MF Global’s PIIGS Problem

Posted on November 3, 2011 at 9:41 AM PST by

For some investors this Halloween, a trick instead of a treat was found in their proverbial retirement portfolio bag. Why? Because of the spooky gift supplied to clients via MF Global’s announcement of bankruptcy, the eighth largest in U.S. history.

Any while many investors had previously never heard of MF Global, the firm’s failure led to an approximately 10 percent single-day hit to financial stocks. A better understanding of the MF Global debacle may help you exorcise the goblins that may be lurking in your investments.

Indecent exposure

Apart from the alleged $700 million in missing money and illegal activity, MF Global’s core investment problem was its gun-slinging investment approach towards the sovereign debt of Portugal, Ireland, Italy, Greece, and Spain (better known as PIIGS).

Upon filing for Chapter 11 bankruptcy Monday, margin calls of some $6.3 billion in Eurozone debt was revealed. That’s five times the size of MF Global’s equity. MF Global placed a very large bet on PIIGS and in the end, it got stuck in the mud. Ironically, MF Global’s homepage mission statement reads: “Working relentlessly to bring our clients superior market access, hardworking insights and powerful trading and hedging solutions.” If accusations of wrongdoing prove true, they apparently left out: illegal use of funds, shortcuts, and daredevil investing. Powerful indeed!

Just when you begin to feel a bit of relief that your retirement dollars aren’t with that firm, a bit of research reveals that U.S. bank exposure to PIIGS and Eurozone debt is substantial. According to a recent report by the Congressional Research Service, nearly 5 percent of total U.S. banking assets are in PIIGS. That may mean your institution is silently at risk as well. Add to the sobering $641 billion in PIIGS exposure by U.S. banks $1.2 trillion in exposure to German and French banks and you are left with significant risks to U.S. banking infrastructure in the event that the Eurozone goes caput.

This brings us back to our investment primer—be a hawk at diversifying assets and managing risk. Warren Buffett’s famous maxim for investing is simple: “Rule One: Never Lose Money. Rule Two: Never Forget Rule One.” In the case of MF Global, rule number one was long forgotten in favor of leaning dangerously out to grab the brass ring. How does your investment portfolio look when it comes to risk management? Do you have global exposure to six or seven asset classes, or are your investments all stuffed into one asset class in a reach for high returns?

Will the big bad wolf blow your house down?

Worse yet, initial statements seem to indicate that MF Global had more than poor asset allocation to worry about. According to a board member at the Greenwich, Connecticut, firm Interactive Brokers, there appears to be at least $700 million missing from client accounts. Interactive Brokers was pursing a possible acquisition of MF Global when the alleged wrongdoing emerged.

Broker-dealers are charged with keeping client funds separate from company dollars, but according to testimony, MF Global used client money unbeknownst to clients for its own internal investing. How can an investor know if his broker is behaving similarly? The obvious answer is one can’t. Surely, however, placing funds under the care of one of the leading discount brokers that is less inclined to get involved in more esoteric investment banking activities is a start.

How safe is my money?

Moody’s downgraded MF Global last week. This downgrade was met by MF Global’s CEO publically minimizing the rating adjustment. In fact, while MF Global was swirling the toilet, its marketing arm was simultaneously sending out letters to clients reassuring them of the firm’s strength. Once calamity struck, clients who called MF Global on Monday were met with nothing more than a voice recording.

When a similar catastrophe strikes your broker, how do you know your money is protected? Investors may be aware of the Securities Investors Protection Corporation, a government-created entity which provides account insurance and oversees liquidation proceedings. Not all accounts have SIPC protection, so the matter of first importance is to confirm that your account is covered.

If your dollars are in fact covered by SIPC, you must understand the SIPC is not a guarantee that you will receive all lost funds. Unlike the secure promise of FDIC bank account insurance, SIPC coverage must be applied for within a designated deadline and may not cover all forms of fraud. It is the responsibility of the investor to provide the appropriate proof of assets and documentation with his application.

Kevin Bell from SIPC was asked about the process. “What customers ask is, ‘When am I getting my money?'” said Mr. Bell. “You tell them to sit tight, and start gathering their information so they can file claims.”

Some investors thought they had their money securely tucked away in a credible investment house. This week they awoke to their own nightmare to discover that their money was locked away in a house of horrors. Take some time to do a bit of research and vet your broker. Find out what their PIIGS exposure actually is. See if they in fact have high ratings from the ratings agencies. And keep a copy of your records close at hand.