What Happened At MF Global?

Barry Ritholtz explains his understanding of the sequence of events at MF Global.  Here he is describing how it appears MF Global may have utilized weak UK regulations to circumvent U.S. regulations, and how MF Global's Canadian customers didn't lose their money because of tougher regulations:

We have two last international aspects of this debacle to mull over: Canada and Britain.
Clients of MF Global who lived in Canada lost no money in the collapse. Canada’s regulations do not allow client-segregated monies to be borrowed for speculative purposes. Further, voting and lobbying laws there do not tolerate the sort of corrupt legislative lobbying that is rampant in the United States. Hence, regulators in Canada are far more independent and less affected by lobbying than the regulators in the United States.
Across the pond in Britain, the rules were far looser regarding re-hypothecation than even here in the States. Christopher Elias reported in Thomson Reuters that the Brits allowed U.S. brokerage firms to circumvent U.S. rules. In Britain, there is no limit to the amount of leverage against borrowed collateral through re-hypothecation. Unlimited leverage? As Elias wrote, it was “as simple as having MF Global UK Limited, an English subsidiary, enter into a prime brokerage agreement with a customer, a U.S. based prime broker can immediately take advantage of the UK’s unrestricted re-hypothecation rules.”
Finally, one last disturbing bit: The shadow banking system — the alternative system existing outside of the regulatory rules — is highly dependent on derivatives and leverage. In particular, it is highly dependent on the sort of accounting and credit games like the re-hypothecation and off-balance sheet repos that led to MF Global’s demise. Its failure revealed an enormous degree of systemic risk that remains in the current banking system.
MF Global may have been the first firm that tapped into segregated client monies to speculate and lose it all. It won’t be the last.

Barry is a proponent of the rehypothecation explanation that using client accounts as collateral on proprietary trades is what MF Global did, and that it is legal under dramatically weakened CFTC regulations.  Others have said that instead, MF Global was a poorly run firm which resorted to fraud in a time of crisis, and that rehypothecation didn't have any impact on the customer accounts.  As a hick farmer in the Midwest, I think there are grains of truth in each position.  Clearly, MF Global was poorly run, as:

1) They failed, and failed spectacularly

2) They can't (or won't) explain what happened to assets in custodial accounts, which should be readily available for customers to withdraw at any time.

3) They don't have recordkeeping which shows where all these were located

As far as the rehypothecation argument goes, it seems to be all about what assets could legally be purchased using hypothecated custodial accounts as collateral.  This is more of a regulatory interpretation issue.  I would guess that if one were able to peer into the actions of the investment banks to see how they behave day-to-day, we could get an understanding of what the understood interpretation of these regulations are.  Unfortunately, if the CEOs of the investment banks were called before Congress to explain their activities related to rehypothecation, they would all claim that they never performed such transactions.  When it was discovered that indeed, their firms did act in just the same way as MF Global, the CEOs would claim ignorance.

I also get the feeling that MF Global is the AIG of this situation.  Yves Smith wrote a post on JP Morgan's push for unlimited rehypothecation, which is very informative.  I get the feeling that JP Morgan knew that MF Global was poorly run, and knew that they were making larger bets than they could support using collateral outside of the custodial accounts.  Therefore, JP Morgan felt they could make a killing by loaning to MF Global for them to continue to hold their bets on European debt, while securing the loans by taking the custodial accounts as collateral.  In this situation, MF Global played the role of AIG in 2008, while JP Morgan played the role of Goldman Sachs.  Instead of the U.S. government stepping in to pay off Goldman Sachs when AIG failed, JP Morgan just came in and cleaned out the custodial accounts, as they were apparently permitted to do under UK and U.S. regulations.  In other words, the smarter guys at JP Morgan took advantage of the more stubborn guys at MF Global. 

Unfortunately for all the financial players, the people who didn't know what was going on were the customers.  That is why nobody will come forward and explain what happened.  They fear a global run on investment banks, as customers didn't realize that if an investment bank failed, they could lose their custodial accounts.  I would speculate that all investment banks use custodial accounts as collateral on proprietary trades, just to a much lesser extent than did MF Global, and probably for only overnight repos funds.  That gives them some reasonable interest rates at low risk.  MF Global decided to step up the game, and JP Morgan went along for the ride, figuring that only the folks at MF Global would face legal issues when it didn't work out.  The coverup is to protect JP Morgan and the rest of the industry, not to protect MF Global.

Update: more here.