Did accounting help sink Corzine’s MF Global?
By Bethany McLean
The opinions expressed are her own.
On Monday morning, MF Global, the global brokerage for commodities and derivatives, filed for bankruptcy.Â The firmâs roots go back over two centuries, Â but in less than two years under CEO Jon Corzine, whose stellar resume includes serving as the chairman of Goldman Sachs, as New Jersey’s U.S. Senator, and as New Jerseyâs governor, MF Global collapsed, after buying an enormous amount of European sovereign debt. The instant wisdom is that he made a big bet as part of his plan to transform MF Global into a firm like Goldman Sachs, which executes trades on behalf of its clients, and also puts its own money at stake. Although the size of the wager has received a great deal of scrutiny, the accounting and the disclosure surrounding it have not–and may have played a role in the firmâs demise.
In the 24 hours since the filing, more ugly questions have piled up, with the New York Times reporting that hundreds of millions of dollars of customer money have gone missing, and the AP saying that a federal official says that MF Global has admitted to using clientsâ money as its problems mounted. Whether this was intentional or sloppy remains to be seen; MF Global didnât respond to a request for comment by press time.
At the root of MF Globalâs current predicament was a simple problem:Â the profits in its core business had declined rapidly.Â That core business was straightforward, even pedestrian; what the firm calls in filings a âsignificant portionâ of total revenue came from the interest it generated by investing the cash clients had in their accounts in higher yielding assets and capturing the spread between that return and what was paid out to clients. As interest rates declined sharply in recent years, so did MF Globalâs net interest income, from $1.8 billion in its fiscal 2007 second quarter to just $113 million four years later. MF Globalâs stock, which sold for over $30 a share in late 2007, couldnât climb above $10 by 2009.
Enter Corzine in the spring of 2010, who had just lost his job as New Jerseyâs governor to Chris Christie. He was brought in by his old pal and former Goldman partner Chris Flowers, whose firm had invested in MF Global. Fairly quickly, Corzine accumulated a massive net long sovereign debt position that eventually totaled $6.3 billion, or five times the companyâs tangible common equity as of the end of its fiscal second quarter. Iâm told Corzineâs move was highly controversial within the firm.Â But no one overruled him, maybe because after all, he was Jon Corzine. In a mark of just how much Corzine mattered to the market, in early August, MF Global filed a preliminary prospectus for a bond deal, in which the firm promised to pay investors an extra 1% if Corzine was appointed to a âfederal position by the President of the United Statesâ and left MF Global.
Buying European sovereign debt may not have been just a bet that the bonds of Italy, Spain, Belgium, Portugal and Ireland would prove attractive. An additional allure may have been the way MF Global paid for the purchases, and thereby, the way the accounting worked. MF Global financed these purchases, as its filings note, using something called ârepo-to-maturity.â That means the bonds themselves were used as the collateral for a loan, and MF Global earned the spread between the rate on the bonds, and the rate it paid its repo counterparty, presumably another Wall Street firm. The bonds matured on the same day the financing did.
The key part is that for accounting purposes, MF Globalâs filings say the transaction was treated as a sale. That means the assets and liabilities were moved off MF Globalâs balance sheet, even though MF Global still bore the risk that the issuer would default; that means the exposure to sovereign debt was not included in MF Globalâs calculation of value-at-risk, according to its filings. And that also means MF Global recognized a gain (or loss) on the transaction at the time of the sale. The filings do not say how much of the gain was recognized upfront.Â But if it were a substantial portion, then these transactions would have frontloaded the firmâs earnings.Â That, in turn, may have helped cover the fact that MF Globalâs core business was struggling.
MF Globalâs public filings also donât say how much this contributed to earnings. But one indication of the size of the repo-to-maturity deals comes in this small excerpt from MF Globalâs most recent 10K, under the heading of âOff balance sheet arrangements and riskâ: Â âAt MarchÂ 31, 2011, securities purchased under agreements to resell and securities sold under agreements to repurchase of $1,495.7 million and $14,520.3 million, respectively, at contract value, were de-recognized.â (âDe-recognizedâ means moved off the balance sheet.) Of that $14.5 billion, 52.6% was collateralized with sovereign debt. One way to get a sense of the ramp-up of “repo to maturity” transactions is to compare the figures to those as of March 31, 2010:Â The securities sold under agreements to repurchase increased by some $9 billion.
Once the regulators and rating agencies began to zero in on all of this, it didnât matter that the trade itself may not have been that risky. (The debt all matured by the end of 2012, and MF Global, of course, had financing in place until it matured.) But it was European sovereign debt, after all, and the trade was hugeâand it appears that part of the concern may have been the accounting, and certainly the lack of disclosure. On September 1, MF Global said in a filing that the Financial Industry Regulatory Authority (FINRA) was requiring it to âmodify its capital treatmentâ of the European sovereign debt trades.Â According to an affidavit filed by MF Globalâs president on the day of the bankruptcy, FINRA was âdissatisfiedâ with the September filing and Â âdemandedâ that MF Global announce that it âheld a long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity.â Words like âdissatisfiedâ and âdemandedâ arenât good in the context of a regulator!
By the time the market opened on Monday, October 24th, MF Globalâs stock had already fallen 62% from its high of almost $10 following the announcement that Corzine was joining the firm. Then, Moodyâs downgraded the firm’s debt, citing MF Globalâs âinability to generate $200 million to $300 million in annual pretax earnings and keep its leverage within acceptable range.â In other words, Moodyâs was concerned about the real profitability of the business. The next day, MF Global reported its $6.3 billion position, per FINRAâs demand, and also reported that it had lost almost $200 million in the quarter ended in Septemberâin large part because the firm had reduced its deferred tax assets by $119.4 million, a sign that the accountants were saying there wouldnât be a return to big profits any time soon. By the end of the week, all three rating agencies had downgraded MF Global debt to junk. Moodyâs wrote that its downgrade âreflects our view that MF Globalâs weak core profitability contributed to it taking on substantial risk in the form of its exposure to European sovereign debt.â MF Globalâs stock finished the week down 67%.
The actual details of the run arenât clear yet, but according to the CFOâs affidavit, the ratings downgrades âsparked an increase in margin calls,â which drained cash. Plans to sell all or part of the business fell through, reportedly because of the discovery of the missing cash. Another part of the explanation might be that potential buyers found out just how weak the core business was.
Of course, if Corzine made the trades for an accounting play, thereâs a deeper question of why he would feel the need to do this. And isnât that always the question in situations like this?
PHOTO: Jon Corzine, MF Global Holdings Ltd. CEO, leaves the office complex where MF Global Holdings Ltd have an office on 52nd Street in midtown Manhattan, October 31, 2011. REUTERS/Brendan McDermid