This article is from Cafe Hayek and is republished with permission of the author.
By Russ Roberts
The collapse of MF Global, a highly leveraged gambler on Europe’s fate using other people’s money means that those who funded those gambles have lost virtually all of their money. Some of those who financed those gambles were pretty savvy firms. William Cohan, writing at Bloomberg, wonders what those with an ownership share were thinking as MF Global took on more and more risk:
Where, for example, was J. Christopher Flowers, the billionaire founder of J.C. Flowers & Co.? According to MF Global’s most recent proxy statement, Flowers’s firm owned 6.8 percent of MF. But then Flowers had reasons to have blind faith in Corzine: It was Flowers who recruited the former governor to MF in 2010, and also made Corzine a partner in his private-equity fund. When the two men were at Goldman Sachs in the 1990s, they had a symbiotic relationship: As Flowers was head of the financial-institutions group, Corzine relied on him to make introductions to other Wall Street bosses so they could ponder strategic deals.
Where were MF Global’s other institutional shareholders, such as Fidelity Investments (which held a 14.8 percent stake, according to the proxy), Guardian Life Insurance Co. (7.4 percent), TIAA-CREF Investment Management LLC (6.6 percent) and Piper Jaffray Cos. (PJC) (6.3 percent)? Were they too dazzled by Corzine’s resume to take a serious look at how he intended to transform MF Global from a backwater to a major player on Wall Street? Where was MF Global’s auditor, PriceWaterhouseCoopers LLP, which managed to pocket almost $25 million in fees from the company over the past two years?
Those are all good questions. But these were equity investors who stood to make lots of money if the bets of MF Global paid off. Perhaps they had ways of hedging against the risk that MF Global was taking. The real question is why the creditors of MF Global lent so much money with so little security or upside.
So what happened? Last week, MF Global disclosed that it had $6.3 billion exposure to the shakiest of European sovereign debt.
Its balance sheet was huge but terribly fragile. While it had lots of assets on its books, it also had a huge amount of borrowing. For every dollar of its own capital on its books, it had borrowed $40, a leverage even greater than that of Lehman Brothers at the time of its collapse.
Why is that a problem in a time when near-zero interest rates extend as far as the eye can see? Because leverage is always treacherous and 40-to-1 leverage is madness. Even when interest rates are low, lenders demand security. When the value of that security goes down, the demand for margin — additional collateral to secure the debt — goes up.
The plunge in the price of European sovereign debt meant that MF Global had to stump up more cash or easily marketable securities to its lenders so that they would have adequate security for their loans. A well capitalized, reasonably leveraged firm should be able to handle margin demands and survive. But with only 2.5% or so of its assets representing capital rather than borrowed money, MF Capital could not find enough of its own cash to satisfy its lenders.
Did those creditors who allowed MF Global to be so leveraged think that Corzine’s political connections would lead to the bailout of creditors as had occurred with Bear Stearns, AIG, and others? Or were they just naive or too trusting or too busy or too hungry for yield? Did they think that MF Global’s bets were likely to pay off despite the risk?
It’s the same debate over why the financial crisis occurred. Was it moral hazard or greed coupled with stupidity (or at least overconfidence)? In this case, it hardly matters because MF Global is headed to bankruptcy court and the investors and creditors will get whatever scraps are left of the company. There doesn’t seem to be a crisis despite a bankruptcy of $40 billion heading to court. And I have this strange view that losing most or all of their money will make some of those investors and lenders a little more careful down the road. It’s a feedback loop that is very powerful. Lend money and lose it all and you feel the pain. That’s how capitalism is supposed to work. Maybe, just maybe, the next MF Global will have a hard time convincing lenders that it’s OK to be leveraged 40-1.
But both Lewis and Cohan believe that the natural forces of profit and loss are inadequate to discipline recklessness. They both want more regulation. Here is Cohan:
The collapse of MF Global points once again, in the strongest possible terms, to the importance of having a substantive, teeth-bearing regulatory regime charged with overseeing the kind of asynchronous risk-taking that gives people like Corzine the incentive to gamble with other people’s money in hopes of reaping financial windfalls. And yet, more than three years after the collapse of Lehman Brothers and the onset of the financial crisis, we don’t have in place anything close to necessary regulations to try to prevent companies like MF Global from exploding.
Why does the collapse imply a need for regulation? I don’t get it. Earlier in his piece, Cohan writes:
It didn’t have to be this way. The tragic element of Corzine’s MF Global is that Monday’s bankruptcy filing could have easily been avoided if Corzine’s ego and ambition had been held in check by someone — anyone — willing to stand up to the former New Jersey governor, senator and senior partner at Goldman Sachs Group Inc. (GS)
Is that a problem now? Isn’t it pretty clear that from here on out, we don’t have to worry about someone holding Corzine in check? He’s done it all by himself. He’s going to find it a lot harder to get people to fund his risk-taking the next time out. And what “didn’t have to be this way?” That’s a question for the investors and creditors to answer for themselves. Why is it a question for the rest of us? Why do we want the government to protect naive or greedy investors from their own shortcomings? Let’s them learn a lesson for a change. Why won’t that work?
Here is Eric Lewis:
Many will view the demise of MF Capital as just another bit of the “creative destruction” of capitalism. The Republican candidates complain that Dodd-Frank, last year’s financial reform bill passed in response to the credit crisis, is stifling healthy risk-taking. The reality is that Dodd-Frank does not do enough to prevent financial institutions from taking excessive risks with investors’ money. While it imposes leverage requirements on banks, those requirements are still quite limited, and institutions not regulated by federal banking agencies are not restricted in their risk-taking in any meaningful way.
If their huge bets on European debts had paid off, Corzine and his colleagues would have added to their immense wealth. All of their incentives were to borrow as much money as possible so that small price movements in their direction would make them rich and large price movements in their direction would make them unimaginably rich.
Their debts did not pay off; they are still rich, but there are many others who will be much poorer. Leverage is the steroid of modern finance that creates the hazardous incentives to bet big, keep the winnings and dump the losses onto others.
What MF Global shows is that the problem is not too much regulation but too little. Without meaningful leverage restrictions on borrowers and meaningful lending restrictions on those who are willing to underwrite this steroidal debt expansion, MF Global is likely to be the tip of yet another iceberg. And we have yet to recover from the last financial Titanic.
There are two ways to restrain imprudent leverage. The first just got imposed on Corzine. His creditors lost most or all of their money. They’ve learned a lesson. If they were overly optimistic about a bailout, they have adjusted their expectations somewhat for the next time. If they were just overly greedy or optimistic or naive they’ve had some prudence and sense knocked into them in a very expensive fashion. If we can avoid the temptation to bail out firms leverage will shrink as lenders learn its risks or at least lose their money. Both make it harder to keep leverage high in the future.
The alternative is capital regulation which Cohan and Lewis advocate. We’ve tried that already. Count along with me: One Basel, Two Basel, Three Basel. That approach has failed. They’ll respond and say we just need to do it right. Or that it’s too risky to let firms go bankrupt when there’s systemic risk.
Who writes the regulations? They do. Not us.
Who should lose money? Them, not us.
Let’s change the rules of the game. Let’s tell creditors that they can lose all their money. When that actually happens, I think it will actually change their behavior. You’re on your own. You can’t go to the regulator and make a case for why your kind of leverage is actually really safe. You’re on your own. You make good decisions, you make money. You make bad decisions, you lose money. It’s called capitalism. Let’s try it.