Rehypothecation Is An Old Story: MF Global's Is a Different Story of Filched Funds

By: Janet_Tavakoli

Yesterday Congress held another hearing on MF Global. One representative seemed to suggest that MF Global's movement of money to the UK may have somehow been allowable under Rule 1.25. It was as if a Member of Congress had become Corzine's PR flack, an apologist for Corzine, and was trying to create a false excuse for Corzine. Jon Corzine has been a big Congressional fundraiser and bundler, and it is interesting to see how cheaply some Members of Congress can be bought.

Rule 1.25 wouldn't allow investment in foreign sovereign debt for U.S. dollar accounts, and even if it did, the accounts' assets must be segregated. Rule 1.25 does not allow anyone to filch funds from customers' accounts.

Accounts at MF Global are missing money and have no corresponding asset entries. There is a shortfall of an estimated $600 million to $1.2 billion.

Congress keeps asking how we can prevent this in the future, and I have an answer for them. Run firms with honest people that can reasonably explain the workings of their business to other honest and reasonable men. Reasonable explanations took a holiday from the Congressional hearings.

CFTC Commissioner Jill Sommers did a good job of explaining MF Global's problem in earlier testimony. The cases in which investment in foreign sovereign debt for customers' own accounts are limited to the extent of their foreign exchange deposits (so a small minority of accounts), and it is never allowable to transfer money out of the customer accounts to commingle with MF's investments.

Lies, Cover-ups, and Rubber Checks While Corzine Headed MF Global

The behavior of some Members of Congress is disgraceful because so many honest people were cheated. Here's just one example. While Jon Corzine still headed MF Global, customers requested wire transfers of their money, but MF Global stalled, rubber checks were written and sent to customers, and the checks bounced.

Yet on November 1 while Corzine still headed the firm, 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." But that wasn't the truth.

"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, WSJ, November 2, 2011.)

We bailed out large failed financial institutions with invisible support amounting trillions of taxpayer dollars and visible support amounting to billions of taxpayer dollars. Hardworking farmers and others that had accounts with MF Global have been left to twist in the wind. Innocent reputations and businesses have been damaged due to MF Global's shortfall.

Filched Funds

We already know for a fact that many US dollar accounts were not intact. Money was missing and there were no asset entries as was required. There's not enough perfume to make this pig smell good. At issue is MF Global's use of segregated customer funds and commingling of segregated customer assets to cover its own shortfall. Another Potential Crime: Did MF Global Misrepresent Source of Funds to the Fed?

Why did the Fed award prestigious primary dealer status to shaky MF Global, an entity it doesn't regulate and for which it doesn't provide surveillance? Did MF Global subsequently make misrepresentations to the Fed?

MF Global's financials and risk management procedures were shaky ever since Man Group spun it off in 2005 and saddled it with a lot of debt. In fact, in August of 2011, MF Global settled a lawsuit for misrepresentation of the quality of its risk management procedures. Yet MF Global was added to the Fed's list of 22 primary dealers in February 2011, less than one year after former Goldman CEO Jon Corzine came on board. Primary dealers buy and sell U.S. treasuries at auction and are a counterparty to the Fed's Open Market operations.

William C. Dudley is the president and chief executive officer of the FRBNY. He is also vice chairman of the Federal Open Market Committee (FOMC) and VP of the Markets Group, which oversees open market and foreign exchange trading operations and provisions of account services to foreign central banks and manages the System Open Market Account. Dudley is a former partner at Goldman Sachs (1986-2007), and he was Goldman's chief economist.

The biggest benefit to primary dealers is the perception that they are protected by a Fed safety net. This belief is based on precedence, since the Fed has already provided funding to primary dealers during a systemic liquidity crunch. Just before Bear Stearns imploded, the Fed changed the rules so that non-U.S. banks, along with brokers that were primary dealers (as MF Global was), were allowed to borrow through a program called a Term Securities Lending Facility (TSLF) to finance mortgage backed securities, asset backed securities, and more. TSLF's start date was too late to help Bear Stearns, and the program has now been discontinued, but the precedence has been set.

As MF Global's financial condition deteriorated in September and October, MF Global was required to increase its reserves to cover potential Fed losses if MF Global went under, as it eventually did. In Congressional testimony yesterday, New York Fed General counsel Thomas Baxter testified that MF Global said that money posted to the Fed did not come from customers' accounts, and MF Global gave those representations to the Fed in writing. Baxter testified: "If that representation turns out to be false, a federal criminal offense has been committed."

This will be up to investigators to determine, however, since there is no public evidence. Nonetheless, it raises disturbing questions as to why the Fed awarded primary dealer status to an operation like MF Global in the first place. CME head Terry Duffy: Under Corzine, Inaccurate Report Kept Regulators in the Dark

Throughout the Congressional hearings, Jon Corzine kept testifying as to how he had no explanation or even expert opinions on what happened at MF Global. He often referred to the fact that he's no longer with MF Global or that events happened after he left. Terry Duffy testified to events that happened under Jon Corzine's leadership:

CFTC and CME staff and auditors returned to the firm on Sunday, Oct. 30, and were informed by this discrepancy was caused by "an accounting error." Our auditors, working with the CFTC, devoted the rest of the day and night, to find the so-called "accounting error." No such error was found.

