MF Global: JPMorgan Produces Smoking Gun

In my opinion, MF Global former CEO Jon Corzine knew or should have known there was a strong probability that customer funds would be transferred. As it happens, they were.
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When New York-based MF Global collapsed on October 31, 2011, its $41 billion in assets made it the eighth largest bankruptcy in U.S. history and the biggest financial firm to implode since Lehman in September 2008. Then Chairman and CEO Jon Corzine is connected to the head of one of his key regulators, the Commodity Futures Trading Commission (CFTC), through his former protégé at Goldman Sachs, Gary Gensler. He also knows the Fed's William Dudley, a key member of the Fed's Open Market Committee, from their days at Goldman Sachs. The Fed approved MF Global's status as a primary dealer, a participant in the Fed's Open Market Operations, less than one year after Jon Corzine took its helm. Corzine is also a former New Jersey governor, a former New Jersey U.S. senator and was a major campaign contribution bundler for President Obama.

MF Global failed because of a disastrous leveraged bet on weaker European sovereign debt made by Jon Corzine. The problem wasn't that the debt defaulted, rather that he didn't have the money to throw in the pot when it was his turn to ante up. The firm filed for bankruptcy protection Oct. 31 after dipping into customer accounts. Around $1.6 billion of customers' money is still missing.

Probable Shortfalls of Customer Money Throughout 2011

MF Global reportedly employed 30:1 leverage -- some reports are higher -- against a portfolio of European sovereign risks including Belgium, Italy, Spain, Portugal, and Ireland. According to Bloomberg News, Corzine's position on these sovereign trades was a gross position of around $11.5 billion, and the risk was only partially offset by short positions in stronger European credits. MF Global's March 2011 report showed a net position, including offsets, was around $6.3 billion. According to Bloomberg's information from an unidentified source: "At multiple meetings, Corzine reassured directors that the trades would work out... Corzine said the European countries he selected wouldn't default before the bonds matured, and that the market was mis-pricing the debt." ("Corzine Pushed Bet on Europe Debt to $11.5B," by Miles Weiss, Cristina Alesci and Matt Leising, Bloomberg News, Nov 28, 2011.)

The accounting board, FASB, allowed Jon Corzine to characterize his trade as a "repo-to-maturity." The problem with that is repo transactions are on balance sheets, and Jon Corzine's trade was an off balance sheet transaction. In substance Corzine's trade was a "total return swap-to-maturity," a funding that includes a type of credit derivative, and Corzines trade received the off balance sheet accounting treatment of the total-return-swap-to-maturity. It allowed Jon Corzine to make a highly leveraged bet on fixed income securities that were going down in value and it allowed him to make that bet off balance sheet.

In 2011, this trade was moving against Corzine. His reassurances to the board were empty, because his chief problem wasn't default, it was not being able to come up with the cash to meet margin calls with his trading partners on this large leveraged bet.

MF Global would have had several trading days in 2011 with moves of 5 percent to 10 percent on this sovereign risk. MF Global was so thinly capitalized that this trade alone could eat up half of its capital. Any of MF Global's other asset positions moving the same way in 2011's highly correlated markets would have put MF Global in a position of negative equity.

From a risk management point of view, examiners have to consider the very strong possibility that MF Global had several negative equity days throughout 2011. An investigation into money flows throughout 2011 is in order.

August 2011: MF Global Agrees to a $90 million Settlement

In early 2008, a rogue trader racked up $141.5 million in losses in unauthorized trades that exceeded his trading limits. It seems he accomplished this in under seven hours. In August 2011, MF Global and the underwriters of its 2007 initial public stock offering (IPO) agreed to pay around $90 million to settle claims by investors that they were misled about MF Global's risk management prior to the rogue trader's actions. Since 2008, MF Global's financial condition has been nothing to brag about. Now the settlement is in jeopardy due to the bankruptcy.

In August, customers started pulling billions of dollars out of their segregated accounts with MF Global. It was the biggest outflow of funds since January 2009. The bankruptcy trustee may claw back transfers of funds from MF Global as it was teetering, because it is likely that employees within MF Global were well aware of the problems and tipped off key customers.

Also in August of 2011, FINRA seemed to catch on that MF Global's transactions were riskier than it previously thought and asked for more capital against these trades.

Investigators Examining Possibility of Illicit Transfers in August

According to the New York Times, "investigators are now examining whether MF Global was getting away with illicit transfers as early as August." The illicit transfers refer to the use of customer funds to make up for MF Global's own shortfall of funds needed to meet its margin calls and other expenses. As noted previously, it would be reasonable for investigators to look at MF Global's accounts even earlier in the year. ("A Romance With Risk That Brought On a Panic," by Azam Ahmed, Ben Protess, and Susanne Craig, NYTimes' Dealbook, December 11, 2011.)

