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A CFTC Regulatory Change Opened the Door For MF Global Bankruptcy – And Worse

Courtesy of Jesse’s Cafe Americain 

This is a very good analysis of how regulatory capture and the erosion of regulatory oversight opens the door wide for public loss and the defrauding of investors.

And it is also important to remember that in addition to bad investments, the MF Global scandal apparently involves the use of customer funds to meet margin calls for the firm’s positions, which is a scandalous theft of funds.  And when they were going bankrupt they used checks instead of wire transfers to fulfill customer requests for the return of their money, so they could bounce the checks, even while they were paying bonuses to their own London traders.  

The government needs to address this as well and if appropriate bring the charges.  I have suggested that the fraudulent conveyance law has some potential applicability, and possibly RICO statutes depending on the involvement of third parties.  Since Jon Corzine is a high ranking Democrat, a lack of action by the Obama Administration on this would be particularly odious.

History shows that it is never the initial criminal action that brings down a government, but it is always the subsequent coverup and obstruction of justice that destroys careers and cripples administrations and their parties.  In this case it might even be worse, since it involves a more widespread corruption that is caught in a credibility trap.  It cannot be addressed credibly with reform over even honest discussion by those in positions of authority because they have been involved in a crony capitalism that is not limited to a few transactions, but is rather, pervasive.  

And this is why even the Republicans may not use this scandal as an issue, because they may be complicit as well.  And so the failure of the honest regulation of the markets festers, crippling the real economy.  

The ideological fantasy that government is the problem, and simply getting rid of it is the answer, is a great propaganda slogan for white collar criminals to promote, but it makes little sense in the real world of flawed human beings and a persistent rogue element in any society.

For it is the constant weakening of regulations by the banks and their lobbyists that led to the financial crisis and the looting of the public trust.   If the criminals have corrupted the policeman, one does not get rid of the police department as a solution, because that is to fulfil the very intent of the criminal element in the first place.  One reforms what has been corrupted, and prosecutes the criminals more vigorously.

"Turn where we may, within, around, the voice of great events is proclaiming to us, Reform, that you may preserve."

Thomas B. Macaulay

The problem is the weakening of government by corruption. And the solution is reform, not more of what went wrong with the rule of law, replacing it with lawlessness.

The danger is that when, in the name of libertarian reform or some other misguided anarchist movement, the laws are knocked down, and the social fabric is torn, very often the worst of us, the truly ruthless opportunists, put forward their ‘strong men’ or a ‘great leader’ to bring back order and act as the law, or merely preside over the law of the jungle

And then begins the real descent into hell.

Tiny Rule Change at Heart of MF Global Failure
By William D. Cohan
November 15, 2011, 9:15 PM EST

Nov. 16 (Bloomberg) — Laurie R. Ferber has quite a resume. She is currently the general counsel of MF Global Holdings Ltd., the New York-based futures and commodities brokerage that filed for bankruptcy on Oct. 31, listing some $40 billion in liabilities….

Before that, she spent more than 20 years at Goldman Sachs Group Inc., where first she was general counsel for J. Aron & Co., a commodities business that Goldman Sachs bought in 1981, and then was the co-general counsel of Goldman’s principal business, known as FICC — for Fixed Income, Currency and Commodities — when J. Aron was merged into the rest of Goldman’s fixed-income division.

But at the moment, her greatest significance may be as a long-time advocate for revisions to a little-known and vastly underappreciated Commodities Futures Trading Commission rule called Regulation 1.25.

Before 2000, the rule permitted futures brokers to take money from their customers’ accounts and invest it in a number of approved securities limited to “obligations of the United States and obligations fully guaranteed as to principal and interest by the United States (U.S. government securities), and general obligations of any State or of any political subdivision thereof (municipal securities.)” That is, relatively safe securities with high liquidity.

Internal Repo Allowed

The banks, however, pushed the CFTC to expand the investment options that would allow firms to practice “internal repo.” In this scheme, money is taken from customer accounts and invested short-term in a variety of securities, with the futures brokers reaping the not- insignificant financial rewards from their customers’ money.

