MF Global’s fall from ‘junk’ to bankrupt

The job of unravelling MF Global’s books now goes to bankruptcy court and an unwieldy collection of regulators – and possibly law enforcement officials – some of whom have their own questions to answer about their scrutiny of the failed broker-dealer.

It became clear last week that the company had no independent future after credit rating agencies cut it to “junk” on fears over its bets on European sovereign debt. But it was a mysterious mismatch in MF Global’s books, with allegedly hundreds of millions of dollars missing from client accounts, that scuppered a last-ditch sale to its rival Interactive Brokers Group and is now the focus of regulatory attention.

The CME Group, on whose Comex metal and Nymex energy exchanges MF Global was the top broker by volume, said it had discovered MF Global was in “violation” of its rules on segregating accounts. “They were ‘under-segged’,” said another person familiar with the work of the Commodity Futures Trading Commission and Securities and Exchange Commission in examining the books.

Daniel Waldman, a lawyer at Arnold & Porter and former CFTC general counsel, said: “The segregation system is extremely important for the protection of customers, the whole notion being that house and customers funds are not commingled. If you’re dipping into customer funds to cover proprietary losses, that is a huge no-no.

“There’s a pretty strict legal requirement,” he added. “There are audits and there are reviews, But if somebody takes a big loss in Europe and is willing to dip into an account he shouldn’t be dipping into, unless you’ve got a policeman on the beat all the time it’s going to be hard to catch this kind of misfeasance.”

MF Global did not respond to requests for comment on Tuesday but other people close to the situation said they expected the shortfall might ultimately prove much smaller than it initially appeared.

A widespread concern among futures traders in Chicago is over how much of customers’ funds held in MF Global’s segregated clearing account at the CME they will be able to reclaim.

Craig Donohue, CME chief executive, suggested on Tuesday that customers would ultimately be responsible and suggested they may have to bear any shortfalls. “Customers have the risk of other customer losses in the customer segregated pool and there’s always the risk as well that customer funds are not properly protected,” he said.

As of August 31, MF Global was required to keep $7.3bn in segregated accounts on behalf of customers, according to the CFTC.

The Securities Investor Protection Corporation, which protects customer money in a brokerage failure, will advance funds to customers whose funds are tied up in the failed brokerage, said Stephen Harbeck, SIPC’s chief executive.

James Giddens, the court-appointed trustee, is likely to hire forensic accountants to comb through MF Global’s books to determine why it failed, and how customers’ funds went missing, if that ends up being the case, Mr Harbeck said.

The SEC told the SIPC that customer funds from the company’s commodities business were missing, he said, adding that no customer cash or securities from MF Global’s securities business were missing.

Apart from whether the CME and CFTC should have detected violations of the rules before the company began to fail, questions are also being asked of the Federal Reserve Bank of New York, which appointed MF Global as a primary dealer, licensing it to sell government securities.

“The critical question in regard to MF Global has not been asked. How is it that the Fed allowed a primary dealer to operate with 40-to-one leverage in this day and age?” said Steve Blitz, senior economist at ITG Investment Research in New York.

The New York Fed is not the regulator for broker-dealers such as MF Global - it merely requires its primary dealer counterparties to have a minimum level of capital. But that raises the question of who is monitoring the systemic risk from companies such as MF.

As well as clients, creditors to MF Global are left waiting for the case to work its way through bankruptcy court, including bondholders who bought bonds as recently as August. Then MF Global sold $325m of five-year bonds, which have since traded to about 40 cents on the dollar.

“It is fairly unusual that you have a default happen that quickly, particularly on an issue where they haven’t even paid a coupon yet,” said Lon Erickson, a portfolio manager at Thornburg Investment Management.

Reporting by Tom Braithwaite, Gregory Meyer, Kara Scannell, Shahien Nasiripour, Nicole Bullock and Dan McCrum in New York, Hal Weitzman in Chicago and Robin Harding in Washington