The collapse of MF Global would never have happened had the Volker rule been in place, according to Chicago-based securities attorney Andrew Stoltmann.
The firm headed by CEO Jon Corzine, a former Goldman Sachs chairman, filed for a Chapter 11 bankruptcy this week after taking highly leveraged and un-hedged positions on European debt.
Forbes reported that the firm had bought $6.3bn of European debt without hedging it, and that the firm was leveraged at 80 to 1 with $41bn in assets, against $39bn in debt. This outstrips Lehman Brother’s fatal leverage levels of 35 to 1 in 2008.
“There is no riskier asset class than European sovereign debt at the moment. To think it was not even $1 was hedged is absolutely incredible,” Stoltmann told Global Investor/ISF.
The Chicago Mercentile Exchange later revealed Corzine had also been using clients’ money to make trades as financial troubles escalated at the firm. Now $700m of clients’ money is unaccounted for.
Stoltmann says the situation illustrates the importance of stronger regulations for banks and brokerage firms, including the implementation of the Volker Rule.
Part of the US Dodd-Frank act and currently in draft form, the Volker rule restricts ability of most banks and Wall Street firms to use their own funds to buy and sell stocks, corporate bonds and derivatives.
Stoltmann says had the Volker Rule been in place, such risky positions would not have been possible.
“There is no question that if the Volker had been in place, this meltdown at MF Global never would have happened. If this had been two years from now there is no way MF Global could have even engaged in this sort of trading and certainly couldn’t have had a leveraged an 80 to 1 position, and that’s why the Volker rules is so important,“ he says.
Fitch Rating’s said that its October 27 2011 downgrade of the company's Issuer Default Ratings (IDR) to 'BB+/B' from 'BBB/F2' was partly as a result of the firm's increase in principal and the proprietary trading activities that had elevated the firm's traditional risk profile.
Fitch warned that the firm's persistently weak earnings and leverage were "no longer consistent with an investment grade financial institution", and that "sizeable concentrated positions relative to the firm's capital base" had left MF Global vulnerable to potential credit deterioration and significant margin calls.
Rosanne Felicello, an attorney at Felicello Law, says without proper analysis it is not yet possible to say exactly whether MF Global’s proprietary trading would have been within the rubric of the Volker rule as there are a number of exemptions within and the definitions of proprietary trading are still being worked out.
She says the bigger issue is that MF Global was using client money that was meant to be kept separate.
“That is problem with or without the Volker rule and is a violation of rules that area already in effect,” she says.
Regardless, Stoltmann says it is “disconcerting” that even a relatively small outfit can take these sorts of risks and he is concerned that there may be larger players in the market with comparable levels of exposure to European debt.
“The concern is what other banks and brokerage firms have a similar concentration of European debt. That’s why the markets are so spooked. The big fear is that those in a similar position start to deleverage. I hope that isn’t the case but it is certainly possible,” he says.
Under the Chapter 11 bankruptcy filing the firm will now be reorganised so that it can pay off its debts and try to become profitable one again. However, for MF Global’s $2.2bn unsecured bond holders, the future is uncertain.
When MF Global bonds were issued in August 2011, they were investment grade rated as the risk of bankruptcy was considered remote. But when the firm reported its biggest ever quarterly loss of $191m on October 25 2011 - mainly because of losses on proprietary trading - rating agencies Moody’s, Standard & Poor's and Fitch downgraded the firm’s issuer ratings. MF Global’s shares quickly fell by nearly 70% and the bonds began to trade at distressed levels.
Bond holders will now have wait in line with everyone else who is owed money by MF Global.
The trustees of the bonds are JPMorgan Chase with $1.2bn in corporate bonds and Deutsche Bank with $1bn in bonds. However, Stoltmann says that these custody banks will not suffer directly.
“There are not going to be any implications legal, regulatory or customer wise