Ian Nar­ine

Three years ago, we had the fail­ure of CL Fi­nan­cial. That sto­ry is still un­fold­ing, but it is im­por­tant to ques­tion the ex­tent to which lessons have been learned and changes made so that there will not be a next time.This is­sue is posed in the con­text of what is cur­rent­ly tak­ing place in the Unit­ed States, which is rat­ed by all as the most reg­u­lat­ed and ef­fi­cient cap­i­tal mar­ket in the world. Ten years ago, there were the col­lapse of En­ron and World Com based on ac­count­ing fraud. Three years ago, there was the col­lapse of many fi­nan­cial com­pa­nies due to poor risk man­age­ment.

To­day, af­ter all the pub­lic en­quiry, in­ves­ti­ga­tions and new reg­u­la­tions in­vestors are faced with the bank­rupt­cy of MF Glob­al. For those un­aware, MF Glob­al was once the world's largest in­de­pen­dent fu­tures bro­ker­age firm. On Oc­to­ber 31, 2011, it filed for what is the eighth largest bank­rupt­cy in Unit­ed States his­to­ry.

Client's funds were comin­gled with those of the firm and now an es­ti­mat­ed 22 per cent (US$1.2 bil­lion) of the client funds have gone miss­ing. Recog­nise that this event has tak­en place just a few years af­ter Mad­off and Stan­ford and al­so a few years af­ter Lehman and AIG.

MF Glob­al's lessons for T&T

MF Glob­al of­fers a fun­da­men­tal les­son to in­vestors in T&T. When­ev­er those who in­vest­ed in Cli­co's ex­ec­u­tive flex­i­ble pre­mi­um an­nu­ity (EF­PA) prod­ucts seek to de­fend their ac­tions the first point is that the in­vest­ment as they un­der­stood it was guar­an­teed by a statu­to­ry re­serve at the Cen­tral Bank. All of the failed US com­pa­nies just men­tioned were al­so reg­u­lat­ed. In the case of MF Glob­al, there are rules re­strict­ing the use of client funds. If, how­ev­er, man­age­ment is bent on cir­cum­vent­ing those rules then reg­u­la­tions are just a hur­dle that has to be crossed.

A de­sire to cir­cum­vent the rules is in my view a key el­e­ment in the fall of CL Fi­nan­cial and we must ap­pre­ci­ate that all of us as in­vestors are re­spon­si­ble for whom we give our mon­ey to. Very of­ten we ab­di­cate that re­spon­si­bil­i­ty for the sake of ex­pe­di­en­cy but, hope­ful­ly, that is one les­son that in­vestors have learned well and will not re­peat.

An­oth­er point is that at the time of its bank­rupt­cy MF Glob­al had as­sets of US$41 bil­lion and li­a­bil­i­ties of US$39.7. The as­sets ex­ceed­ed the li­a­bil­i­ties yet the com­pa­ny filed for bank­rupt­cy. Hope­ful­ly, this will serve as a point of re­flec­tion for those who con­tin­ue to mis­lead the lo­cal pop­u­la­tion as to the sta­tus of the CL Fi­nan­cial Group and Cli­co back in Jan­u­ary 2009. When a com­pa­ny is un­able to meet its oblig­a­tions when due, it is in­sol­vent from a cash­flow per­spec­tive. The as­sets on the bal­ance sheet are ir­rel­e­vant in that con­text.

If the tax­pay­er pro­vides the liq­uid­i­ty to sup­port the cash­flow short­fall then the tax­pay­er should be en­ti­tled to some mea­sure of com­pen­sa­tion for such an out­lay. Yet, three years on, and the lo­cal tax­pay­er is the bear­er of a sig­nif­i­cant por­tion of CL Fi­nan­cial bill with­out any hint of a re­turn.

What is shock­ing to me is that there are in­vestors and share­hold­ers ex­pect­ing that they emerge from such a sce­nario with­out penal­ty and a view that they are en­ti­tled to 100 per cent of their mon­ey.

Sim­i­lar be­hav­iours

Let's go through some de­tails about MF Glob­al and see if it sounds fa­mil­iar to what we have ex­pe­ri­enced lo­cal­ly. What if I tell you that days be­fore fil­ing for bank­rupt­cy, MF Glob­al paid bonus­es to staff? Sounds very sim­i­lar to what we are hear­ing in the lo­cal com­mis­sion of en­quiry, not so?

MF Glob­al was head­ed up by an icon­ic leader by the name of Joe Corzine. He was at the helm of Gold­man Sachs when it be­came a pub­lic com­pa­ny. He was a for­mer US sen­a­tor and a for­mer gov­er­nor of New Jer­sey.Last week, Corzine was be­fore the US Sen­ate try­ing to ex­plain what hap­pened and be­ing called to ac­count for the miss­ing bil­lions of client mon­ey. The on­ly thing dif­fer­ent from the T&T sce­nario is the head of CL Fi­nan­cial be­ing called to ac­count, but we wait and hope.

MF Glob­al was at its core, a US bro­ker/deal­er spe­cial­is­ing in com­modi­ties and fu­tures trad­ing. Un­der the helm of Corzine, the com­pa­ny moved away from its core to be­com­ing a full- ser­vice in­vest­ment bank. Com­pare the sim­i­lar­i­ty to what was os­ten­si­bly an in­sur­ance com­pa­ny that sub­se­quent­ly mor­phed in­to an en­er­gy, re­al es­tate and al­co­holic drinks con­glom­er­ate.

