Corzine’s Know-Nothing MF Global Defense

Jon Corzine’s evasive testimony before the Senate Agriculture Committee was scripted so as to lay foundations for his defense against customer and possibly shareholder suits and reduce the already very low odds of an indictment.

Although I’ll touch on other interesting elements shortly, the key item from his presentation was one that the New York Times’ Dealbook noted:

“I never intended to break any rules,” said Mr. Corzine, dressed in a dark suit but without his trademark sweater vest. “I know I had no intention to ever authorize the transfer of segregated moneys. I know what my intentions were.” Mr. Corzine has not been accused of any wrongdoing….

Still, over three hours of testimony, Mr. Corzine danced carefully around questions touching on the scandal of the missing funds, using phrases like “never intended” and “not to my knowledge.”

To prove fraud, you need to prove intent. So Corzine’s insistence that he didn’t intend for customer accounts to be raided would seem to get him off the hook, unless documents or the testimony from multiple employees establishes otherwise. His justification amounts to blaming any misdeeds on the fog of war: “Yes, I told staffers to be aggressive, but I never meant for them to bayonet old women and babies.”

In other words, if anything bad was done deliberately, it was all a really big miscommunication:

He did not rule out possible wrongdoing at MF Global. In theory, an employee may have misused customer cash after misinterpreting the chief executive’s words, he said.

Now as regular readers know, CEOs morphing suddenly from Masters of the Universe to empty 42 longs who are clueless as far as operational details are concerned was supposed to go the way of the dodo bird with Sarbanes Oxley. Sarbanes Oxley requires key corporate executives, typically at least the CEO and CFO, to certify the adequacy of internal controls. For a financial firm, that has to include risk controls, which were the big point of failure in the crisis and with MF Global. And the beauty of Sarbox is the criminal provisions track the civil, so if a prosecutor were to prevail in a civil suit and thought it had enough dirt to pass the “reasonable doubt” threshold, it could file the related criminal suit.

Knowing violations of Sarbanes Oxley certifications are subject to up to five years in jail; willful violations, up to twenty years. To my knowledge, only one executive has faced charges under Sarbox: HealthSouth’s Robert Scrushy. He won that case, but as someone who followed it off and on in the Birmingham press, it is not a stretch to argue that Scrushy had a position in the Birmingham area that would make him more difficult to prosecute than most CEOs. And it it also pretty typical for it to take a while to perfect cases when using new legal arguments, so losing an early case or two is often part of the learning process.

So a “know nothing” argument would not only be useless in defending against Sarbox charges, it might actually be damaging (“How can you say you know nothing about operations yet sign that certification?”). Note that for financial statements, the usual approach is to shed liability by relying on auditors. But there are no comparable players in the risk modeling/control world. The banks are typically on the bleeding edge in some areas, which often include very profitable new strategies, which works against third party validation.

There were some other oddities in the Corzine testimony. Remarkably, he insists the firm got to be less risky on his watch because its gearing fell from over 37 to one to 30 to one. Immediately after that, however, he describes the repo to maturity trades in some detail, and points out, as others have, that they were treated as off balance sheet for accounting purposes. Since these trades were clearly NOT off balance sheet from an economic standpoint, any discussion of the firm’s true economic risk should include the repo to maturity transactions. It would clearly lead to a higher level of leverage than Corzine presented in his testimony, and likely higher than under the predecessor regime.

In fact, the repo to maturity trade had the exact same defects as the negative basis trade that we described in ECONNED, which blew up the global banking system. There, traders were able to achieve high leverage (typically, they used no capital at all) by holding AAA tranches of CDOs and hedging them with an AAA counterparty (in some cases, remarkably, a mere A rated counterparty, meaning ACA, was deemed acceptable). These were very attractive to traders because all the discounted income over the life of the trade, less funding and hedging costs, was treated as immediate profit. The magic of an AAA rating plus a hedge was treated as if all credit risk had been eliminated. We know how that movie ended.

With MF Global’s repo to maturity trades, the credit risk was effectively assumed away due to the short duration of the trade and the matched funding (and like the negative basis trade, all expected profit was recognized up front). But as has been discussed elsewhere, the people running the book forgot about mark to market risk, that if the value of the trade OR MF Global’s credit rating fell, they’d be required to put up more collateral. With MF Global not having a great credit rating to begin with, failing to recognize that they might face higher haircuts was a glaring oversight.

Finally, it appears that Corzine, thanks to the advice of the Boston Consulting Group, was in the process of trying to become the next Bear or Lehman: a subscale full service investment bank, presumably with a strength in commodities.

The Bear/Lehman movies ended badly for a simple reason: if you are going to compete directly with the big boys, you need roughly 90% of their infrastructure. The business has large minimum scale requirements: back office, computers, broad product mix to serve corporate and institutional clients, presence in major geographies, you might be able to get away with not being in certain secondary locations. Yet you only have 60% to 75% of their volume. That gives you inferior economics, which in turn puts you at a disadvantage in attracting and retaining the dreaded “talent.” Sadly, many producers do have leverage, in the sense that they can take their franchise to another full service firm. If they heads of business units leave and take their top two subordinates with them, the hole is very difficult to plug short term and will have a detrimental impact on related operations.

So what do firms in those positions do? They take on outside risks in the hopes of producing higher returns than the industry leaders, so as to make them more attractive to industry professionals and to help them over time reduce the scale gap with the leaders. But the network effects (primarily, information advantages) of being a top player are so large that even superior risk taking acumen (or just dumb luck) are almost certain to be insufficient to overcome the advantages of the very top firms.

So in other words, MF Global blowing up by taking too much risk was not an accident. It was inevitable, given its strategy, as the examples of Bear and Lehman attest (remember, Lehman suffered a near death experience in the Asian crisis of 1997). But MF Global did unravel awfully quickly. We will hopefully know in due course exactly what bad decisions and management failings were the proximate causes of its death, and more important, the loss of customer funds.

This post originally appeared at naked capitalism and is posted with permission.