MF Global

[traderadvantage]

As you know, MF Global has gone bust thanks to outrageous bets on worthless sovereign debt. But as you will read, it wasn’t the sovereign debt alone but how MF Global treated these bets via accounting shenanigans. Accounting gimmicks…it is so often accounting gimmicks.

The following is a great article, by way of ZeroHedge, of the accounting scams pulled by so many on Fraud Street but most recently by MF Global.

Submitted by Jeff Snider, President & CIO of Atlantic Capital Management

MF Global Shines A Light On Monetarism's Incapacity To Enhance The Real Economy

The temptation to compare any financial institution’s failure to those that preceded the 2008 crisis and panic are reasonable. It is easy to classify MF Global as 2011’s “Lehman” event, just as it was to use the same term to describe Dexia a few weeks ago. The use of the term “this year’s Lehman” is somewhat misplaced simply because its users are looking for an event that kicks off another crisis or panic. Instead of using “Lehman” to describe a potential inflection point that propels the crisis into panic, it might be better to see MF Global as AIG.

The comparison to AIG is not to say that MF Global was as interconnected, that its failure will be as devastating, or that it is the straw that breaks the European camel’s back. The urge to see the past in the present is historically valid, but it will never be exactly alike (Mark Twain had this right). Rather I think the comparison is useful in that AIG taught the wider world what was really rotten at the core of modern finance, namely hidden risks that were shockingly existential. MF Global’s failure importantly shows that none of the lessons have been heeded in the days since, providing a somewhat unique window into the real dangers that still lurk hidden in the shadows. More than that, though, MF Global demonstrates an obvious shortcoming of the financial system as it relates to the real economy.

The transaction in question was a “repo-to-maturity” financing deal, collateralized with the troubled sovereign European debt that everyone has been talking about in the past few days. What is particularly striking about this is that a “repo-to-maturity” deal is accounted for as a sale, meaning that what is essentially an ongoing collateralized loan is, surprise, hidden off the balance sheet. Maddeningly, MF Global likely booked a profit up front at the transaction’s consummation using obviously faulty mathematical expressions of those “reasonable” expectations of profit, thus avoiding the need to post any liability to the balance sheet.

MF Global was expressing a bet that it could earn a spread, essentially risk free, on the rate it paid on the repo transaction (the lowest borrowing rate around) and the interest it received on the Euro sovereigns (among the highest rates of the sovereign class), all the while counting on the European politicians and the ECB to provide enough “support” to maintain a relatively constant debt price in order to fool the marketplace into complacency about real risks. So the risk hidden but embedded within the transaction appears long before there is a default, hitting the company once the repo counterparty devalues the collateral (the market was apparently not fooled enough by the ECB’s attempts at price stability). This is the essential financial misrepresentation of the age. Repo accounting is responsible for so much hidden risk, yet it has become central to the ongoing survival of the system as it is currently constituted.

That is why this system has to change at some point. It is exactly designed to be misleading, and the reason is so very simple. In any fractional system there will be a desire to amplify that fraction to the maximum degree. But in doing so, participants recognize that the process of maximization entails creating negative human emotions and perceptions since history is not really that kind to this manner of fractionalization. So the system has institutionalized, abetted by the very regulators that are supposed to cap fractions and leverage, these methodologies of hiding just how much financial entities have engaged in maximizing themselves under the cover of mathematical precision. Trillions in derivatives are no problem because there are powerful and elegant equations to net and hedge them.

The fact that money is disconnected from the real economy never enters the consciousness of monetarists since money is always the answer. The primary reasons for this global malaise are that money has lost its productive capacity, its proper place as a tool within the system, not as the ultimate object of that system. MF Global’s failure is an apt demonstration of just how far modern finance has strayed, just as AIG was 3 years ago.

Trade well and follow the trend, not the so-called “experts.”

Larry Levin
Founder & President of Trading AdvantageTM