Advisers, regulators must heed MF’s lessons

Quick, what was the primary cause of the demise of Lehman Brothers in 2008? If you answered “excessive leverage,” you are correct. Now, what was the primary cause of the bankruptcy of MF Global Holdings Ltd.?

Excessive leverage. Correct again.

One final question: What warning sign did the regulators who oversaw MF Global fail to act on soon enough to stave off its bankruptcy?

Right. It was excessive leverage.

MF Global’s bankruptcy illustrates again that excessive financial leverage is dangerous, that regulators must remain on high alert for dangerous situations and that they must act expeditiously when they perceive that a firm’s leverage appears too high. Regulators must pay careful attention to the financial reports that major financial services firms are required to submit regularly so as to identify dangerous situations.

The situation also illustrates that Wall Street’s hubris remains intact, as some executives remain willing to “bet the firm” in pursuit of huge profits, and that the risk management practices at major firms must remain suspect.

Risk can bring down even Wall Street’s elite, including former MF Global chief executive Jon Corzine, who resigned last week.

Mr. Corzine, a former co-CEO of The Goldman Sachs Group Inc. who served both as a New Jersey senator and governor, encouraged a huge bet on European sovereign debt, believing it to be undervalued and wishing to boost profits at his firm.

Reports say that the ill-advised MF Global bet on the foreign sovereign debt, particularly Italian and Spanish government bonds, was leveraged 40 times, right up there with the kinds of leverage that brought down Lehman Brothers Holdings Inc. and pushed The Bear Stearns Cos. Inc. into JPMorgan Chase & Co.’s hands at a bargain price.

The bet, without that enormous leverage, wouldn’t have brought MF Global down. The firm simply could have waited until those bonds matured next year or the year after.

But because of the leverage, when the situation in Greece worsened and uncertainty washed over Italy and Spain, driving down the prices of the bonds, MF Global had to put up more capital to back the loans used to buy them.

Ultimately, it couldn’t get the needed capital. As it reported bond losses and the regulators began asking questions, investors fled.

Luckily, although MF Global was a major financial derivatives broker and a primary dealer in U.S. Treasury securities, it wasn’t large enough for its collapse to trigger another financial crisis. Unfortunately for those who invest in financial derivatives, large sums of money have been frozen while regulators and the Bankruptcy Court figure out who owns what of MF Global’s assets.

This was another warning that leverage is dangerous when taken to excess, and excessive leverage should be a warning to regulators, investors and all those who advise them.

INNOCENT VICTIMS

Investors may be tempted to say they would never get caught with such leverage. But they can become the innocent victims of leverage if the firms that they invest or trade through make bad, highly leveraged trades, or those firms trade through others that do.

In addition, many ordinary citizens take on too much leverage outside their investments.

Many took on too much leverage when they bought expensive houses with little or no money down during the housing bubble. Others took on too much credit card debt and saw their savings disappear.

Financial planners and advisers must constantly warn clients about the dangers of leverage.

Archimedes reputedly said, referring to leverage: “Give me a place to stand and I shall move the world.” Today he might rephrase that to: “Give me enough leverage and I will destroy the world.”