While most of the above are co­in­ci­den­tal oc­cur­rences, the re­al sim­i­lar­i­ty with our lo­cal sce­nario is the ex­ces­sive use of lever­age and the use of client funds in high-risk ven­tures. Al­so sim­i­lar was the com­pa­ny's abil­i­ty to hide its true li­a­bil­i­ties and mask a num­ber of off bal­ance ex­po­sures from the reg­u­la­tors and in­vestors. I re­peat, where man­age­ment is bent on ma­nip­u­lat­ing the rules, the reg­u­la­tor is lit­tle more than a hur­dle to cross.

Le­gal mis­ap­pro­pri­a­tion

Back in the days of Lehman Broth­ers, I wrote about "re­po 105" where the com­pa­ny sought to ar­bi­trage dif­fer­ing laws be­tween the US and Unit­ed King­dom so as to ma­neu­ver short-term loans and in­stead have them clas­si­fied as sales. Ap­pre­ci­ate that a loan is a li­a­bil­i­ty on the bal­ance sheet where­as a sale rep­re­sents rev­enues that con­tributes to prof­itabil­i­ty-a vast­ly dif­fer­ent out­come.

In the bro­ker­age in­dus­try, clients are of­ten al­lowed to use mar­gin. So in a mar­gin ac­count I can put $800 of cash and use mar­gin (debt) to pur­chase an­oth­er $200 worth of stocks to have a to­tal port­fo­lio val­ue of $1,000. The US reg­u­la­tors al­low the bro­ker to pledge up to 140 per cent of the clients mar­gin for their own bor­row­ing needs. In this case, it is 140 per cent of 200 ($280).

Here again the US and UK rules dif­fer, and the UK rules are such that there is no lim­it on what a bro­ker can pledge for their own use from client funds. So if the clients as­sets are trans­ferred to a UK-reg­is­tered bro­ker­age op­er­a­tion, then in­stead of be­ing able to pledge $280, the bro­ker­age can pledge the full $1,000. This, of course, is al­low­ing lever­age on top of lever­age.

So now armed with in the­o­ry all of its client as­sets that can be used as col­lat­er­al for its own pur­pos­es a bro­ker­age firm has a ready-made liq­uid­i­ty back­stop. The next part of the deal was where MF Glob­al un­der­took sale and re­pur­chase agree­ments (com­mon­ly known as a re­po) where it bor­rows to pur­chase the sov­er­eign debt of dis­tressed Eu­ro­pean coun­tries.

Such a move may cause alarm bells for in­vestors ex­cept the firm used an ap­proved ac­count­ing rule to take the trans­ac­tion off bal­ance sheet. If the term of the as­set and the loan is the same (re­po-to-ma­tu­ri­ty), then the rules con­clude that the firm has ef­fec­tive­ly "re­lin­quished con­trol" of the as­set and the li­a­bil­i­ty and so it is tak­en off bal­ance sheet.

Just as with much in the CL Fi­nan­cial Group, the orig­i­nal propo­si­tion was not ex­ces­sive­ly risky.

These trans­ac­tions orig­i­nat­ed in the in­dus­try with US Trea­suries where the cred­it risk was nil and be­cause ma­tu­ri­ties were matched, there was no mark to mar­ket im­pli­ca­tion (nil mar­ket risk). How­ev­er, as with the fi­nan­cial cri­sis of 2008, the search for yield drove MF Glob­al to­wards more risky as­sets, in this case, dis­tressed Eu­ro­pean sov­er­eigns. These are the types of hid­den risks that ac­cu­mu­late in the sys­tem be­cause of ab­nor­mal and ar­ti­fi­cial­ly low in­ter­est rates that I was speak­ing about last week. Our pol­i­cy­mak­ers, in my view, need to pay greater at­ten­tion to this is­sue.

The size of the ex­po­sure to the debt of Italy, Spain, Por­tu­gal and Ire­land by MF Glob­al was such that it ex­ceed­ed the firm's book val­ue five times over. Un­like US Trea­suries, these se­cu­ri­ties did car­ry cred­it risk and, as cred­it risk de­te­ri­o­rat­ed, mar­gin calls be­came nec­es­sary.

A mar­gin call is the post­ing of ad­di­tion­al col­lat­er­al to cov­er a lever­aged po­si­tion and is ef­fec­tive­ly a liq­uid­i­ty event. Giv­en the size of the ex­po­sures, the mar­gin calls turned out to be greater than the liq­uid­i­ty re­sources of the firm. The next stop was the avail­abil­i­ty of client funds un­der UK reg­u­la­tions so that client as­sets were then pledged as col­lat­er­al to sup­port the grow­ing mar­gin call.

Even­tu­al­ly, it all un­rav­elled, coun­ter­par­ties lost con­fi­dence in their deal­ings with MF Glob­al and the firm filed for bank­rupt­cy. Many clients have lost mon­ey and share­hold­ers have been wiped out.As I will ex­plain next week, it is not just MF Glob­al that is in­volved in these types of trans­ac­tions, this is per­va­sive across the in­dus­try.Ian Nar­ine is a bro­ker reg­is­tered with the Se­cu­ri­ties and Ex­change Com­mis­sion