Wednesday, Oct 26, and Thursday, Oct 27, 2011: "Substantial Deficit" in Customer Accounts

Christine Serwinski, MF Global's chief financial officer for North America, testified in a March 28, 2012 congressional hearing that she was told on October 27 of a "substantial deficit" in customers' accounts for October 26, the previous day. She was on vacation when she was informed of the shortfall and claims she was told the shortfall was only in the "cushion" that MF Global had in customer accounts. She claimed the deficit didn't violate rules -- which is implausible given other events of that week (see MF Global's check kiting below). Obviously there was a huge problem at MF Global and this would have gone to the top of the house, to CEO Jon Corzine, in a firm that had any sort of reasonable corporate governance. Serwinski further testified that on October 30, she was told of a nearly $1 billion deficit in customer funds. Regulators weren't told of deficits until October 30. The firm collapsed into bankruptcy on October 31. ("MF Global exec cites early worry on risk to funds," AP, March 27, 2012.)

Thursday October 27: MF Global Breaks Custom of Wire Transfers and Writes Rubber Checks Instead

Jon Corzine claims he didn't know about improper transfers of customer funds and of shortfalls in customer accounts until October 30, yet on Thursday, October 27, four days before the bankruptcy and again on Friday, October 28, three days before its bankruptcy, dozens of MF Global customers asked for wire transfers when they closed accounts, and they didn't get them. Instead, MF Global wrote paper checks and sent the checks via snail mail. The checks bounced, since customers received them after MF Global declared bankruptcy on Monday, October 31. ("Clients Raise Questions About MF Global Checks," NY Times Dealbook, April 1, 2012, by Azam Ahmed and Ben Protess, and "MF Global and the Rubber Check," by Matthew Goldstein, Reuters, November 5, 2011.)

October 28: Edith O'Brien writes of Corzine's "Direct Instructions" to transfer $200 million

By now every officer of MF Global should have been on red alert that MF Global was short of cash and was at risk of using customer funds to meet its daily needs, and this is prohibited.

On the morning of Oct. 28, three days before MF Global's bankruptcy, JPMorgan contacted MF Global about an overdraft in London. A Congressional memo circulated March 23, 2012, quoted an email from Vinay Mahajan, MF Global's global treasurer. Vinay wrote JPMorgan was "holding up vital business in the U.S." and called for funding "A.S.A.P." Bloomberg News reported that on October 28, Edith O'Brien, an assistant treasurer for New York-based MF Global, wrote an email saying that a $200 million transfer of funds was "Per JC's direct instructions." It turns out that part of that money was customer money, and the transfer was impermissible. ("MF Global's Corzine Ordered Funds Moved to JPMorgan, Memo Says," by Phil Mattingly and Silla Brush, Bloomberg News, March 23, 2012.)

October 28's Smoking Gun: JPMorgan Doesn't Buy Corzine's Story

Jon Corzine testified before the Senate Agriculture Committee in December: "I never gave any instructions to misuse customer money, never intended to give any instructions or authority to misuse customer funds, and I find it very hard to understand how anyone could misconstrue what I've said as a way to misuse customer money." But that isn't the standard to which Corzine is held. If investigators can show he knew of the risk that customer money might be included in the $200 million transfer he ordered, Corzine faces potential legal liability. ("MF Global's Corzine May be Liable if Customer Risk Known," By Linda Sandler and Phil Mattingly, Bloomberg News, Mar 25, 2012.)

Money went from a U.S. customer account to a U.S. MF Global account, and then it was transferred to a UK account. Even those who wish to claim Corzine slipped through a dubious loophole in the UK are out of luck. The original impermissible transfer of money occurred from a U.S. customer account to a U.S. based MF Global account. In my opinion, Corzine knew or should have known there was a strong probability that customer funds would be transferred. As it happens, they were.

On October 28, JPMorgan didn't buy Corzine's story, either. Having been a risk manager myself, I believe Barry Zubrow, JPMorgan's chief risk officer, did exactly the right thing. He called Jon Corzine to get him to verify that the funds belonged to MF Global and that none of the money was customer money. Zubrow, an outsider, was well aware of the possibility that customer funds had been transferred. It's implausible that Corzine wasn't aware of the potential impermissible transfer of customer funds when he gave the authority to make the transfer. By doing its job, JPMorgan removed Corzine's ability to credibly deny knowledge of the potential problem.

