MF Global: the story gets weirder and weirder

MF Global

Man Financial, the trade-processing subsidiary of the UK hedge fund manager, Man Group, was spun off from the parent in 2007 and renamed MF Global.

My take, without having studied the transaction carefully, is that Man Group was trimming away a low-growth, low PE multiple peripheral operation.  Sans MF Global, Man Group would look growthier and presumably achieve a higher PE rating from investors.  MF Global would have a chance to write its own history.  So maybe the separate parts would also be worth more than the whole.

In 2010, the board of MFG hired Jon Corzine, former crack trader, former head of Goldman, former US Senator, former governor of New Jersey (perhaps best remembered for having been in a high-speed auto accident while not wearing a seat belt) to be its new CEO.  His first-year compensation was $14 million+.  The idea was that Corzine would turn MFG into an investment bank like Goldman.

On Halloween 2011, MF Global filed for Chapter 11 bankruptcy, as the financial markets lost confidence in the aggressive proprietary trading strategy Mr. Corzine had crafted.  That’s when–like a train wreck in slow motion–the weirdness began.

investment significance

There may be a certain perverse fascination associated with looking at cases like this (after all, Schadenfreude is a word–or two).  Nevertheless, there is an important investment point as well.

It’s that when a company begins to struggle, the first signs of distress, however awful, are rarely the last.  The trail of bad news is, in my experience, almost always longer than initially expected.  It can also reach destinations never dreamed of on day one.  Therefore, betting that all the bad news is out can be very risky.

what’s come out so far

In this case, what’s happened has been highly publicized (the best account I’ve read of the run-up to Chapter 11 is in Vanity Fair):

–in August 2011, MFG issues bonds that promise to pay a higher interest rate if Corzine were to leave the firm for Washington (rumors suggested he would become the next Secretary of the Treasury)

–in October 2011, MFG declares bankruptcy–undone by Corzine’s aggressive proprietary trading strategy

–a last-minute deal to save the firm falls through because of possible accounting irregularities

–the bankruptcy trustee indicates that up to $1.6 billion in customer money is missing

–the first of many claims of “sloppy bookkeeping” are made by the authorities–the assertion that in an age of ubiquitous, cheap management control software, MFG had no procedures for recording the trades it made.  I’ve got no experience with commodities, but I find this particularly hard to believe.

–the former chief risk control officer, fired after repeatedly warning the Corzine trading strategy was too risky, says he thinks the warnings were a reason for his dismissal.

–Mr. Corzine testifies he has no idea where the missing money is.  Although he’s the CEO, he says he had no knowledge of, or involvement in, the day-to-day operation of MFG.  He names the employee who he says assured him that no client money was delivered to lenders to meet margin calls.

–the named official refuses to answer questions without being granted immunity from prosecution.  Other company executives, including the CFO, say they, too, have no idea what happened to the missing money.

the latest wrinkle

After five months, you’d think that everything about the last days of MFG would already be out on the table.  But that’s not right.

Customers who tried to close their accounts with MFG shortly before the Chapter 11 filing did not receive the wire transfers which they requested and which are the customary way of liquidating accounts.  It’s not yet clear, but it sounds like at some point MFG decided to stop wiring money to customers who closed their accounts but to send checks in the mail instead.

The use of checks has two consequences.

For customers, instead of getting their money through a wire transfer on the same day the accounts were closed, checks dated, say, October 28th arrived only in November–after MFG declared bankruptcy.  Those checks, of course, bounced.  The holders are now unsecured creditors of MFG.

For MFG, check issuance would create in effect a “float” of customer money that it could use for several days–without the same regulatory restrictions on customer accounts–until customers received and cashed their checks.

Lawyers for the clients in question are now approaching the Justice Department with collections of “float” data, which they hope will convince the government that the check issuance was not as innocent as simply shoddy bookkeeping.

is the story over yet?

My guess is that we still don’t know everything.

In my early days as an oil analyst, a veteran geologist told me that wells come in two types–good and bad.  The former continually exceed expectations.  The latter, no matter how far down you ratchet your expectations, somehow manage to still disappoint.

