MF Global

                MF Global has been in the news recently for their bankruptcy and the misallocation of customer funds.  The majority of media outlets report that the failure was the result of failed bets on Euro Zone debt.  However, that does not appear to be the case as many of those bets were profitable.  Well then, how exactly did MF Global go bankrupt if most of their bets were profitable?  The simple answer is that they were overleveraged with regards to their trades. 

                The way the majority of broker-dealers leverage their trading is not only through margin accounts, but is through a process called re-hypothecation.  Re-hypothecation occurs when a broker-dealer receives collateral on a loan and then uses that collateral as collateral for a loan of their own.  In the absence of a “haircut” (http://en.wikipedia.org/wiki/Haircut_(finance)) this initial collateral can multiply almost infinitely.  If this concept is confusing, that’s because it is; essentially this works in the same way as banks would with a reserve requirement of zero and no FDIC insurance.  The United States does place a limit on the amount of times an asset can be re-hypothecated, but MF Global found a loop-hole in the UK financial system where they were able to re-hypothecate assets with no limit, thereby leveraging to the hilt.

                There are positives and negatives to leverage; it is possible to greatly increase returns on investment, but can also multiply losses.  MF Global was so leveraged that their Euro Zone bets were profitable, but the slightest hiccup caused a run on their assets.  The high levels of leverage MF Global was exposed to did not leave much capital to be able to face margin calls.  As with any financial firm who encounters trouble, contagion spreads and all their creditors demand more collateral so they are not left holding the bag.  This was the end result of the MF Global debacle: they may have had some profitable trades on Euro Zone debt, but were sufficiently overleveraged and illiquid that they were not able to meet their repayment requirements.

                Now keep in mind, this says nothing about the missing customer funds, which appeared to be used in their speculative bets.