MF Global: How Not to Manage Risk -- Securities Firm Goes Bankrupt With Seasoned Risk Team in Place

Nov. 3, 2011 -- "We believe that effective risk management is critical to the success of our business." So begins a little ditty on how to avoid financial ruin, straight from the pages of the annual report of MF Global, which, with ex-New Jersey Gov. Jon Corzine at its helm, hit a financial iceberg this week and sank, leaving behind a slick of impropriety so oily that the FBI now is investigating.

The highly leveraged firm filed for bankruptcy protection Monday, after a big bet on European sovereign debt went sour. That same day, allegations of financial malfeasance began to surface, with regulators saying it appeared the bank had broken at least one sacred rule of Wall Street: It failed to keep its' clients money separate from its' own.

Money appeared to be missing -- a cash shortfall in customer accounts possibly as high as $700 million. MF Global attorney Kenneth Ziman has since told a New York City bankruptcy judge there was no shortfall -- that management had accounted for all the "missing money."

Mark Williams, author of "Uncontrolled Risk," a book that analyzed the collapse of Lehman Brothers, has worked as a bank examiner for the Federal Reserve and today teaches risk management at Boston University's business school. He called MF Global "an Enron, a Lehman Brothers and a Refco all rolled up into one." The bank, he said, "apparently engaged in unethical behavior" and "took risky bets using excessive leverage. When the market woke up to these disturbing facts, a run ensued that "closed the bank in a matter of days."

Williams said MF Global was almost a textbook example of greed-driven disaster so egregious that "Occupy Wall Street should drop all other placards and simply declare, 'Remember MF Global!'"

MF Global's bankruptcy -- the biggest since Lehman Brothers' -- Williams attributes to five factors:

From the start, he said, Corzine moved the bank to "a more aggressive risk profile," transforming it from a brokerage, which put none of its own capital at risk, into an investment bank that did. Second, MF Global took concentrated, risky bets, primarily on sovereign debt of European countries, including Portugal, Italy and Spain. The reason was simple, he said: "Investing in that risky debt brought two to three times the yield of U.S. Treasuries." Third, Corzine increased the bank's leverage.

Requests for comment to MF Global's attorney, Kenneth Ziman, were not returned.

In 2010, MF Global had $40 billion in assets and $3 billion in equity, a ratio of 13 to 1. By 2011, the same $40 billion was supported by only $1 billion in equity, or leverage of 40 to 1. A 2 percent downturn would be enough to totally eliminate all equity. "That's not a big move down," said Williams, "but the more heavily you're leveraged, the smaller the setback that can put you into bankruptcy."

Some customers, awakening to this increase in leverage, ran away. Others stayed but insisted that the bank post additional collateral. To do this, MF Global "tapped all its credit lines," Williams said. By so doing, "they showed themselves to be financially weak, and that was blood in the water." Customers' demands for higher equity increased.

An MF Global executive told regulators Monday that the securities firm had "diverted" clients money as its financial problems grew, The Associated Press reported. "Probably they thought that they could pay it back," Williams speculated. "But that never happened."

By now the bank's fate, in his view, was sealed. "When the marketplace loses trust, you can't operate anymore," said Williams. "Credit dries up, evaporates. It can happen in days, even hours."

Among the things Williams would like to know -- and that may emerge from an investigation -- is what kind of risk management controls the bank had in place. "In an environment where everybody is motivated by profit," said Williams, "you've got to have a counterbalance"-- checks and procedures to make sure, for example, that firm accounts and customer accounts remain segregated. "Who was on the risk committee? That would be interesting to know."

Not only was there a risk committee, there was -- and still is -- a chief risk officer: Michael Stockman, 63, a visiting scholar at Dartmouth's Tuck School of Business, where, according to MF Global's website, he shares with students his "risk management insights" and recommendations how "to avoid the next crisis."

While Stockman did not respond to ABC News' request for comment, he apparently had plenty to say on the record while at Dartmouth. Asked during a Q&A why he opted to work for MF Global, Stockman described the slot as "a really cool opportunity for someone with my skills."

Asked why an in-depth understanding of the causality of past financial crises was important for business school students to acquire, Stockman replied, "One of my bottom lines is: If you don't understand what your mistakes were, you're destined to repeat them."

Stockman said he "inherited a very athletic, so to speak, team" at MF Global.

"They're open and willing to shape this for the future with the benefit of our experience," he said

He said he "personally catalogued a series of trading and business mistakes and will pass the knowledge on to my colleagues.

"And we've got plenty of evidence that the same series of mistakes have been made over hundreds of years, believe it or not," he explained to his alma mater. "Part of my commitment is to not let those issues happen at MF Global if I can help it."

As for Corzine, his fall from glory is such that Reuters has now reported that President Obama's re-election campaign is considering returning Corzine's political donations to him if he's charged with any wrongdoing, telling Corzine, in effect, to -- in the words of another ditty -- "take back your mink, take back your pearls."