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Smooth Criminals

Disclaimer: I work in regulation in the financial services industry. My commentary, from time-to-time, will reflect on experiences and thoughts as it relates to the incalculable industry that is Wall Street and Derivatives Finance. I am not part of a profit-center, au contraire: while “cash is king”, leveraging it against the unfamiliar is like buying a Honus Wagner baseball card from someone who has never seen a baseball game.

Jon Corzine. Nary does a name in recent memory inspire such a high volume of negative commentary. For those unfamiliar, Corzine is the ex-CEO (and ex Democratic New Jersey Governor) of the now bankrupt MF Global (previously Man Financial, amongst many other names). Widely panned as irresponsible and brash, many have linked him directly to the fallout of the entity itself. SeekingAlpha’s Benjamin Trotter pulled some nice numbers from the bankruptcy filing of MF Global (bankruptcy filings are all public documents) which I will utilize below:

  • $6.3 billion in bets on European Sovereign Debt

  • $191.6 million in a 2011 Q3 loss

  • $39.7 billion in total debt

  • $41.0 billion in total assets

  • $7.3 billion in total client obligations (customer funds held by MF)

Remember, many of the assets are based on firm valuations, and if in illiquid instruments (i.e. things you can’t sell and get out of right away), it would mean a significant loss. Remember 2008? Balance sheets at financial institutions are notoriously difficult to value, as the prices of an “instrument” can be extremely volatile. Additionally, demand can dry up quite quickly. The system is built on what others believe something is worth; this is why a crisis of confidence is so detrimental.

MF’s balance sheet, from above, is nowhere near where they say it is because A) the instruments are overvalued, and B) that’s assuming you can get out of these instruments whenever you want, which you can’t (these markets do not have tons of buyers and sellers). If you know a company is going out of business, won’t you wait for prices to drop? Financial institutions do the same to one another. While Corzine claimed all along the company would be fine if his bets turned, this would only occur if people believed in him and kept loaning him money. The second they didn’t (i.e. Europe started freaking out like the Double-Rainbow guy), people didn’t trust him and pulled their money.

A quick aside to provide an example: Let’s say you own a specialty cake business, making cakes exclusively for pet tigers. Business is going well, and needless to say you don’t have tons of competitors. You have sold all of your current cakes, and you just bought materials to make more. Your cash is low, but you have assets in the form of the materials (Let’s say these amount to $1,000). You receive revenue of $100 per cake and have enough materials to make 100 cakes. Accordingly, you list your assets as $10,000 in cakes. Realistically, this is your asset value ONLY IF you sell all your cakes.

All of a sudden, there is a crisis in your field…people decide that your cakes may make their tigers go on sugar-frenzied attacks (who knew??). No one knows how much they’re worth, but your patrons are damn sure they aren’t worth $100 to risk their life. If you’re on the cusp of going out of business, what do you do? Sell the cakes at cost, $10? Ideally. But let’s say you can’t even get your money back. Would you sell the materials at a loss? Sell the company at a loss, just to make sure you kept a job with whomever owned your firm? This would equate to selling the company for $500 even though you have materials worth $1,000 because no one would know how many worthless cakes you have already made. Now pretend that your leverage, or bet, on those cakes, was 35-1. That’s right, you have $3,500 worth of cakes, meant to sell for $35,000, of which no wants any. Someone would be crazy to lend you that money, right? Not if you’re an investment bank!

This is a lot like what happened to Bear Stearns. Even though the asset values of the instruments they had on their balance sheet were significantly higher than what they received, the fact that no one knew how to value their “bets” on invented financial instruments meant they sold the company for $2 a share. The physical building of Bear Stearns itself was worth more than $2 a share, but no one knew how to value its “bets”, and no one was willing to pay very much (remember that when a financial institution “buys” an instrument, it usually pays a small “margin,” or between 0-20% of the total “cost” of that instrument.” In 2008, banks were leveraged 35-1. This meant that they only owned 2.8% in cash for a single instrument…if the market moved 2.8% or more, they were broke. Note: this is not like the housing market, because if you are FHA approved and your house drops in value over that percentage, there is a lot more supply to value your house against and to take the loss…in this case, these opaque financial instruments are not ubiquitous, but rare and hard to value).

You are now broke, and the thing you value highly (cakes/European Sovereign debts) are basically worthless to everyone else…what do you do to save your business? If you’re a normal person, you either sell your company for a loss or declare bankruptcy. If you’re Jon Corzine, you steal!

Instead of getting out of business, you take the money customers have paid for undelivered cakes and use it to resell and repay your debts (at MF it was customer $ for financial products, here it is customer $ for cakes). Then whammo, you make more money and pay back your customers! Except for that little in-between period when you’re using your customer money for things they don’t have yet, and for cakes you never deliver. It’s also called fraud if you get caught during your brilliant transition period.

Hyperbole aside, the premise is the same: Use of customer funds, which are protected by federal law, can be criminal if done fraudulently. As prosecutors have noted, the lack of criminal charges right now turns on a lack of evidence. The most reprehensible actions, besides the irresponsibility of betting on risky financial instruments that no one can truly value without ALL of the information on how and on what they were created is bad. Even worse is committing fraud while doing it, and ignorance in a corporate culture that prides itself on greed, lawlessness, and negligence means the CEO is as guilty as anyone (isn’t Sarbanes-Oxley a pain in everyone’s ass for exactly this reason?).

The real reprehensible number? 3,271. The amount of jobs lost due to the MF Bankruptcy. That’s 3,271 families, fathers, mothers, sons, daughters, and children who were required to venture out to the worst marketplace in 80 years in order to seek employment. On top of this, on August 16, 2012, news surfaced that Corzine wanted to start a hedge fund. Would you trust him with your money? After some pondering, the number at the beginning of this paragraph should be adjusted to 3,270. I think he’d be better off in the cake business.

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