Daniel Lubetzky

This is one of the most cogent pieces written about the behind the scenes machinations that took place at MF Global – and the motivations behind them.

Francine McKenna, Contributor

I cover the accounting industry and accounting issues for investors.

3/28/2012 @ 5:15PM |888 views

The Story Behind Today’s MF Global Congressional Testimony

If the only stories you read about MF Global come from the major daily media reports and congressional testimony, you’ll miss most of the truth and quickly become confused about who knew what and when. The Wall Street Journal,New York Times, and Reuters, in particular, have gone back and forth on the story many times, flip-flopping around with every new leak, every new published document, every supposed scoop. I’d have whiplash by now if I’d jerked my head one way and then the other and back again as often as their reporters have when telling you, today, who done it.

What you should really wonder is why none of these reporters are doing any real investigative work. Why aren’t the reporters cultivating sources other than those who have a strong motivation for steering the story in one direction and then another, perpetuating misdirection and buying time until they they figure out the political and practical ramifications of what really went on? Why aren’t they reporting the corrections and contradictions to the versions they’ve been repeating?

I’m sticking to the same theory I’ve had since I published it here on November 9^th: MF Global and its executives ran out of time and legitimate sources of funding for the growing amount of collateral demands on the sovereign debt repo-to-maturity transactions and customer redemption requests. By Wednesday October 26, 2011 they were out of options. They had no plan to file bankruptcy until they were forced to at least plan for the contingency and, according to the first day filings with the bankruptcy judge, hired Skadden on Friday the 28th.

Corzine and Co.’s goal was to sell the company or, at least, the broker dealer. To do that required keeping it all viable until that deal could be sealed. To do that, I believe, senior executives illegally pledged customer assets – Treasuries and Bunds – as collateral for a short-term loan over the weekend of the 28^th. The plan was to put those assets back in the accounts when the buyer paid. Unfortunately for everyone, MF Global was forced to file Chapter 11 on Monday October 31. General Counsel Laurie Ferber did not admit until later that day that executives had “discovered a significant shortfall in its segregated funds account”.

Unlike similar bankruptcies before that – Lehman and Refco – the broker dealer was not sold cleanly. There was eveidence of potential fraud on day 1, October 31. The regulators never should have allowed the holding company to be put in Chapter 11 – debtor in possession – versus Chapter 7. By doing so, Judge Glenn allowed the pirates – the executives who caused the shortfall – to continue to control the ship until Freeh was appointed Trustee for the holding company a month later. The customer assets that had been illegally pledged were seized by the “lender of last resort” as soon as bankruptcy occurred. I have evidence someone was worried almost immediately about a clawback. That party took the excess collateral for the loan as well as the value of what they lent. They will have to be forced to give it back.

And with that you explain the huge hole in the balance sheet.

Everything we’ve heard since then – revelations, testimony, secret emails and admissions – supports my theory. They only thing left is to identify the “lender of last resort”. I have my suspicions. I suspect the trustees and investigators know who that party is, too. And it’s only one. No time for lots of deals with several and better to limit those who know what really happened. In the meantime, we have tons of blather about what Jon Corzine did or did not authorize in reference to legitimate transactions with JP Morgan.

What these recently revealed emails do prove is that MF Global was capable of the two-step process needed to wipe customer characteristics off a portfolio of assets so they could be used by a house account to pledge for the loan.  In that way the assets were “monetized” without the settlement delays they were already experiencing. The two-step is a necessary step for my “lender of last resort” theory.

We still don’t know which firms were counterparties to the Euro sovereign debt repo-to-maturity transactions. Could the repo-to-maturity counterparties have been the same ones doing business with MF Global when the transactions were backed by relatively harmless Treasuries in 2010 BC “Before Corzine”? Those firms got a lot of money from MF Global during the last week of its life, according to the Trustee almost $1 billion. That kind of liquidity was certainly not apparent on the balance sheet during the prior months. That money was seemingly pulled from the ether. Any one of the earlier counterparties could be the lender of last resort. Or the secret lender may be someone much closer to the situation that had a vested interest in moving on without taking a bath.

Bob English, of the blog Economic Policy Journal, digs in to the SEC filings for MF Global today and finds two interesting pieces of information: The names of the counterparties for MF Global RTM transactions “Before Corzine” and the fact the SEC was interested in the accounting and disclosure of those transactions more than a year before FINRA stuck its nose into it.

The SEC issued a comment letter to MFG (Holdings) on March 16, 2011 regarding its 201010-K (filed in May, 2010 for the year ended March 31, 2010).  About a third of the questions deal with the treatment and disclosure of repo to maturity transactions. In the year ended March 31, 2010, the trades were limited to US debt and were much smaller than the European positions it would eventually acquire.  However, the timing of this comment letter is interesting. MF Global responded on March 30, 2011, literally one day before MFG’s 2011 year-end.  It would have put the MFG execs (including new CFO and PwC alum Henri Steenkamp as of March 31) and PwC (the auditor) on notice they would need to provide more disclosure about the RTM trades in the 2011 report due in a few months.

Did the SEC know about the growing size of MFG’s European debt trades?  Was the SEC trying to nudge MFG into disclosing just enough to cover its rear and also look like the SEC was an alert watchdog regulator? With hindsight, we are left with more questions than answers. Why did FINRA have to be the one to raise a fuss in June after receipt of the May 31, 2011 broker audit when the SEC had already honed in on the RTM issue? The SEC (and now FASB) is now questioning whether MFG public disclosures were sufficient. That’s more of an indictment of the SEC than MFG.

I’ve already reported on English’s digging into the SEC filings by MF Global’s broker dealer and reports PwC is required to file, as the external auditor, oninternal controls over segregated funds. The 2011 report was never posted and the report of discrepancies PwC found in 2010 is not available to the public.Neither is whatever MF Global reported to the CFTC as an FCM as of September 30. If we could see this information, we would know if the regulators were warned the company was dipping into customer segregated accounts, or flying too close to the sun, earlier. The SEC comment letter response also identifies the counterparties for the more benign Treasury-backed RTMs.

Q: Tell us whether the repurchase agreements qualifying for sales accounting areconcentrated with certain counterparties and/or concentrated within certaincountries. If you have any such concentrations, please discuss the reasons for them.Response: We entered into repo-to-maturity agreements, which, as described above qualify for sales accounting treatment, mainly with inter-dealer brokers includingTradition, ICAP, Tullet and Garban and banks such as UBS. While the trades were executed with these parties bi-laterally, these were primarily novated, settled and margined via the Fixed Income Clearing Corporation (100% was held with the Fixed Income Clearing Corporation at March 31, 2010). The underlying collateral for these repo-to-maturity agreements was U.S. Treasury securities, and as such we had concentration risk with the U.S. as an issuer, which we did not consider a significant exposure.

It might be noted, UBS was also the major counterparty to Lehman Brothers on their Repo 105 transactions.  UBS stopped doing business with Lehman when they feared Lehman might fail. Lehman was forced to file bankruptcy because of a lack of liquidity.