Instead, at about 2 a.m. Monday morning, Oct. 31, MF Global informed both the CFTC and CME that the shortfall was real and that customer segregated funds had been transferred out of segregation to the firm's broker dealer accounts.

After receiving this information, CME remained at MF Global while (the firm) attempted to identify funds that could be transferred into segregation to reduce or eliminate the discrepancy.

A CME auditor also participated in a phone call with senior MF Global employees, wherein one employee indicated that Mr. Corzine knew about the loans made from the segregated accounts."

[On Monday, October 31] MF Global revised its segregation report for Thursday, Oct. 27, indicating that the alleged $200 million in excess segregated funds should have been reported as a deficiency of $200 million. This shortfall on segregation on Thursday, Oct. 27, was hidden by the inaccurate report, a telling sign to keep regulators in the dark.

It remains to be seen whether this failure to disclose permitted additional segregated funds to be improperly transferred.

Throughout this time, the firm and its employees were under the direction and control of MF Global management. Transfers of customer funds effectuated by MF Global for the benefit (of the firm) constitute very serious violations of our rules and of CFTC regulations.

A very good summary of Terry Duffy's testimony and its implications can be found at National Hog Farmer. It provided the best early financial coverage on this topic.

Allowable Rehypothecation: Problematic, But A Different Problem Than MF Global's

There has been a lot of misinformation about rehypothecation, and old term that seems to have been newly rediscovered by bloggers. To be clear, allowable rehypothecation is not the dark question that has been raised about MF Global. Filching funds as I described above is illegal. Writing rubber checks is illegal.

My favorite rehypothecation story involves Henry Jarecki, then head of Mocatta Metals and current head of Gresham Partners LLC. I'm sure he'll tell the story better and give you more details than I. But here is the basic story, and it is a parable of this problematic but legal practice.

Around 1979, Mocatta Metals owned 30 million ounces of silver that Jarecki leased to industrial users. He was long silver outside the exchanges, and he hedged by being short silver on the exchanges using futures contracts. But all the price action was on the exchanges where prices were soaring. Jarecki used cash to meet margin calls. People started getting nervous and rumors circulated, because most people were unaware he owned a huge silver position.

Meanwhile, the Hunts had borrowed $50 million from Mocatta to buy more silver and had deposited 10.7 million ounces with Mocatta as collateral for the loan. Jarecki rehypothecated the Hunts' silver, meaning he used it as collateral for his own borrowing. This wasn't prudent, but it was definitely legal. After the Hunts posted the silver as collateral with Mocatta, the price of silver tripled. The Hunts were nervous after hearing the rumors about the cash margin calls for Mocatta's futures hedges, and they showed up in Henry Jarecki's office in a very bad mood.

The Hunts new the value of their collateral at then market prices far exceeded the cash value of their loan, and they wanted the loan size increased so they could buy more silver. Jarecki agreed to a bigger loan, but the increase wasn't big enough increase to satisfy the Hunts, who became suspicious that Jarecki was in financial trouble. The Hunts then said they wanted to prepay the loan and take back their silver. Jarecki responded that the loan terms didn't allow for early repayment. Now the Hunts were afraid and angry.

If Jarecki had to buy the Hunts silver in the open market or if he had to cancel his futures trades with no offset to meet the Hunts' demands, it would have created a liquidity crisis for Mocatta. Instead, Jarecki solved everyone's problems. He arranged an exchange of futures for physicals (an EFP to cancel out his and the Hunts' futures positions in exchange for a special agreement on the silver) and sold the Hunts 23 million ounces of silver for cash at what was then the top of the silver market.

Honest People Don't Look for Malicious Loopholes

At all times the Hunts had cash in exchange for their assets, there was a full accounting, and Mocatta metals was good for its obligations. In fact, Mocatta metals immediately satisfied the Hunts' demands. Even better, it sold the Hunts more silver, which the Hunts wanted. Honest people don't exploit customers by citing malicious loopholes, they come up with creative solutions to more than satisfy customers.

Mocatta used creativity to prevent a liquidity crunch. Even in its best form, rehypothecation can create a liquidity crisis and panic due to the basis risk. Mocatta averted that and everyone was satisfied. It's poetic justice that Mocatta was also lucky in its timing in the silver market.

But as I said at the outset, allowable rehypothecation is not what has everyone up in arms about the missing money at MF Global.

See: "MF Global Revelations Keep Getting Worse," Huffington Post, November 22, 2011, and "Jon Corzine Dodges the Fraud Question," Huffington Post, December 9, 2011. For more on the history of the Hunt's attempt to corner the silver market, I recommend The Great Silver Bubble, by Stephen Fay, Coronet Books, 1983.

By Janet Tavakoli

web site: www.tavakolistructuredfinance.com

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct associate professor of derivatives at the University of Chicago's Graduate School of Business. Author of: Credit Derivatives & Synthetic Structures (1998, 2001), Collateralized Debt Obligations & Structured Finance (2003), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, September 2008). Tavakoli’s book on the causes of the global financial meltdown and how to fix it is: Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009).

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