If you’ve been following these Market Update pieces you have been reading about how the recent pullback has been a buying opportunity and how I suspected the Treasury yields might not last for long at the lofty and optimistic levels we had recently attained.
Two stories are impacting the market today
The first is that politicians in Greece are doing some things that are putting the rescue plan in doubt. Despite the markets upbeat attitude toward Europe’s plans…reality is creeping back in. The Greek government is considering putting the EU’s bailout plan up for a vote…which could cause the plan to be derailed. I don’t understand politics in my own country so I won’t even try to guess how Greek politics work. Perhaps the best summary I can find of what’s going on in Greece is the following quote from Societe Generale:
“What the Greeks are considering doing would result in about as disorderly a default as you can get. That threatens to return Europe to the maelstrom”
That should sum up things on the European bailout front. A disorderly default will cause a lot of problems…it might cause the type of problems that make me glad there is an ocean between us. Germany’s Angela Merkel openly warned of war coming to Europe if the Euro is allowed to fail. When a head of state is making statements like that I tend to listen. It would be different if it were the leader of some third world, ragtag, banana republic country…but this is the leader of Germany so you have to pay attention.
The second story is that the MF Global plot continues to thicken. Before we talk about the problems at MF Global we need to do a quick review of “margin calls”. A margin call is where a position has moved against you and your broker or counterparty calls and demands you put some more money into the pot to cover the increased loss/risk. Normally you’d cover the margin call with cash or by selling something to generate cash. Then you sit back and hope the position comes your way…if it moves against you again you get another margin call and you’ll have to raise more cash and/or sell more positions. Many of you will remember this cycle from late 2008 and 2009 when the hedge funds were all getting destroyed. Their trash positions were moving against them and they had to sell their high quality paper (GSE debt). Spreads widened as supply was dumped on the market and we were all able to buy MBS at huge spreads as we took advantage of the geniuses that were running hedge funds.
Show me the money
This brings us to current day Wall Street. MF Global began getting margin calls as some of their positions began moving against them. At first they covered with cash…then they ran out of cash. Apparently somebody notices that while the firm was out of cash, they still had a lot of customer money lying around. I don’t know how the next chain of decisions gets made…but I picture it going something like this:
Trader 1: “Hey, we’re getting more margin calls on these European bonds…and I just used up the last of our cash.”
Trader 2: “Dude if we can’t meet these margin calls our counter-party is going to liquidate the positions and the losses will go from “un-realized and un-nerving” to “immediate and tragic”. We are going to get canned. What are we gonna do?”
Trader 1: “Well…there is a ton of cash sitting in these accounts that we manage for customers…they’re not using it right now, they’re just sitting on it. They’ve been sitting on it for like two years…it’s just sitting there doing nothing.”
Trader 2: “Great idea…we just need it to cover until our positions come back. Once things calm down and prices recover we’ll just pull some equity out of our positions and put the money back. Their cash will be back in the account before anyone knows what’s up.”
Trader 1: “Sweet….grab me a few hundred million of it to cover these margin calls…then we can get back to surfing the net.”
Trader 2: “Done.”
I don’t know how the actual conversation went but I have no idea how you could get to a point where stealing customer funds to cover your own mistakes sounds like a good idea. I’m tempted to ask “Where has “integrity” gone?” but in reality the people that do these types of things never had it to begin with.
Many years ago the Marine Corps taught me that the quick and easy definition of “Integrity” is that “you do the right thing even when no-one is looking.” That rule has served me well over the years…and it sounds like MF Global could have benefited from it as well. Another big lesson that looks to be coming from this is that MF Global lacked appropriate controls…after all…integrity is great and all but when there is a lot at stake trust should go out the window and verification should take its place. This leads me to another phrase that is famous in the military…”Trust me with your life…not your money or your wife”. Trust is great…but verification is even better.
If hundreds of millions of dollars of customer cash are unaccounted for at MF Global it is just one more giant sign that things were poorly run.
Is this the first time a trader has stolen money?
The history of finance is littered with stories of theft and fraud. Without having to look anything up I can think of several cases. Barings PLC (Britain’s oldest investment bank) was brought down in 1995 by a rogue trader named Nick Leeson who was trying to cover losses and using the firm’s weak internal controls to do it. In that case a single trader in a far flung branch office in Singapore was able to bring the entire bank down because of poor controls. Leeson generated losses that were more than twice the amount of capital the bank had available.
More recently Societe Generale got smacked with a $7.2 billion loss by a rogue trader named Jerome Kerviele. That one was so shocking that people internally thought at first that it was a joke. Another was hedge fund Amaranth Capital that got torpedoed by one of their own natural gas traders who generated a $6.6 billion loss.
I guess it surprises me a lot that customer money could be misappropriated at MF Global after we’ve had so many big firms destroyed by employees operating in an environment with poor internal controls.
Maybe I’m jumping the gun…maybe the hundreds of millions of dollars of customer money will show up…perhaps it was just put in the wrong drawer. We’ll see how it turns out…but if you had money at MF Global I’d start making some calls to see if you’ll be getting it back.
From the bad timing file
Another interesting fact from MF global is that a group of investors were so enamored with John Corzine’s leadership abilities that they bought $650 million in bonds from the firm just a few months ago. In what has to be just about perfect timing, the firm will be bankrupt before they make their first interest payment on those bonds. This reminds me of the scene from Vegas vacation where the guy takes Clark (Chevy Chase) to the second-rate casino’s that are “off the strip” and have some familiar games like rock-paper-scissors and flip-a-coin.
Clark walks up to a table where the game is called “guess the number”. He puts his money on the table and the dealer says “I’m thinking of a number between 1 and 10” Clark says “seven”. The dealer says “nope” and then promptly takes his money. That scene just became a lot less funny to investors in MF Global debt.
The end
So…MF Global and Greece are the latest news…its’ now “Game off!” and people are rushing to the sidelines with their money. The 10-year Treasury is up over a point this morning, pushing its yield down to a 1.97% currently. It’s yield has dropped 43 basis points in the last three trading days.
People are starting to realize that things haven’t changed. Anytime we see yields pop up with no change in the underlying fundamentals I think we should view it as a buying opportunity. That’s all the news to report for now. I think I’m going to call my broker and make sure he’s not inter-mingling my funds to cover his losses. This should be a fun one.
If you have any questions or if there is anything I can be doing for you just let me know.
Steve Scaramastro, SVP
800-311-0707
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