Econintersect: The bankruptcy of MF Global, the investment firm and Federal Reserve Bank of New York primary dealer headed by John Corzine, formerly head of Goldman Sachs, U.S. Senator and Governor of New Jersey, has become a grotesquely strange story that seems to be about a company that didn’t know what it was doing, supervision by regulators that never occurred and a Federal Reserve administrative process that has a “hear no evil, see no evil, speak no evil” mentality. The result is a bankruptcy with $600 million mysteriously unaccounted for, even after more than ten days of investigation.The first steps in trying to determine what has been going on at MF Global requires that we get some of the basic definitions and relationships pinned down.
What are Primary Dealers?
Wikipedia defines PDs and their function in the simplest terms that Econintersect has found:
Primary dealer is a formal designation of a firm as a market maker of government securities. Primary dealer systems are present in many countries including Canada, France, Italy, Spain, the United Kingdom, and the United States. 
In the United States, a primary dealer is a bank or securities broker-dealer that is permitted to trade directly with the Federal Reserve System (“the Fed”). Such firms are required to make bids or offers when the Fed conducts open market operations, provide information to the Fed’s open market trading desk, and to participate actively in U.S. Treasury securities auctions. They consult with both the U.S. Treasury and the Fed about funding the budget deficit and implementing monetary policy. Many former employees of primary dealers work at the Treasury because of their expertise in the government debt markets, though the Fed avoids a similar revolving door policy.
The Federal Reserve Bank of New York is responsible for “administration of relationships” with PDs. It seems that the relationships administration was little more than a kind of “if you’ve got the money honey, I’ve got the time.”
Supervision and Regulation
The Federal Reserve Bank of New York has no regulatory responsibility for PDs. Here is the supervision statement from the New York Fed web site:
A primary dealer must be either a broker-dealer4 registered with and supervised by the Securities and Exchange Commission (SEC) or a U.S.-chartered bank (commercial bank, thrift, national bank or state bank) that is subject to official supervision by bank supervisors. The primary dealer must meet certain minimum capital requirements:
- A registered broker-dealer must have at least $150 million5 in regulatory net capital as computed in accordance with the SEC’s net capital rule.6 The broker-dealer must otherwise be in compliance with all capital and other regulatory requirements imposed by the SEC or its self regulatory organization (SRO).
- A bank must meet the minimum Tier I and Tier II capital standards under the applicable Basel Accord and must have at least $150 million of Tier I capital as defined in the applicable Basel Accord.
From a Wall Street and Technlogy article, the only regulator mentioned for MF Global was the CME Group, which is a SRO (industry self-regulating organization).
The Dismal History
What do Bear Stearns, Lehman Brothers, Merrill Lynch and Countrywide Financial have in common? They are all Federal Reserve primary dealers (PDs) who have not been able to survive as solvent entities. Merrill Lynch, which was merged into Bank of America in September 2008 in a shotgun wedding to avoid bankruptcy, still remains on the list of 21 PDs at the New York Fed website as of October 31, 2011 as the dealer firm name for the Bank of America.
With MF Global joining the list of failed PDs, questions are again being raised about the standards that are being required for PDs. Such a designation has traditionally established a level of prestige for a firm, although the following statement appears on the New York Fed web site :
…third parties are reminded that the designation of an entity as a primary dealer by the New York Fed in no way constitutes a public endorsement of that entity by the New York Fed, nor should such designation be viewed as a replacement for prudent counterparty risk management and due diligence.
But, according to Reuters:
Despite questions it has faced in the wake of MF Global’s failure, the Federal Reserve Bank of New York doesn’t have any plans to change its standards for primary dealers, a spokesman for the bank said on Thursday.
“While the New York Fed regularly reviews its policies and practices, we are not currently considering raising capital requirements for primary dealers,” the spokesman said in a statement to Reuters.
What Really Happened?
The short and most direct answer is that we simply don’t know. From the Wall Street and Technology article:
Regulators hunting for about $600 million in customer money that went missing shortly before MF Global Holdings went bust have been taken aback by how poorly kept the securities firm’s records are.
“Their books are a disaster,” Scott O’Malia, a commissioner at the Commodity Futures Trading Commission, one of the regulators leading a hunt that has stretched 10 days so far, said in an interview (subscription required) with the Wall Street Journal. “We’re trying to figure out what numbers are the real numbers.”
According to reports from some who saw MF Global’s trading records and balance sheet before the company filed for bankruptcy on October 31, the firm’s books had incomplete transactions, and numbers that just didn’t seem to add up.
Whether there was direct and deliberate fraud driven from the highest levels, fraud perpetrated by lower levels in the company or simply total lack of administrative control leading to uncontrolled chaos, the result is the same: We have another case study in control fraud.
Control fraud is defined by Wikipedia:
Control fraud occurs when a trusted person in a high position of responsibility in a company, corporation or state uses their powers to subvert the organization and to engage in extensive fraud for personal gain.
The term is attributed to William K. Black, professor at the University of Missouri Kansas City.
Editor’s note: Econintersect suggests that fraud that occurs through lack of control should also be included in the same category with other control frauds. Fraud is the act of causing people to be defrauded, having their assets taken through acts of misrepresentation. To those defrauded, incompetence by those in a position of power can cause as much damage as deliberate acts.
So now we will conclude with a long statement in answer to the question of what happened. It is the same as the short answer: We simply don’t know.