Regulatory Insider: How/Why MF Global Failed

We all know that MF Global failed because it had put on massive bets on sovereign bonds in the Euro-zone. There has to be more to it than that, though, right? Yes, indeed.

Wasn’t Dodd-Frank passed in mid-2010 supposed to limit the leverage that could be utilized by banks and broker-dealers? How and why was MF Global able to leverage itself upwards of 50 times in bets placed in late 2010 and throughout the better part of 2011?

Let’s navigate and go over the financial regulatory wall to learn the answers to those questions from a regulatory insider. This insider recently wrote to me and offered the following:

I want you to realize that the root of the problem with our financial system is a flaw in the SEC’s Net Capital Rule (15c3-1) which allows large broker-dealers (net capital > $250K) to dodge any leverage restrictions.

Under the Net Capital rule, a broker-dealer’s total aggregate indebtedness (unsecured liabilities) cannot exceed 15X its net capital; however, if the broker-dealer’s net capital is > $250K, it can elect to file under the Alternative Method ratio requirement meaning that its net capital must only adhere to the > 2% of aggregate debit items (customer receivables) restriction. (This criteria is meaningless from a financial risk perspective as it does not directly measure leverage.)

In 2011, this flaw in the SEC’s net capital rule caused the MF Global debacle as Jon Corzine placed leveraged bets on PIIGS sovereign debt resulting in 50X net capital leverage ratios, the MF Global bankruptcy and $1.2 billion in missing customer funds. (These speculative bets again breached the SEC’s leverage limit for small broker-dealers of 15X net capital.)

The Lehman and MF Global debacles could have been prevented if large broker-dealers (net capital > $250K) had been forced by the SEC to limit their leverage to 15X net capital (like everybody else).

In my opinion, this flaw is caused by the incestuous relationship between the government regulators and Wall Street. This relationship allows large broker-dealers to borrow unlimited $ amounts to place humongous speculative bets in the market which in turn puts creditors, investors and customers at immense financial risk.

The only purpose this flaw in the SEC’s net capital rule serves is to accommodate the agendas of greedy individuals like Dick Fuld and Jon Corzine whose goal is to get rich using other people’s money.

Unfortunately, our present system allows people like Dick Fuld and Jon Corzine to walk away “scot-free” even after causing tremendous financial pain to countless investors, creditors and customers (in Corzine’s case).

To prevent a re-occurrence of Lehman and MF Global, we need to do “God’s will on earth” and urge the SEC to correct the flaw in its net capital rule which enables large broker-dealers to dodge leverage restrictions.

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Financial regulatory reform? In name only. The next time we hear a political hack in Washington or elsewhere reference that our financial industry has been “reformed”, think about this loophole in the SEC’s Net Capital Rule and realize that the crony capitalism in our nation remains firmly in place. Why is that the phonies in Washington allow this sort of corruptible practice to continue?

Remember, the banks and brokers own Washington. The more we “hope” that things might “change” and that our country might be moving “forward”, the more we need to realize that things truly remain very much the same. Does this surprise you?

Any other insiders care to weigh in on this or other issues?

Given the importance of this specific case and this topic at large, I hope readers will spread this commentary far and wide!!

Written By: Larry Doyle