Bankrupt brokerage MF Global showed appetite for risk
NEW YORK -- Moody's Investors Service said it saw no reason to change its rating of MF Global when Jon Corzine became CEO of the Manhattan-based brokerage in March 2010.
But while citing the "first-rate industry and leadership experience" of the onetime Goldman Sachs head, former U.S. senator and ex-New Jersey governor, the ratings agency posed a question.
"What will new management do to return MF Global to consistent, long-term profitability while keeping its risk appetite in check?" asked Alexander Yavorsky, a Moody's vice president who has since left the firm.
After last week's Chapter 11 bankruptcy filing by MF Global, a collapse triggered in part by the brokerage's heavily leveraged, multibillion-dollar bets on European government debt, the question seems somewhat prescient.
Yet a series of other statements by ratings agencies, along with charges in lawsuits against MF Global, spotlighted serious questions and warnings that threatened the firm's future before the implosion.
A costly bad trade
MF Global's Memphis branch office was the epicenter for arguably the most significant previous financial tremor in February 2008. Evan Dooley, a broker there, placed an unauthorized wheat futures position while trading for his own account. His financial bet went $141 million bad.
Dooley had no apparent way to pay, so MF Global was forced to make good on the contracts. The brokerage and its insurers have been fighting in New York state courts ever since over whether MF Global's policies should cover the incident. The brokerage initially prevailed, but the insurers appealed in April.
In an earnings conference call with Wall Street analysts after the incident, MF Global's then-CEO Kevin Davis described the shortfall as an "aberrational" loss that had prompted "false rumors regarding our liquidity." He also said "the worst is behind us."
But by then, Moody's had downgraded the brokerage's long-term issuer rating from A3 to Baa1, a grade signifying moderate credit risk on Moody's Aaa to C rating scale. Moody's also placed the rating on review for a further possible downgrade.
"The failure of MF Global's systems to prevent the placement of trades in an account with insufficient funds represents a serious breakdown of risk controls," the ratings agency said, adding that it would re-evaluate the firm's risk management.
In January 2009 — soon after the peak of the financial crisis — Moody's downgraded the rating to Baa2 and changed the outlook from stable to negative. While saying MF Global had "largely stabilized" despite losses of customer balances and lower trading volumes, the change came with another warning.
"MF Global's franchise ultimately relies on customer and counterparty confidence, which is especially fragile for many financial institutions in the current time of stress," said Moody's.
Ten months later, Yavorsky raised concern that the brokerage had doubled its balance sheet leverage, the measure of its reliance on debt financing, since the end of 2008 in response to lower revenue. "If leverage remains at currently elevated levels, particularly if combined with increases in duration or credit risk, this would put negative pressure on the rating," he said.
As economic uncertainty over the finances of Greece, Italy and other European nations roiled financial markets over the last year, MF Global fought a Commodity Futures Trading Commission proposal that would have barred the brokerage and other futures commission firms from investing customer funds in foreign sovereign debt.
"In our view, the CFTC's proposal is unnecessary and will eliminate a liquid, secure, profitable and necessary category of investment," MF Global and key competitor Newedge USA wrote in a joint Dec. 2, 2010, comment to the market regulator.
High confidence
Corzine sought to reassure Wall Street about the firm's financial bets on European debt even as he announced an 83-cents-a-share quarterly loss during an Oct. 25 earnings conference call. "At the inception of these positions, we made the judgment that the securities we financed to maturity would repay given their high credit rating and short duration," he said, a transcript shows.
But ratings agencies weren't swayed. Moody's downgraded the brokerage's long-term ratings to Baa3 and placed them under review for possible further reduction. Noting that MF Global's $6.3 billion sovereign debt exposure was five times the firm's tangible common equity, Moody's warned, "The risk appetite revealed by this position, in tandem with the significant quarterly loss … subjects the firm to a heightened risk of loss of client and counterparty confidence."
Saying the European debt bets were "very high compared to the company's loss-absorbing capital base," Standard & Poor's placed the brokerage on a credit watch with negative implications on Oct. 26.
Fitch went further the next day, downgrading MF Global to "junk" status. The announcement said the brokerage's reduced commissions and profitability, plus increased proprietary trading, had left it "at risk for credit deterioration and-or margin calls."
The downgrades proved to be self-fulfilling prophecies. MF Global filed for bankruptcy court protection on Oct. 31 when efforts to find a buyer for the company broke down amid signs that an estimated $600 million in customer funds could not be accounted for.
Corzine resigned four days later as regulators and the Justice Department began investigating.