This scheme appears to be standard practice on Wall Street:
It appears that MF Global, as well as every other major US investment banking firm, has taken “advantage of an asymmetry in brokerage borrowing rules that allow firms to legally use client money to buy assets in their own name,” Christopher Elias notes in a recent Thomson Reuters article.
Simply put, MF Global borrowed money, and, using that borrowed money, purchased the debt of the European periphery (Italy, Ireland, Greece, Spain, and Portugal) at very attractive yields. The borrowings and the debt purchased had the same maturity date, so the proceeds of the debt maturities were to pay back the borrowings. MF collected the difference between the low rate it paid on the borrowings and the high rate it received on the debt.
The euro debt it purchased was guaranteed by the European Financial Stability Facility (EFSF). To get the low rate, MF had to pledge collateral. So, it pledged the euro debt, and as additional collateral, it borrowed and pledged its clients’ assets, which assets it held as custodian.
As of 2007, there was $10 trillion in collateral lurking in the shadow banking system. The problem is that traders such as Corzine have pledged each dollar many times over to various creditors, leading to the eighth largest bankruptcy in American history:
In 2007, MF Global booked revenues of $4 billion from interest it earned on the billions of dollars in customer funds it held against outstanding trades. However, with interest rates approaching near-zero in parts of the world, this figure fell to under $517 million for the 2010 fiscal year.
With core sources of income drying up, enter much maligned CEO Jon Corzine, the former New Jersey Governor and Goldman Sachs CEO, to turn around the business.
Corzine’s solution was to take advantage of a form of financial engineering that keeps risks off the balance sheet, whilst exploiting the Eurozone crisis to the company’s advantage. Not coincidentally, it involved investing in the very types of bonds that Corzine cut his teeth on as a bond trader at Goldman Sachs.
Some analysts claim that the rehypothecation angle is merely a cover-up. Investors are fuming as even those with receipts to physical assets are taking a hit:
The trustee overseeing the liquidation of the failed brokerage has proposed dumping all remaining customer assets—gold, silver, cash, options, futures and commodities—into a single pool that would pay customers only 72% of the value of their holdings. In other words, while traders already may have paid the full price for delivery of specific bars of gold or silver—and hold "warehouse receipts" to prove it—they'll have to forfeit 28% of the value.
That has investors fuming. "Warehouse receipts, like gold bars, are our property, 100%," contends John Roe, a partner in BTR Trading, a Chicago futures-trading firm. He personally lost several hundred thousand dollars in investments via MF Global; his clients lost even more. "We are a unique class, and instead, the trustee is doing a radical redistribution of property," he says.
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