October 28: JPMorgan Asked for Written Assurances and Didn't Get Them

According to the New York Times, Jon S. Corzine, the former chief executive of MF Global, was told during the brokerage firm's final day of business that a crucial transfer of $175 million came from the firm's own money, not from a customer account, according to an internal email. The email, sent by an executive in MF Global's Chicago office, showed that the company had transferred $175 million to replenish an overdrawn account at JPMorgan Chase in London. The transfer, the email said, was a 'House Wire,' meaning that it came from the firm's own money. The email, sent at 2:20 p.m. on Oct. 28 to Mr. Corzine and two of his assistants in New York, says the transfer came from a 'nonseg' account, industry speak for a noncustomer account. ("E-Mail to Corzine Said Transfer Was Not Customer Money," by Ben Protess and Asam Ahmed, NY Times Dealbook, March 25, 2012)

The problem with the NY Times report is that the email never said that the original source of funds wasn't from a customer account, and a 'house wire' just means an internal transfer of funds. The email only verifies that the money was eventually transferred from a 'nonseg' account. It doesn't rule out that money was transferred from a customer account to an MF Global account, which as it happens -- and the NY Times later reports within the same story -- it was.

The New York Times bolloxed up the title of this story, and even within the story it acknowledges: "But it is unclear whether someone at the commodities brokerage firm told Mr. Corzine the origins of the money during a phone call or in person."

To be clear, the email in no way exonerates Jon Corzine and it in no way proves that he was unaware that the original source of funds was from a customer account and that the transfer included customer money. The email only suggests that the eventual transfer to the UK was from a U.S.-based MF Global account. But MF Global was short of funds, and the money that seemingly magically appeared in its 'nonseg' account was first transferred from a customer account.

According to his December Congressional testimony, Jon Corzine said he spoke with Ms. O'Brien, who confirmed that the transfer was proper. "I had explicit statements that we were using proper funds, both orally and in writing, to the best of my knowledge." But "proper funds," could just mean funds from a 'nonseg' account that gave the appearance of being proper. Corzine knew or should have known that MF Global's U.S. account only had funds because customer money from a U.S. account had been transferred into it. Ms. O'Brien has asked for, but not yet been granted, immunity. Last week she invoked her Fifth Amendment rights at a Congressional hearing.

As for JPMorgan, it asked Jon Corzine for a signed letter stating that the transfer was legitimate. He reportedly responded: "Send me the letter and we'll have our people look at it." It was disingenuous of Jon Corzine to pass JPMorgan's letter to Edith O'Brien to sign given that it asked for a sign-off that all "past, present and future" transfers complied with the law. Ms. O'Brien would have been asked to take responsibility for all transfers without having the authority over them. Jon Corzine had the broad authority to sign the letter, but by passing it on, he effectively stalled.

JPMorgan sent additional versions of this letter in response to MF Global's requests for revisions, but JPMorgan never received a signed letter back.

On October 31, 2011, MF Global Admitted to Impermissible Transfers

MF Global's officers admitted to federal regulators that before the collapse the firm diverted cash from customers' accounts that were supposed to be segregated:

MF Global Holdings LTD... violated requirements that it keep clients' collateral separate from its own accounts... Craig Donohue, CME Group's chief executive officer, said on a conference call with analysts today that MF Global isn't in compliance with the rules of the exchange and the Commodity Futures Trading Commission.

("MF Global Probe May Involve Hundreds of Millions in Funds," Bloomberg News, November 1, 2011, by Silia Brush and Matthew Leising.)

Yet on November 1, Kenneth Ziman, a lawyer for MF Global, relayed information from MF Global to U.S. Bankruptcy judge Martin Glenn in Manhattan: "To the best knowledge of management, there is no shortfall." If that sounded like a cover-up, it was:

According to a U.S. official, MF Global admitted to federal regulators early Monday [October 31, 2011] that money was missing from customer accounts. MF Global acknowledged a shortfall in a phone call amid mounting questions from regulators as they went through the firm's books.

("MF Global's Collapse Draws FBI Interest," by Devlin Barrett, Scott Patterson, and Mike Spector, Wall Street Journal, November 2, 2011.)

The initial bankruptcy estimate was a shortfall of around $600 million. As of Monday November 21, MF Global's liquidating trustee believed the shortfall may be as much as $1.2 billion and later estimates put the shortfall of customer money at $1.6 billion.

MF Global Debacle Damages a Key Global Market

Even if all of the money is eventually clawed back and recovered, this remains an impermissible act. Moreover, full recovery -- even if it is possible -- is not the same as restitution. People have been denied access to their money, and businesses and reputations have been tarnished.

The futures market is a globally connected market and it is a key mechanism for farmers, metals miners, and metals fabricators (among others) to hedge their risk. Confidence in the futures market has been shaken. No one knows if their money is safe, but what is more disturbing is the appearance of crony capitalism once again giving favored treatment, lax regulation, and absent oversight to a crony capitalist that abused all of these perks to blow up a large financial firm and damage a key global market.

So far, no one has been held accountable.

On March 26, 2012, I discussed these issues with Lauren Lyster on RTTV's Capital Account:

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