The collapse of MF Global will have many fascinating story lines to uncover over the next several months. Here are at least four...
1) How did regulators like FINRA, which noticed leverage problems with the firm's $6.3 billion bet on European debt over the summer, not act sooner and more decisively to prevent the questionable speculation with other people's money from ending very badly?
2) Between $600 million and $1.2 billion in funds are missing. What's more interesting to me than where the money is found, is how it got illegally moved from customer segrated accounts in the first place.
Did Jon Corzine call the shots? We may never know if he pleads the Fifth next month and no one else tells the truth.
3) What does this mean for futures exchanges like CME Group (CME - Analyst Report) who up till now have maintained a spotless record of protecting customer funds involved in trading positions through a rigorous risk control system using mark-to-market against exchange-monitored collateral?
It's one thing for an exchange to be vigorous with the trading risk and collateral it watches every second of the day, and another to be responsible for constantly auditing the cash balances of tens of thousands of customer trading accounts not directly under its control and spread around the world.
4) If we do get more facts on how the former Goldman Sachs (GS - Analyst Report) chief may have gambled away the money and livelihoods of thousands of people, what will we learn about the decision-making processes of an apparently upstanding citizen who served New Jersey for nearly a decade as both a US Senator and its Governor?
I can take a shot at giving you a preview of the answer to number four because I predicted something like this would happen (again) in a July 2008 article I wrote for SFO Magazine, "The Mental Models of Financial Sabotage."
So even before we learned of Bernie Madoff's enormous ponzi scheme in December 2008, Raj Rajaratnam's insider-trading club in October 2009, and the hidden $2 billion shank by a UBS AG (UBS - Snapshot Report) trader recently, I made a list of the biggest rogue traders and hedge fund blow-ups and proposed that they would keep on happening.
Here's how I described the scene in mid-2008 as the housing crisis and bank/credit bubble was just about to top $500 billion in losses for big bumblers like Bear Stearns, Lehman Brothers, American International Group (AIG - Analyst Report) and Bank of America (BAC - Analyst Report)...
The question that keeps flying around the financial media is some form of "How does this keep happening?" In an era of complex risk-management structures and systems -- and in the aftermath of Barings Bank, Long-Term Capital Management, Amaranth Advisors LLC and a dozen other financial implosions -- it surprises us that the decisions and actions of a few individuals can still jeopardize billions of dollars of investor wealth. But as sophisticated as risk analysis, control and compliance have become in the modern financial institution, all of these structures ultimately depend on the one thing that never seems to change -- human nature.
Why Smart People Get Dumb With Money and Risk
It all comes down to ego, irrationality with risk, and a dash of greed. And greed is usually the smallest of these influences. Big trader types with millions and even billions at their disposal want to be known as the great trader. So they take big bets to prove they are masters of the universe.
And when things go badly what do they do? They cover up the losses because they "know" the trade will come back their way. Or at least they hope it will. What is so amazing, but should be common knowledge to us by now, is that not only do we not like to admit mistakes, we hate even more to admit really big ones that cost other people lots of money.
Then there is the irrational part of our brains that can't even do simple risk/reward math when prehistoric human emotion meets modern financial leverage. When a smart, responsible guy like Jon Corzine takes excessive gambles on the debt of the European PIIGS, something has gone very wrong in his ability to calculate costs vs. benefits.
What You Can Learn from Rogue Traders
When I began designing and teaching a probability and risk training for traders almost ten years ago, I always used stories about rogue traders to illustrate what goes terribly wrong when a $1 million loss escalates into a $1 billion loss.
My thesis is that the same psychology is at work when the individual trader destroys his or her own account. What the rogue does to a billion dollars, we do to our own money when we trade without sound risk control and money management principles.
From my 2008 SFO Magazine article, here's a partial list of some "great" teachers and their wealth destruction...
Rogues' Gallery of Risk and Ruin
Robert Citron -- Orange County, CA 1994 Treasury Derivatives $1.7 billion
Toshihide Iguchi -- Daiwa Bank 1995 Treasury Bonds $1.1 billion
Nick Leeson -- Barings Bank 1995 Nikkei Index Futures $1.5+ billion
Peter Young -- Morgan Grenfell 1996 Speculative Stocks $700 million
Luke Duffy -- National Australia Bank 2003 Currency Options AU$360 million
Jerome Kerviel -- Societe Generale 2008 Stock Index Futures $7 billion
Both Iguchi and Hamanaka were hiding losses for 10 years, while Rusnak’s total losses (not just the $691 million he hid) may have exceeded $1 billion.
And this list doesn't include the geniuses at Long Term Capital Management (LTCM), chief among them Nobel Prize winner Myron Scholes who blew up another fund after the original article was published. As I said then...
A case could be made that the lone gunmen in the "rogues' gallery" are not so far removed from -- or beneath -- the "Mensa Club" of hedge fund masters who have caused as much, if not more, damage.
LTCM was well profiled in Roger Lowenstein's When Genius Failed as having the smartest minds that extreme amounts of leverage could buy, while Amaranth's natural gas trading superstar Brian Hunter was not a solo risk taker in his multi strategy, model-based firm's collapse.
LTCM dropped nearly $4 billion in its leveraged bet on global interest rate spreads, and Amaranth blew the biggest hole by a trading firm (before Kerviel) with almost $7 billion in losses.
The bottom line: no amount of financial regulation or controls can change human nature. Therefore, you really can't trust anyone with your money. So you better exert the maximum control that you can, and choose only the best fiduciaries with the strictest internal controls, before the regulators have to come in and figure out where your money went.
And when it comes to controlling yourself and managing your own trading risk, have a plan and develop the discipline to make your losing trades much smaller than your winners. But, that's a big topic for another article series/book I'm working on, adapted from my probability and risk seminar. Here are the first two parts...
Why You Need a Trading System, Part 1
Why You Need a Trading System: Scientific Proof
Finally, check out SFOMag.com for the complete "Mental Models" article, where I also provide a list of financial "heuristics," the mental short-cuts we use in investing, trading, and all sorts of decisions involving money and risk. And there's also a list of recommended reading in behavioral finance and "neuro-economics." Just register on the site to read all my articles there.
Kevin Cook is a Senior Stock Strategist with Zacks.com
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