Traditionally staid and conservative firm seeks buyers as concentrated bets in European Sovereign debt markets go badly wrong
In an episode of art imitating life, the movie Margin Call depicts a financial services firm that concentrated all its risk in one sweeping bet that went badly wrong. In the case of the movie, the trade that exploded in the debt markets of 2008 forced a financial services firm to liquidate assets in an attempt at survival. Fast forward to October 2011, and MF Global, one of the industryâ€™s leading Futures Commission Merchants (FCM), is struggling for survival as it receives a real life margin call. As of this writing the New York Fed suspended conducting business with the firm and more significantly the CME Group has cut off trading access to the firm.
The eighth ranked FCM in 2010 with $8.6 billion under management, MF Global was, like many futures brokerage firms, following staid and conservative management principles that generally didnâ€™t gamble company assets through proprietary trading. (In 2008 when a rogue Wheat trader made headlines by racking up $145 million in losses, such unauthorized trading wasnâ€™t part of the firmâ€™s management plan.)
Things changed rather dramatically during spring of 2010. This is when a gambler took the reins of power. As a result, the company is currently scrambling for liquidity to raise cash while its leader, former Goldman Sachs superstar Jon Corzine, might be looking at the numbers to figure out what went so very wrong. This might be similar to 1994 when Mr. Corzine was co-lead of Goldmanâ€™s fixed income group when it posted losses that almost took down the investment bank. But upon reflection, it looks more like the 2008 car wreck then NJ Governor Corzne was in while speeding down the expressway without a seat belt.
What Went Wrong?
With a University of Chicago background, a school known for producing strong quantitative minds, Mr. Corzine really needs to look no further than another U of C alumnus, Nobel Prize winner Harry Markowitz, to figure out why things went so bad so quickly.
As MF Global, one of the leading brand names in the futures and options industry, fights for oxygen and liquidity, Mr. Corzineâ€™s significant concentration of risk towards a single market move in Sovereign debt highlights what is known as investment concentration. This means all risk in a portfolio might be influenced by one significant macro global force. In this case, when the credit markets in Spain, Portugal and Ireland logically fell apart without significant austerity measures in place, the bond investments and the fortunes of MF Global all lost value at the same time. This investment concept stands in contrast to Markowitz, whose Modern Portfolio Theory promoted the concept of asset diversification of returns streams, a cornerstone of proper derivatives risk management. Mr. Corzine might have missed that diversification memo.
There are several points of derivatives risk management Mr. Corzine and his well connected crew have ignored. Perhaps the most significant also was related to a debt issue. While at Goldman Sachs, Mr. Corzine and those designing non-transparent derivative products were witness to a warning from a demure female with a powerfully strong will: Brooksley Born.
Ms. Born was CFTC Chairwomen when, in 1998, she sounded alarm bells regarding non-transparent and toxic derivative products that were not managed in accordance with open, transparent and regulated rules that existed in the exchange traded derivatives markets. While she and her prophetic call for transparency into toxic assets were generally ignored â€“ and she was effectively muzzled by a â€śWorking Groupâ€ť in Washington D.C. that existed of the likes of Alan Greenspan, Larry Summers and former Goldman alumni Robert Rubin and Timothy Geithner â€“ Ms. Born eventually resigned office on June 1, 1999. The toxic assets to which Ms. Bornâ€™s warnings were targeted famously exploded in fall of 2008. Ms. Born, her ignored warnings now vindicated, nonetheless keeps professionally quiet on the topic, letting facts speak for themselves.
The History of a Debt Crisis
After losing re-election as Governor of New Jersey in 2009, Mr. Corzine set his sights on making his mark in the derivatives world again when he replaced former Chicago Board of Trade president Bernard Dan as CEO of MF Global on March 23, 2010. While his results at MF Global were similar to his re-election attempt, Mr. Corzine made a different choice in the derivatives markets this time around. Instead of non-transparent off-exchange mortgage derivatives, Mr. Corzine chose the regulated derivatives industry when he took the reins at an FCM that had deep historic roots tracing its roots dating back to 1783 when English commodity trader James Man founded the firm. Little did anyone know at the time MF Global, long considered an industry icon of sorts, was now on a path to being sold off in bits and pieces in a fire sale to the highest bidder.