And, lo and behold, such efforts were successful. In December 2000, the CFTC agreed to amend Regulation 1.25 “to permit investments in general obligations issued by any enterprise sponsored by the United States, bank certificates of deposit, commercial paper, corporate notes, general obligations of a sovereign nation, and interests in money market mutual funds” — in other words, riskier investments that could make more money for Wall Street.

Then, in February 2004 and May 2005, Regulation 1.25 was further amended and refined to the liking of Ferber and the banks. In the end, the door was opened for firms such as MF Global to do internal repos of customers’ deposits and invest the funds in the “general obligations of a sovereign nation.”

This practice, of course, may well be the centerpiece of the MF Global disaster. We now know that Corzine — who was CEO of Goldman Sachs from 1994 to 1999 — bet $6.3 billion on the distressed long-term bonds of countries such as Italy and Spain, although it’s unclear if clients’ funds were used. Bart Chilton, a CFTC commissioner, told Bloomberg News on Nov. 10 the loss to customers’ accounts may have resulted from a “massive hide-and-seek ploy.”

While the CFTC’s and the Federal Bureau of Investigation’s probes into the missing money continue, it isn’t too soon to pass judgment on how the too-close relationship between Wall Street and Washington can lead to seemingly innocuous changes in the obscure rules governing the securities industry, which, in turn, can result in financial disaster.

Hands on Keyboards

This danger is especially relevant now as hundreds of new regulations are being written that will govern the way Wall Street operates in post-crisis, post-Dodd-Frank world. Needless to say, Wall Street’s lobbyists are looking to place a heavy hand on the regulators’ keyboards and make sure the new rules are rewritten the way they want them to be.

This is nothing new, of course. For years, the finance industry has been influencing the regulations that govern it, often with devastating consequences. For instance, in June 2004, the Securities and Exchange Commission — then the chief Wall Street regulator — without much fanfare agreed to allow securities firms to vastly increase the amount of leverage they could use in their businesses.

So authorized, the financial institutions went to town, levering up their balance sheets on the order of 50- to-1 intra-quarter, and then lowering the leverage to around 35-to-1 by the end of the quarter when it came time to report their financial condition. As a result, a mere 2 percent or 3 percent decline in the value of the assets on their books could wipe out a firm’s equity.

As anyone who has closely studied what happened to Wall Street in 2008 knows, the value of many of the assets that firms such as Bear Stearns Cos., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. jammed onto their balance sheets declined significantly — causing huge losses, wiping out their equity and causing them to be virtually or actually bankrupt. (The same thing happened to MF Global of course, which was leveraged by some 40-to-1 at the end.)

We’ll see if MF Global will claim that the changes to Regulation 1.25 during the past decade gave it cover for its actions. It now seems clear that investing customer money in the risky, distressed long-term bonds of European countries shouldn’t have been permitted. Then again, it’s more than a little amazing that the CFTC allowed futures brokers like MF Global to do internal repos with client funds under any circumstances.

Reform Went Nowhere

In a nifty bit of Washington irony, about a year ago, shortly after the Dodd-Frank Bill was passed, the CFTC proposed vastly restricting the way customer money could be invested. One of the proposed changes was to eliminate the possibility of investing in the sovereign debt of other countries. “The Commission seeks to simplify Regulation 1.25 by narrowing the scope of investment choices in order to eliminate the potential use of instruments that may pose an unacceptable level of risk,” read the CFTC proposal.

Unsurprisingly, the reform effort went nowhere. Equally unsurprisingly, one the many comment letters from financial professionals to urge the CFTC to keep the status quo came from Laurie Ferber.

Now, MF Global is gone, along with thousands of jobs and billions of dollars in creditor money — to say nothing of the still missing $593 million. “I believe we have to tighten how investor funds can be used,” Gary Gensler, the CFTC chairman and another former Goldman Sachs executive, said on Nov. 7. “They’re segregated and must be segregated at every minute of every day. And then if they are invested, they should be invested with good collateral with outside parties.” That’s the right idea; I hope this time the commission means it. 

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