Lessons from MF Global's unraveling
The of MF Global provides a stark reminder of why we need to implement the Dodd-Frank financial reform legislation, a policy that every R candidate for president has promised to .
Two things to look at here.聽 First, I鈥檝e been on this re the importance of capital reserves.聽 There are a lot of moving parts to financial regulation, but at the end of the day, investors will find ways to make bets that are unregulated and systemically risky.聽 And what we (should have) learned in the late 2000s was the extent to which leverage amplifies such risks.
MF was leveraged 44 to 1, according to the link above (leverage ratios below 20 used to be the norm).
If financial institutions have enough of a capital cushion to absorb such losses, it serves as built in insurance against the next new form of 鈥渋nnovative鈥� finance that gets ahead of the regulators.
Second, there鈥檚 interesting moral hazard in the MF case.聽 The firm, and its benighted chief, former Gov Corzine, appears to have been betting on a bailout.聽 And it probably wasn鈥檛 a crazy bet, except for the timing, which was what sunk the firm.聽 (I know it鈥檚 20-20 hindsight, but betting on the alacrity of the European鈥檚 timing in their debt crisis is really a very risky bet.)
The firm surmised that the banks exposed to troubled sovereign debt would get bailed out, and thus leveraged up to buy a lot of that debt at a steep discount.聽 Had the bailout come sooner, MF and their investors would have made a lot of money鈥攁t the expense of European taxpayers.聽 A classic case of socializing losses and privatizing gains.
It鈥檚 not obvious how to prevent this.聽 Dodd-Frank has oversight provisions designed to spot trouble in systemically connected institutions before bailouts are necessary, but there鈥檚 every reason to believe that we鈥檒l be back here again someday.聽聽 I suspect some would say, 鈥渘o bailouts ever.鈥澛� That鈥檚 not realistic.
The answer is to provide regulators with the information to track leverage, exposure, and the risk profile of the global system.聽 聽Dodd-Frank is surely not perfect by a long shot, but to repeal it without a better replacement鈥攖o return to the assumption that markets will self-regulate鈥攊s policy by amnesia.
