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When Failure is an Option

Jon Corzine’s appearance before the House Agriculture committee was a yawner and yet breathtaking.  By candidly not pleading the 5th Amendment the testimony was completely lacking in fireworks.  But the substance of it, pleading whatever amendment gives you the right to say “I dunno”, left everyone cold.  As much as $1.2 billion is missing from MF Global – but Corzine has no idea where it is.

As the poster child for more financial regulation, MF Global has a lot to teach.  It was nowhere near “Too big to fail”, but it was big and messy.  This will highlight the laws we have in place and what happens when failure is an option.

One thing we can be sure of in this case is that lawyers will be all over it.  Investors will get back as much money as they possibly can from the company and, more importantly, the insurance carried to personally protect the board of directors.  The financial industry is far from self-regulating in any appropriate way, but you can bet that between their lawyers and insurance companies there will be a drive to tighten up standards based on precedents coming from MF Global – even if Congress does nothing new.

The next obvious question is how the auditor, Price Waterhouse Coopers (PWC), signed off on this company.  They might yet be held liable as well, triggering a different kind of self regulation.   Audits in the US are paid for and held at the direction of the company being audited, meaning they are not reliably independent and full of conflicts of interest.  There is definitely a place for new laws and/or standards to change many of these practices, but again a team of lawyers and a big settlement might do the trick on its own.

There is also the likelyhood of criminal penalties including jail time for MF Global’s executives.  We are about to see if personal responsibility for running a company into the ground is possible with the laws we have in place.  While some institutions might be “Too big to fail”, there’s no reason people can’t be strung up and made into an example for the industry.

Corzine’s testimony, largely hinging lack of awareness of what went on, may be little more than a legal strategy.  It could also have the advantage of being true.  He has only been at the head of this company for 18 months, and the level of fraud and mismanagement appears to be so broad and deep that it could not possibly be the work of one person.  The autopsy on MF Global may open up the smelly guts of a lot of industry practices that should prove enlightening.

It’s not as though “Too big to understand” is hard to accept.  Financial “innovations” are often created with little care as to their broader implications in the market and sold by advisors who really do not understand what it means to their clients.  Regulation of this process is almost certainly going to be impossible, since new products can be crafted around any well-loopholed law.  That is why a broader framework is probably much more helpful.

Consider for a moment the Federal Deposit Insurance Company (FDIC) and its role in banking.  This agency is self funding, getting its operating capital by charging an insurance premium to member banks.  When there is a failure, the team from the FDIC swoops in quickly, often on a Friday afternoon.  Their team might work through the weekend to clean up the mess and determine just how much capital the operation needs to guarantee all deposits and then arranges to have it open under new management on Monday morning.  To depositors, it’s usually as if nothing happened at all.

This model might prove useful for investment houses as well.  The insurance premiums would go up and down based on the relative risk of industry practices and the results of an audit directed and paid for by this agency.  There would be incentive to self-regulate built into the system while allowing for innovation.  And if the pool of capital proved insufficient for a big investment house, a loan from the government or the Fed could tide it over until it was repaid with higher insurance premiums going forward –  stiffing the industry, rather than taxpayers, with the tab.

The examination of MF Global will tell us if a model like this might work and generally make failure an option – possibly even on a very large scale.

The story of MF Global will play out in courts for many years.  The main purpose of a regulatory structure is quick action that could stem a system-wide meltdown and yet allow failure to occur when it has to.  This could be where we learn just how to make that happen if we pay attention.

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22 thoughts on “When Failure is an Option

  1. I hope you dont mean to suggest that these guys could ever be ‘self regulating’ … they are criminals plain and simple and should be called out for what they are

    • Oh, no, not at all! But we do know that there are at least two outside groups, lawyers and insurance companies, that have an interest in keeping these guys in check – and both are pretty powerful. It’s something. I also believe that any public regulation has to start with a truly independent audit – that may be wishful thinking, but if investors get tired of all the BS there’s always a chance that they’ll either insist on such a system or just flee from these pirates until they get their act together.
      As for being criminals, we’ll see if there are enough laws in place to make that a full-on reality in this case. If not, we may need new criminal laws to hold people accountable – I really don’t know. We’ll see.
      But there may be ways of getting around this “too big to fail” that don’t involve just shoveling money at them because anything else could cause economic collapse. That’s not to say we might not want to break up big companies like JP Morgan or Goldman Sachs, but even if we don’t there may be ways to reign them in. But I guarantee you, it’ll start with lawyers and insurance companies whether we like it or not.

