“Any sufficiently advanced technology is indistinguishable from magic.”
Arthur C. Clarke
Every day the total volume of international currency trades is more than $4 trillion dollars. These currency flows, mostly in the form of derivatives, are more than 70 times global trade flows. Where are all those dollars, yuan, euros and yen going? Who keeps track of them?
Making sense of these kinds of numbers is daunting. Our brains are ill-equipped to process the information. When we were children, our thinking about money started with our piggy banks, full of jingling coins and rustling dollars. We graduated to passbook savings accounts, then eventually to checking accounts, credit cards and home mortgages. But long before we arrive at those daily trillions of cross-border currency flows, we simply lose our ability to process the how and why of it.
How can I go to an ATM on a back street in rural Indonesia and withdraw funds that I deposited at my local branch bank in West Chester, Pennsylvania? Even for me, a reasonably bright guy who has worked in finance since 1978, it is impossible to fully understand.
As science-fiction author Arthur Clarke said, it might as well be magic.
Most of us have faith in the magic of the financial system. (Well, maybe not Ron Paul.) We have to, or the entire enterprise would break down. We must believe there are responsible, technically-competent professionals running the entire complex apparatus of electronic money transfers, whom we can count on to keep the electrons moving, not lose any, and make sure no bit or byte goes missing, so all the pennies and dollars end up where they are supposed to be.
We trust in the magic of modern finance, right up until the point that the system fails, as it almost did in 2008.
The latest version of electrons-gone-wrong is MF Global. The firm was a minor player in the commodities futures markets, until it brought in Jon Corzine, former head of Goldman Sachs and former Governor of New Jersey, as CEO in March of 2010. His mission was to transform the unprofitable firm into a big-time player in the financial markets.
Corzine was as ambitious as he was reckless. He beefed up the firm’s trading department and took a huge position betting on the debt of troubled Eurozone governments. We all know how this turned out. Through the fall of last year, one Euro bailout plan after another fell through. The bonds tanked, the trade went bad and MF Global became insolvent in a single chaotic week. When the dust cleared, the firm was in receivership.
The good news is that, unlike Lehman Brothers back in fall of 2008, the failure of MF Global was not large enough to threaten the systemic integrity of the global financial system. The bad news is that, again unlike Lehman, MF Global lost its customers’ money as well as its shareholders’. When it came time to unwind MF Global’s positions, the firm’s regulators tried to arrange a bulk transfer of customer accounts to another firm. This proved impossible, because over a billion dollars of customers’ funds were missing.
Did all this happen by accident, an honest mistake during the chaos surrounding the failure of a highly-leveraged public company? Or did the managers of MF Global, from Corzine on down, choose to compromise their customers’ financial position in a desperate attempt to stay afloat, hoping their trades would work out, the firm would survive and they would be able to make the customers whole after-the-fact?
Was MF Global a failure of technology, of systems or of people? Why didn’t the magic work?
Following Clarke again, I think the magic actually did work, but it was black magic – a use of technology that resulted in the effective theft of over a billion dollars of customers’ funds to cover the firm’s own debts. Investigators are now working to connect-the-dots to determine how so many dollars went astray, who knew about it and who ordered it.
Some large portion of the missing billion-and-change was transferred to J.P. Morgan’s London bond unit on a specific hour of a specific day for a specific purpose – – to make good on a margin call by Morgan, a key MF Global counterparty, which otherwise would have refused to make the trades needed to unwind the tanking Eurobond positions.
The fact that MF Global ended up broke does not mean they are innocent of misappropriating client funds, any more than a pickpocket who purloins your wallet becomes not guilty of theft if he subsequently loses his ill-gotten gains playing the ponies.
Black magic indeed. In the old days, we burned witches. What will we do to Corzine and his colleagues? There’s an old phrase: ‘The rich guy who goes broke in a big way never misses a meal. It is the little guy who runs out of cash a few days shy of payday who goes hungry.’ Which brings us to a really interesting question: Is Jon Corzine, former New Jersey Governor, Friend of Bill, Obama confidante and (until recently) Treasury-Secretary-in-waiting, going to jail? Corzine is worried enough to have hired a top criminal defense attorney.
For investors, the cautionary aspect of the MF Global debacle is this – be skeptical of Wall Street magic. That includes hedge funds, private equity, commodities futures or anything else that an individual of normal intelligence can’t really understand.
I’ve written several times recently about the peculiar challenges investors face today, in the wake of a dismal decade for common stocks and faced with the prospect of an extended period of low secular returns. Investors of all types, from individuals to huge institutions, are desperate to believe there are higher returns somewhere, anywhere. The saga of MF Global is a very specific example of the dangers of chasing high returns. I’ll discuss this issue in more general terms in future posts.