To me, MFG feels like a really bad well.

what I find strange about MF Global

who MF Global is

In mid-2007 the glow of a multi-year bull market had not yet begun to fade.  That’s when the Man Group, the London listed hedge fund group, divested itself of its brokerage arm, which was renamed MF Global.

Looking back, this seems to me to be a standard move of a firm that is in both a fast-growing business (hedge funds) and a slow-growing one (brokerage):  split them apart to create two pure stock market plays.  That allows the strength of the fast-growing business to be seen more clearly, and hopefully gets that stock a higher PE multiple as a result.

As for the mature business, who knows.  There may be investors who want to hold it.  And in any event, the timing of the split-up seems to have gotten MF Global an initial valuation that was relatively high.

Sometimes these splits work out well for the apparent ugly duckling.  Coach, for example, was a spinoff from cakes and tee shirt maker Sara Lee, where it was starved of capital.  Free of a bureaucratic parent, that company has been a rocket ship ride for a decade.

Not the case here, however.  (For anyone who knows the Man Group well (not me), it might be interesting to go back and see how the management talent was apportioned between Man and MF Global.  My hunch would be that, if anything, MF Global was stocked with lesser lights.)

spreading its wings

MF Global appears to have intended from the outset to reinvent itself as an investment bank.  An early trading stumble highlighted management control deficiencies and brought in private equity firm, J C Flowers, as a shareholder.

So far, while things could have worked out better for MF, nothing so out of the ordinary.

the strange stuff

1.  the Corzine hire

In early 2010, MF installed a new CEO.  The new guy had built a reputation as a very aggressive and successful bond trader during the 1980s.  He’d been booted out of his two previous management jobs, reportedly for being unable to get along with others.  The most memorable moment of his public service career was when he survived a 90 mph crash in his New Jersey state car, which he habitually rode in without using a seat belt.

Tidbits of gossip aside, Mr. Corzine had been an individual star in a young man’s business.  But he’d been out of the industry for over a decade.  And whether he possessed any management talent was at least open to question, though New Jersey voters rendered their verdict forcefully in 2009.

Picking him, it seems to me, is like selecting a 60-something ex-athlete to be the star player on your team, not the manager.  The broad of MF seems to have had no problem with this.  Mr. Corzine himself appears to have been blissfully unaware that it might take some time to shake the rust off talents he hadn’t employed in the current century;  he appears to me to have committed the cardinal sin of underestimating the other side of the trade.

According to Reuters, MF paid Mr. Corzine $14 million + to drive the company into bankruptcy in under two years.

2.  the “Goldman” recipe

Robert Rubin, former Goldman partner, advised Citigroup to dive into proprietary trading when he joined the company board.  Disastrous results.

John Thain, former Goldman partner, expanded Merrill Lynch’s proprietary trading when he took over as CEO.  Disastrous results.

Jon Corzine, former Goldman partner,…     Sense a pattern here?

3.  where were the compliance people, or the CEO for that matter?

Press reports, including this FT post, indicate that a last-minute deal to save MF Global by merging it into another financial firm foundered when MF couldn’t account for large amounts of customer money.  As I’m writing this on Thursday morning, it sounds like someone in MF diverted $633 million out of customers’ accounts and into its own last week in order to cover trading shortfalls.

It’s hard to believe this is true.  Things like this might happen in Madoff- or Enron-land but they simply don’t occur in reputable firms.  Nevertheless, this is what the CME Group, MF’s regulatory supervisor is accusing MF of.

I also find it hard to believe, although I guess it’s possible, that Mr. Corzine didn’t have a detailed daily (if not real-time) report of MF’s overall trading positions.  It seems to me that the “magic” appearance of over half a billion dollars in the company’s accounts should have been evident to MF management almost immediately.

 

I don’t think the entire story has been disclosed yet.  The Wall Street Journal, for example, is pointing out the mismatch between Wall Street analysts’ research and Mr. Corzine’s public statements vs. what we now see as the underlying reality.  Stay tuned.