Upon taking control at MF Global, Mr. Corzine had two choices: he could gamble, rolling the dice on a heavy concentration to Sovereign debt, or he could have chosen the path of popularizing a defensive investment portfolio that includes a diversity of returns streams â€“ a concept championed by a host of academic thinkers and investment practitioners. Mr. Corzineâ€™s choice speaks to a lost opportunity at this moment in economic history.
In choosing to gamble with Sovereign debt assets over focus on integrating uncorrelated investments into traditional stock and bond portfolios, Mr. Corzine wasnâ€™t looking to the future, which is unfortunate. Upon taking over MF Global, he quickly stated his long term vision was one of logical asset management, transforming the FCM into the next big thing on Wall Street. This gave those in the managed futures industry reason to cheer. In the end, however, he couldnâ€™t overcome his past where significant risks were taken â€“ some that worked, some that didnâ€™t. The difference between Goldman Sachs and Corzineâ€™s MF Global is that Goldman often takes the both sides of trades â€“ as they did in the mortgage derivatives crisis. At least they embrace the concept of diversification of risk and returns streams. Mr. Corzineâ€™s concentration concept just didnâ€™t work out.
â€śYou shouldnâ€™t risk more than you can lose,â€ť noted veteran industry observer John Lothian. â€śThis goes for traders as well as brokerage firms.â€ť
Whatâ€™s interesting here, the overlooked component is that Mr. Corzine gambled from within the futures industry which is known for â€śgambling.â€ť However, the opportunity Mr. Corzine missed is the industry is really based on risk management and hedging, not raw speculation. The growing futures industry movement is away from raw gun-slinging speculation, to embracing logical asset management with an investment generally uncorrelated to the stock market through managed futures. It is an industry increasingly looking like an insurance company with probability tables and less like that represented by the Wild West and a gun slinger attitude of investment concentration. Unfortunately Mr. Corzine chose making his highly concentrated leveraged bets in Sovereign debt markets rather than expanding the concept of uncorrelated investments.
Itâ€™s in the uncorrelated investing concept that many on Wall Street seem to have problems. Perhaps it was the message about an investment that operates independent of economic strength that just didnâ€™t jive with Mr. Corzine? Or it could have been the industry concept of account segregation and transparency where he might have missed the derivatives management memo? Clearly the defensive concept of true diversification didnâ€™t resonate.
There is a movement in the futures and options industry away from the cowboy speculator and towards a logical and risk-focused investment. This is the direction many had hoped Mr. Corzine would take MF Global, the brokerage firm once considered industry legend. But that, apparently, isnâ€™t going to happen.
As Mr. Corzine and Company are managing their margin call, liquidity drying up all around them, the opportunity to expand the concept of diversification with investments uncorrelated to the performance of the stock market might have received a temporary set-back. However, as a looming US government debt crisis that wonâ€™t go away easily becomes better understood by those including Mr. Corzine, the concept of true asset diversification is something that should not be ignored at this moment in economic history.
Mark H. Melin is currently writing his fourth book on uncorrelated investing. Â He is previous author / editor of three books, including High Performance Managed Futures (Wiley, 2010) and an adjunct instructor in managed futures at Northwestern University. Â He can be reached at firstname.lastname@example.org
Contents of this article Copyright (C) 2011 Mark H. Melin.
Risk Disclosure: Managed futures can be a volatile investment and is not appropriate for all investors. Â Past performance is not indicative of future results.
The opinions expressed in this article are those of the author, may not have considered all risk factors and may not be appropriate for all investors.