  2. I think PWC, the auditor, is the real problem. They did their audit in May and found no problems at all with MF Global. That is just shocking and a complete violation of public trust. It does make you question the entire financial sector when you see such blatant disregard for standards. The mixing of customer and company accounts alone is a huge violation that will probably send people to jail but it was not caught? That is outrageous! I don’t know if you can ever have a truly independent audit that will catch everything but there is something very wrong with the system we have when it catches nothing at a company that everyone knew had serious problems.

    • I completely agree. The system we have now is based on audits, but they are apparently useless. It probably won’t change until people question the whole industry – which they damned well should given how sloppy this one was. It’s a “where there is smoke there is fire” thang – and boy is there a ton of smoke blown around in these audits!

  3. Great blog but I don’t see anything changing until congress changes over. I am sure they will too. The republicans will never allow them to even talk about new regulations even if they are good ones that increase confidence by getting rid of the really bad actors. I don’t think every investment company is run like MF Global was but they sure drag everyone down.

    • I think that is likely true, but that gives us a year to see how this plays out and what really needs to be done. I think nearly everyone agrees that there needs to be a wall between investment banking and commercial banking (ie, a new Glass-Steagall) but beyond that it’s pretty open. MF Global will make the case for action – and the accompanying silence from Congress will probably help get them unelected, yes.

  4. Color me skeptical as well, but I do see your point that as people lose faith finance will have a major problem that they will have to correct. The real problem is how short sighted they are so don’t hold your breath.

  5. After reading this I’m pulling all our savings, cashing in all our CDs, closing our IRA and taking it all and stuffing it in a fire resistant sock, cutting a hole in our basement floor, placing the sock in a weather & fireproof strong box placing the box in the hole and covering it with concrete. We *may* not gain any interest…but we won’t lose another dime.

    • Back in 2007, I was advocating junk silver (coins so worn they have only their silver value, not collectable) and canned tun. Seriously. Search for “junk silver and tuna” and you’ll find it. 🙂

  6. I think we should save by buying US Treasury bonds. Those are safe.

    In Europe Frech and German banks lent to Ireland, Portugal, Spain, Greece and Italy. I believe France and German should rescue the banks within the sovreign borders. In my view tighter fiscal union will annoy the masses because nations like to have control over their budgets. Tighter fiscal union could cause extremism in Europe. During the depression in Europe some of the nations chose fascist dictatorships to solve their problems. They were tired of democracy.

    • Yes, that could happen again. When I say the Euro must print or die, I do mean that “die” is always an option. It’s entirely up to them. However, that process would likely affect us as well – especially if we have financial houses run even somewhat as poorly as MF Global. I think we have to be ready to face what happens when JP Morgan implodes, for example.
      I do plan to revisit this post in the future. MF Global can’t be the only bad actor, even if they are somewhat unusual (which I sorta doubt).

  7. I guess my skepticism about Corzine’s “I don’t know” answers are based on his extensive expertise in the world of banking and debt investments.

    We should remember Corzine’s resume: he served as CEO of Goldman Sachs, and took them from a private to a publicly traded company. He had worked in the Treasury Department before working at MF Global. And MF Global was a much smaller organization than Goldman. With his depth of expertise and experience, I just can’t believe he plain doesn’t know any of the hows/whys of this.

    • OK, I’ll give you that he has some idea what happened, but he doesn’t necessarily know where the money is or who has it. My guess would be either the Caymans or a complex swap involving Banko Industrial de Venezuela (my personal favorite because it involves Cuba) but it’s only a guess. 🙂
      And I am also pretty sure that this is far more embarassing to the guy than his cut of any money, too. He seems to know he has a lot.
      But … it did sound pretty weird to hear him say “I dunno” in so many words, didn’t it?

  8. The Euro is a good idea to begin with because it is very difficult to do business across all these nations when they have different currencies and relatively small economies. That said banks in Germany and France wanted to secure low returns by lending to the overly indebted nations. All I think of is that nations of the world with current account surpluses should help to stimulate the economies of Ireland, Italy, Greece, Spain and Portugal. They need a type of Marshall Plan, so that they don’t go hungry or cold. Their governments had promised them many benefits and nations that have resources should help them with the transition.

    • The problem is that the amount of aid is so large it’s more like Germany doing another Reunification … or, I guess an Anschluss (bad images intended there). So they really can’t do it alone. It would probably involve the US, China … and maybe Brasil. Not something we were banking on.

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