade Nov 02, 2011 - 07:57 AM GMT

By: Money_Morning

InvestorEducation

Best Financial Markets Analysis ArticleMartin Hutchinson writes: In today's politically charged atmosphere, it's nice to occasionally find a situation in which everybody wins. And that's exactly what we have with the collapse of MF Global.

Politically, this failure unites both liberals and conservatives.


Liberals can rejoice, rightly, that Wall Street's pushback against the "Volcker Rule" - the provision in the Dodd-Frank act that said banks should not engage in proprietary trading - has been exposed as completely spurious.

And conservatives can rejoice in the come-uppance of a man who represented the worst of modern Wall Street's obsession with trading and flirtation with left-of-center politics.

Indeed, Jon Corzine turned Goldman Sachs Group Inc. (NYSE: GS) from a respectable corporate finance house into a dodgy trading-dominated casino. And, as if that weren't bad enough, he pushed New Jersey to the edge of bankruptcy. What a career!

Of course, apart from enjoyable schadenfreude on both sides, there are lessons to be learned. But before we get to exactly what those lessons are, we must first perform an autopsy on MF Global to see exactly what went wrong.

How to Kill a Company in 19 Months
MF Global started as a medium-sized derivatives broker before taking over Refco - a major name in commodities brokerage - after that group's 2005 collapse. And while it may be hard to believe now, MF Global at one time was extremely well connected, effectively managed, and had a solidly established business.

Of course, that all changed when Jon Corzine took over in March 2010.

Fresh from his term as governor of New Jersey and flush with cash from his lengthy stint at Goldman Sachs, where he was chairman and CEO from 1994 to 1999, Corzine was determined to make MF Global a major investment bank.

To accomplish this goal, Corzine essentially bet on the same equation he had used in his transformation of Goldman - that brokerage plus hedge fund equals investment bank.

To that end, he took risks with its own capital and maintained an advantage over Goldman and Morgan Stanley (NYSE: MS) by having no banking license. The absence of a license meant MF Global was free from onerous banking rules on leverage and (potentially) on proprietary trading. And under Corzine's direction, MF Global made the disastrous decision of betting too heavily on European sovereign debt.

Corzine believed that bailouts would continue ad infinitum, and that investors would not be made to suffer losses on their investments in such debt. Naturally, under "mark-to-market accounting," the write-down in MF's positions gave the firm enormous losses.

MF Global filed for Chapter 11 bankruptcy Monday after credit downgrades led to margin calls on some of the $6.3 billion in Eurozone sovereign debt the bank held. The position was five-times MF Global's equity.

And so MF Global failed just 19 months after Corzine took over.

As I said earlier, we can take some time to bask in the schadenfreude of all this, or we can take the opportunity to relearn some important lessons - three to be exact.

Those lessons are:

•Steer clear of leverage. Don't leverage up your portfolio and don't buy into companies that leverage up theirs.
•Do not invest based on political beliefs. Rely rather on economic analysis.
•And always stay humble. Maintain a deep skepticism of your own knowledge and wisdom. Neither the best market analysts nor the best baseball players should expect to bat 1.000.

Three Things to Learn From the MF Global Bankruptcy
First, trading and leverage do not automatically bring riches. The Efficient Market Hypothesis says that markets know everything and it's impossible to beat them.

That theory has its faults in long-term investment, where thoughtful analysis of a company's prospects can achieve superior returns. However, it's spot-on in the trading markets, in which adrenaline junkies attempt to achieve quick profits at each other's expense, multiplying those profits by cheap borrowing.

The overall effect of cheap leverage is that it drives up asset prices - thus the dotcom, housing, and commodities bubbles. It also amplifies short-term trading profits, and makes some traders very rich for a time. But in the end, what goes up tends to come down. That certainly was the case with Corzine. And if you need even more evidence, just look at John Paulson, who made billions from the housing crash but whose Advantage Plus fund in early October was down 47% for 2011.

For us ordinary investors, trading and leverage are both dumb strategies.

Second, Corzine believed he was smarter than all the traders in the market. That's why he believed he had found an opportunity in European bonds that others missed. Since the big players have similar skills and knowledge, this is very unlikely and shows hubris.

At Goldman Sachs, it was a little different - the firm has a lot of very smart people who together have huge, and even unparalleled, market knowledge. That's why Goldman can sometimes beat the crowd - although it shouldn't try to, if it wants to keep a banking license. But one smart guy in a medium-sized house is very unlikely to beat the market, and quite likely to come unglued if he makes a leveraged bet the wrong way.

Finally, Corzine believed that the economics he had applied (pretty unsuccessfully) as Governor of New Jersey would work for Europe too. He believed economic recovery required only massive doses of government spending "stimulus," that deficits and debt don't matter, and that "rich" taxpayers can always be called on to bail out mistakes.

As should have been clear a year ago, German taxpayers won't stand for unlimited bailouts at their expense, and providing handouts to Greece won't make that sorry economy viable.

All three of these mistakes were critical errors. And we should all take note.

Source : http://moneymorning.com/2011/11/02/three-lessons-from-collapse-of-mf-global/

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