Prof. Edward Pekarek talks about lessons learned from MF Global

Visiting Prof. Edward Pekarek, assistant director and supervising attorney at the Pace Investor Rights Clinic, spoke at length recently with The Progressive Farmer about lessons learned from MF Global’s collapse. After the company declared bankruptcy on Oct. 31, it came to light that more than $1 billion in client funds were missing.

In the first of two articles on the subject–both of which quote Prof. Pekarek extensively–he is asked how clients can protect themselves:

“One strategy is to work with a local broker,” said Pekarek. “But that is not a total solution — you need to find out who does the clearing for the broker and who holds the money — the ‘back office’ functions.”

Read brokerage contracts closely. “The terms and conditions will play a big role in how the residual funds are distributed,” he said. “Contracts that specifically agree to hypothecation and/or ‘re-pos’ mean that the company’s use of account assets may have been perfectly legal within the applicable laws.”

Another way to minimize your exposure is to use a “cash account,” transferring money in and out only as needed, so your brokerage account doesn’t accumulate a large quantity of cash. Since the MF Global debacle, many grain elevators now sweep their margin accounts daily so no excess funds accumulate.

In the Progressive Farmer’s second article on the topic, running a day later, Prof. Pekarek was asked about the role of leverage in the MF Global case.

Under U.S. law, a securities firm such as MF Global can use up to 140% of the net value of a client’s account as collateral, [Pekarek] explained. So if your account’s net value is $1,000, the company could use it as collateral to buy $1,400 worth of something — such as stocks or T-bills.

The company the firm buys the securities from holds the collateral and in essence lends the balance ($400 in this example). This is similar to buying a house where the mortgage company decides how much downpayment it requires from each borrower, based on credit scores, income, etc. Not only the downpayment, but the house itself is collateral for the loan. If you default on your mortgage, the mortgage company can seize your house.

In the United Kingdom, there is no limit to the amount of leverage allowed — it is whatever the selling bank or investment firm will accept. So by using a UK subsidiary, MF Global could, in theory, use the $1,000 collateral to buy, say, $2,000 or $3,000 worth of securities. That’s just what Pekarek and others believe they did, investing in European sovereign debt. Now suppose the $3,000 worth of sovereign debt devalued to only $1,000 — much like what occurred in the U.S. housing market.

Pekarek believes this explains what happened to the missing client funds: They were being held by the sellers of the debt instrument as collateral. In the last few days of October, when worry was rising about the huge amount of European debt MF Global had accumulated, Pekarek believes the collateral was seized by the securities company(ies) that had leveraged the collateral to “sell” MF Global the securities.





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