Bloomberg News

MF Signs Death Warrant for Short-Term Funding: William D. Cohan

November 15, 2011

Nov. 8 (Bloomberg) -- People ask me all the time: How could Wall Street powerhouses such as Bear Stearns Cos., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. disappear virtually overnight?

How could MF Global Holdings Ltd. be here one day and gone the next? Why was Jefferies Group Inc., the midsized investment bank, whipsawed last week by rumors about its very survival because of questions about its exposure to European debt?

What the demise of Bear, Lehman, Merrill, MF Global -- and the near collapses of Jefferies, Goldman Sachs Group Inc. and Morgan Stanley (before the latter two became bank holding companies in September 2008) -- reveal in spades is that the age-old model by which these firms finance themselves is irreparably broken and should be outlawed.

MF Global found itself in financial peril so quickly because its short-term lenders decided almost overnight that they no longer wanted to take the risk of lending money to the firm. Jefferies faced the same situation -- even if it stanched the bleeding last week -- and it isn’t out of the woods. Both provide further evidence that the short-term funding model for securities firms needs to be ended because it’s simply too risky.

Before the recent financial crisis reached its most acute stages, beginning in March 2008, the dirty secret of securities firms was that without the ongoing financial support of their short-term lenders they couldn’t stay in business. In effect, the short-term lenders to firms such as Bear Stearns and Lehman had a free option -- every night -- about whether to continue doing business with them.

Lenders’ Support

Without the ongoing support of these lenders, the securities firms couldn’t stay open. One day the funding switch is on; the next day it’s off. Period.

For instance, Bear Stearns borrowed about $70 billion a day in the short-term -- so-called repo -- secured financing market. The cost was low, and the risks seemingly negligible. Who wouldn’t keep lending to Bear Stearns, especially with a secured interest in the financial assets -- such as Treasuries or mortgage-backed debt -- on the borrower’s balance sheet?

Or so the logic went before March 2008, when we discovered that without the $70 billion from the overnight lenders -- which was suddenly withheld -- Bear Stearns couldn’t continue as a going concern, even though it had $18 billion in cash on hand.

Admittedly, before Bear Stearns collapsed over the Ides of March more than three years ago, very few financial executives had any appreciation for this subtle funding dynamic. Yet nothing is more fundamental to most banks’ operational strategies than the ability to borrow short and lend long. Such backroom plumbing was thought best left to the firm’s repo desk and its treasurer, all blessed with a little oversight from the chief financial officer and other top executives.

Although it’s true that Wall Street firms rely on short- term financing to varying degrees, by March 2008, Bear Stearns was especially dependent on the overnight repo market because its other sources of liquidity had pretty much dried up. Goldman Sachs depended far less on short-term financing than did Bear or Lehman. That’s because the bank agreed to pay higher interest rates on its borrowings to ensure the money it needed to run its business -- despite having about $160 billion in cash -- would still be there from one day to the next.

Before Bear Stearns collapsed, most senior Wall Street executives would have never imagined that overnight lenders would decide to stop financing their business. But after Bear, then Lehman and Merrill Lynch, went down and was almost followed by Morgan Stanley and Goldman Sachs -- who were saved only by their immediate access to the Fed’s discount window, which made moot the question of where they would get short-term funding -- there could be no more credible excuses for not understanding the tenuousness of the funding model.

Risky Business

Indeed, no self-respecting Wall Street banker would ever advise a client to personally take such short-term financing risks. And yet the industry itself was doing this very thing.

That’s what makes the MF Global debacle so shocking. Jon Corzine, the firm’s former chairman and chief executive officer, had previously been CEO and CFO of Goldman Sachs. He understood exactly the fragile short-term funding dynamic of a securities firm.

His principal financial sponsor, the billionaire J. Christopher Flowers -- one of MF Global’s largest shareholders who installed Corzine as CEO in 2010 -- was a former financial institutions banker at Goldman Sachs.

Flowers made his fortune by buying and turning around a distressed Japanese bank. He also had a seat at the table during the collapses of Bear Stearns, Merrill and the rescue of American International Group Inc. Flowers knew exactly how fragile short-term funding could be. And yet both he and Corzine allowed MF Global to take the risk of financing a long-term bet -- its $6.3 billion gamble on European sovereign debt -- in the short-term markets.

MF Global even admitted in its financial statements that it was at risk if the ratings companies downgraded its debt. “Pursuant to its trading agreements with certain liquidity providers, if its credit rating falls, the amount of collateral” the company “is required to post may increase,” MF Global said in its 10Q disclosure for the second quarter of 2011. It also noted that its debt was rated investment-grade.

But once those ratings changed -- as they did in the firm’s final week -- les jeux sont faits and the gig was up.

Over the weekend, the Financial Times praised Corzine, claiming that he “arguably” deserved “some respect” for “thinking big.” This is pure bunk. All the mea culpas and excuses in the world won’t change the fact that Corzine and Flowers knew exactly the risks posed by the broken funding model relied on by companies such as MF and Jefferies.

They decided to take the risk anyway. As a consequence, about 3,000 MF Global employees will soon be out of work and billions of dollars belonging to creditors and shareholders has been lost.

Don’t worry about Corzine and Flowers, though, they still have their hundreds of millions of dollars in previous winnings socked away. Actually, come to think of it, they deserve to be locked up.

(William D. Cohan, a former investment banker and the author of “Money and Power: How Goldman Sachs Came to Rule the World,” is a Bloomberg View columnist. The opinions expressed are his own.)

--Editors: Max Berley, Stacey Shick

Click on “Send Comment” in sidebar display to send a letter to the editor.

To contact the writer of this article: William D. Cohan at wdcohan@yahoo.com.

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net.


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