Bloomberg News

MF Global Exposes Prop-Trading Risk That Volcker Wants to Curb

November 08, 2011

Oct. 31 (Bloomberg) -- Jon Corzine’s risk appetite just provided Paul Volcker with a demonstration of the dangers of Wall Street proprietary trading.

Nineteen months after former New Jersey Governor Corzine took over as chairman and chief executive officer, MF Global Holdings Ltd. today filed for bankruptcy. The collapse was triggered by Corzine’s decision to boost risk-taking, including a $6.3 billion wager with the firm’s own money on European government debt.

Volcker, a former Federal Reserve chairman who’s advising the Obama administration, pushed for legislation to curb wagering by banks or financial companies that have federal guarantees or are so embedded in financial markets that they’re deemed too big to fail. Regulators and the industry are wrestling over the fine print in the so-called Volcker rule, which takes effect in 2012. Now, three years after Lehman Brothers Holdings Inc. failed, MF Global’s implosion may buttress the argument for tighter trading limits.

“In the wake of 2008, when we all should have learned a lesson, Jon Corzine told me himself that it was a relatively staid, not risk-oriented firm and he needed to ratchet up the risk,” William Cohan, author of “Money and Power: How Goldman Sachs Came to Rule the World,” said on Bloomberg Television. “Well he does that and it blows up in his face and for the first time he can’t unwind the trade. Honestly I’m still shocked and it should not have happened.”

MF Global, with 2,894 employees and $2.5 billion in capital, wouldn’t have been affected by the rule, unlike larger rivals such as Goldman Sachs Group Inc. or JPMorgan Chase & Co.

Bailout Risk

Corzine’s failure “is OK because MF Global is not such a large institution that it’s going to bring down the entire financial system with it,” Neil Barofsky, a former special inspector for the U.S. Treasury’s Troubled Asset Relief Program, said on Bloomberg Television’s “InsideTrack.” “If this is Goldman, if this is JPMorgan, if this is any of those institutions, we’re going to have to go in and bail them out and we’re going to bear the brunt of their bad bets, not the shareholders and possibly the debt holders.”

Corzine, 64, learned the strategy of making big trading bets during his 24 years at New York-based Goldman Sachs, which he ran from 1994 to 1999 before being forced out. It was the most profitable securities firm in Wall Street history before converting to a bank holding company in 2008, when smaller rival Lehman Brothers went bankrupt.

Ramping Up Risk

“Jon Corzine made his bones at Goldman Sachs by going big,” said Cohan, a Bloomberg View columnist who interviewed Corzine for his book on Goldman Sachs. “I see this as a case of Jon Corzine ramping up the risk that MF Global was taking, trying to put it into the big leagues of investment banking, make it more like Goldman Sachs.”

While Corzine was trying to recreate the Goldman Sachs that he remembered, the firm’s current management was reducing risk- taking -- in part in response to the Volcker rule. It closed Goldman Sachs Principal Strategies, a prop-trading team that bet primarily on equities, and the Global Macro Proprietary Trading desk, which wagered on bonds, currencies and commodities.

The Volcker rule will also require Goldman Sachs to reduce investments in private equity and hedge funds to no more than 3 percent of each of the funds -- or 3 percent of Goldman Sachs’s Tier 1 capital. In the latest quarter, such investments were responsible for the firm reporting its second quarterly loss since going public in 1999.

Goldman Sachs

“We’ve already shut down our walled-off proprietary business, so that’s gone,” Goldman Sachs Chief Financial Officer David A. Viniar told analysts after the firm reported a third-quarter loss on Oct. 18. “We think that any investment in funds will be limited to 3 percent.”

Bank executives including Viniar and Morgan Stanley CEO James Gorman have noted their firms’ cooperation in shutting down standalone prop-trading businesses while warning of reduced market liquidity if the rule is interpreted too strictly.

A version of the Volcker rule released by regulators earlier this month has already been criticized by banks and analysts. Brad Hintz, an analyst at Sanford C. Bernstein & Co., said the rule may shave 25 percent from fixed-income trading desks’ revenue. The Office of the Comptroller of the Currency estimated that it will cost banks $917 million for raising more capital and an additional $50 million in compliance and legal expenses.

Weaker Restrictions

Arthur Levitt, a former Securities and Exchange Commission chairman and adviser to Goldman Sachs, said Wall Street lobbyists will fight to postpone and weaken the regulations.

“This is going to be a long slog, and much of that rule that you see today is going to go up in smoke,” Levitt, a Bloomberg LP board member, said on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt on Oct. 13. Levitt said he was speaking for himself and not expressing the views of Goldman Sachs.

MF Global’s board had met through the weekend in New York to consider options including a sale to avert failure, according to a person with direct knowledge of the situation. Following a record loss announced last week, MF Global was suspended today from doing new business with the New York Federal Reserve, according to a statement on the regulator’s website. Trading in MF Global’s stock was also halted.

Shares, Debt

MF Global shares declined 67 percent last week and its bonds started trading at distressed levels amid its disclosures of bets on European sovereign-debt. MF Global held talks with five potential buyers for all or parts of the company, including banks, private-equity firms and brokers, said the person, who asked not to be identified because the talks were private.

“MF was highly leveraged and I think Corzine came in trying to do what he did at Goldman Sachs,” Levitt said today on “Bloomberg Surveillance.” “He was a risk-taker, and the markets went against him.”

Regulators including the Federal Reserve and Federal Deposit Insurance Corp. issued a 298-page proposal of the Volcker rule on Oct. 11. The agencies are seeking public comment on the draft and may make changes before it takes effect July 21.

Stand-alone proprietary-trading groups at six bank holding companies -- Bank of America Corp., JPMorgan, Citigroup Inc., Wells Fargo & Co., Goldman Sachs and Morgan Stanley -- had a net loss of about $221 million from June 2006 through the end of 2010, according to a July 13 Government Accountability Office report.

Generating Losses

The business of betting money for banks’ own accounts produced positive net revenue in 13 of the 18 quarters examined, totaling $15.6 billion, and generated losses of $15.8 billion in the other five quarters, according to the report. The study didn’t address prop trading conducted in other groups besides the stand-alone desks.

“Mr. Corzine’s activities at MF Global are exactly what the Volcker advocates wanted to protect against,” Richard Bove, a bank analyst at Rochdale Securities LLC, wrote in a note to clients. “It is exactly why they were so adamant that the regulators were not enough to stop speculative activities and a strict law had to be passed to stiffen regulator actions.”

The bankruptcy could also influence debates related to other parts of financial-industry rulemaking. MF Global, alongside hedge funds and brokers, had succeeded in urging the Commodity Futures Trading Commission to open access to derivatives clearinghouses for firms with less net capital than Wall Street’s largest swaps dealers.

The CFTC completed a rule on Oct. 18 that would require clearinghouses to open access to firms with at least $50 million in net capital. Clearinghouses would still be able to scale a member’s participation depending on how much capital a company holds above $50 million. Wall Street’s largest derivatives- dealers have said members need experience and adequate resources to manage defaults.

--With assistance from Stephanie Ruhle, Erik Schatzker, Tom Keene and Ken Prewitt in New York. Editors: Steve Dickson, Peter Eichenbaum

To contact the reporters on this story: Christine Harper in New York at charper@bloomberg.net; Silla Brush in Washington at sbrush@bloomberg.net; Michael J. Moore in New York at mmoore55@bloomberg.net

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net.


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