Easy Street

What’s Going on With MF Global?

Heidi Moore Oct 26, 2011

When the market wants blood, it will have it. Today the object of the market’s bloodlust is MF Global, the futures brokerage that has been suffering from turbulence for years. MF Global is hardly a household name, but it becomes more recognizable if you remember that it is run by Jon Corzine, the former governor of New Jersey and former CEO of Goldman Sachs.

MF Global’s stock has lost about 50% of its value recently, and it lost another 30% today after a Wall Street Journal scoop that the firm had hired Evercore Partners, an investment bank, to explore its “strategic options.” In Wall Street-speak, strategic options usually mean a potential sale of the company.

The question may be, who would want to buy it – meaning, who can shoulder the burden? As Sandler O’Neill analyst Rich Repetto pointed out in a research report today, MF Global missed its earnings estimates by a deep chunk this quarter, losing 9 cents a share instead of the 5 cents-a-share profit that analysts expected. It also suffered a steep decline in “principal trading,” which is trading for its own account – to the tune of a 90% drop in revenue from that business.

The biggest strike against MF Global: Moody’s downgraded the firm’s bonds – a disaster for a futures brokerage that depends heavily on its credit rating to do business. In fact, investors have driven MF Global’s bonds into “distressed” territory – which means, if the firm is looking for a sale, it would probably, at this point, look more like a fire sale.

Richard Repetto, an analyst for Sandler O’Neill Partners, took issue with the decision of Moody’s.

“Moody’s downgrade partially mis-characterizes risks. On Monday, Moody’s downgraded MF’s debt to Baa3, one level above junk status. While we don’t question Moody’s call to downgrade the debt, we believe they mis-characterized one of the two items the rating agency used to highlight its view of the “firm’s increased risk appetite and….question about the firm’s risk governance.” Moody’s stated that “(MF) needed to inject capital into its broker-dealer subsidiary to rectify a regulatory capital shortfall”. To be clear, MF’s capital haircuts were increased in August and retroactively applied to the calculations for July. There were no “capital shortfalls” as Moody notes, as MF met its revised regulatory capital immediately after it was informed of its new requirement. Still, a further potential downgrade by Moody’s is a looming risk for MF and the potential impact it could have on client interactions.”

Easy Street’s translation is this: Moody’s downgraded MF Global because it suspected the firm’s risk-management was troubled. “Risk management” is how Wall Street firms figure out whether they are taking on too much risk; to question a firm’s risk management is to suggest that it is, essentially, reckless or careless in its ability to determine whether it is risking more money than it can afford. Because risk management is the single most crucial function standing between a financial firm and total disaster, Moody’s comment created a lot of concern in the markets.

This Moody’s comment brings up some old ghosts. MF Global has had a troubled history in the past three years, and Corzine was the man to turn it around. Back in 2008, the firm’s stock had lost 90% of its value in a year because of the financial crisis and a rogue trading scandal. After the rogue-trading blowup, in which a single trader lost $141 million on wheat futures, a group of pension funds sued MF Global, irritated by what they alleged was the firm’s ability to manage its risk.

Moody’s also suggested that MF Global did not have enough cash on hand to cushion itself against potential losses – the “regulatory capital” point. Repetto rebuts that point and says that MF Global actually did shore up its capital in July.

Even so, MF Global has a whopping $6.3 billion in sovereign debt exposure to Europe – which may be reason enough for the massacre of the stock, considering that German Chancellor Angela Merkel suggested today that the failure of the euro would end in a continent-wide war.

MF Global’s response to those concerned about its sovereign-debt exposure may not fill a lot of people with confidence. The firm argues that most of the European bonds it holds are of short duration, and that they will be backed by the EFSF, which is the European debt-bailout facility. The argument that your trading risks are okay because a bailout is on the way — well, it’s not a way to win Wall Street’s confidence. But it will take months to determine the real answer.

Repetto said: “Over the next approximate 13 months, we’ll see whether MF’s risk taking was prudent in relying on this governmental backstop and other factors as they put on these positions. We note it appears the actual bonds and CDS are NOT foreseeing a default in the European bonds MF holds.”

Even so, Repetto suggested in his report today that MF Global is not in as dire straits as it would appear:

“Still, we believe the magnitude of the stock price movement appeared exaggerated given that most of the issues were disclosed earlier and some appear potentially manageable. However, we
acknowledge the self fulfilling, “aggregate” risk to clients has grown as MF tries to swim upstream against what could be mis-perceptions of its financial strength and risk management practices.”

But Repetto also suggests that the key issue with MF Global’s future is whether Corzine will stick around.

“It’s about CEO Jon Corzine’s legacy. Clearly investors are aware of his importance as bonds issued in August by the company carry an increased rate should Mr. Corzine leave his position at MF and return to government. And as various MF risks have come out piecemail (i.e. European sovereign debt risk over the last several quarters, increase capital requirements on September 1, Moody’s downgrade yesterday and MF quarterly loss today), still its is the “aggregate risk” that Mr. Corzine will be held accountable for and which we believe drove the stock price reaction post earnings. We believe the success of MF Global will ultimately be Mr. Corzine’s legacy and whether he’s viewed as going out “on top or not,” and we suspect he is aware of the same.”

Corzine’s move is to signal that the firm is up for sale. It will remain to be seen whether that will be enough to stanche the bloodbath.

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