Tuesday, November 29, 2011

MF Global and moral hazard

I've been sitting on this post for nearly a month now, ever since ex-Goldman Sachs CEO (I told you, these guys are everywhere) and ex-New Jersey Governor Jon Corzine's firm, MF Global, went belly-up--and "misplaced" a bunch of client funds in the process. The repercussions of this collapse are widespread and still being felt throughout the financial markets, and it cannot be so easily dismissed as an isolated incident. 

There are two primary reasons that the collapse of MF Global is so important. First, the apparent theft of client funds threatens to undermine the confidence of a large set of players in financial markets, players who have a significant amount of leveraged capital at their disposal, and who therefore possess great power in the markets. If they no longer think their money is safe in their managed accounts, the effects of that confidence loss could be devastating.

But second, and perhaps more importantly, MF Global is the first major sign that the bank bailouts of 2008-09--whether through TARP, emergency Fed loans, or myriad other backdoor bailouts like failing to prosecute bank fraud of various sorts--didn't end the concept of "Too Big To Fail", but rather institutionalized it.

When TARP was first being considered, one of the chief concerns among those who opposed it (myself included) was that they would create massive moral hazard in the future, and that banks would continue to take outsized risks that threatened to harm our economy, knowing that the government would have their backs if those bets went wrong. By failing to punish the bad bets of the big banks, the government would only ensure more bad bets in the future, in essence guaranteeing that the financial crisis of 2008-09 would be repeated.

Until now, those concerns have been mostly theoretical, with no empirical evidence to support them. But now, with MF Global, we critics have our first piece of hard data to support our moral hazard argument. As evidence, consider the fact that MF Global, at the time of its collapse, was operating with a staggering 40-to-1 leverage ratio--even greater than that of Lehman Brothers at the time of its implosion in 2008.

The politically-connected Corzine (a top Obama fundraiser) clearly expected that the government would have his back if things went wrong at MF, and why wouldn't he? By bailing out the banking sector, it's clear that the government in essence rewarded the bad behavior, and that broker-dealers became even more bold in response. Corzine may have erred in his judgment (time will tell, but his judgment is pretty clearly lacking), but that doesn't make his actions or decisions any less important in a macro sense.

Think MF Global's high leverage ratio is a coincidence, or just one bad player? Think again--a recent study from the University of Michigan confirmed that bailed-out banks took on more risk than those that did not, showing that they failed to learn the lessons of their previous failures. Of course, that's realistically exactly what the Fed and Congress wanted--a rebubbling of the previous bubble, a resumption of the world "the way it was", rather than "the way it should be".

We may hear people here and there in the banking world bellyaching about Dodd-Frank and the "crazy" regulations that they're now subject to, but the truth is that nothing about our government's response to the financial crisis has done anything at all to prevent the next one. If anything, it's done everything possible to ensure the next financial crisis, and MF Global is Exhibit A in that case.

Dismiss the MF Global collapse as an isolated incident if you wish--many people did so with Bear Stearns in March of 2008, foolishly ignoring the risks until they smacked them upside the head in the fall of that same year. But for any who care in the least about the future financial security of our nation, you must recognize that MF Global has the federal government's fingerprints all over it. Thanks, TARP.

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