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MF Global’s Collapse: The Fed’s Role

·Michael Santoli

The "MF" in MF Global Ltd. may not have really stood for "malfunction," but one year after the brokerage firm succumbed to trading losses and customer defections by entering bankruptcy protection, it's clear the story of the company's demise was multifaceted.

Most immediately, former MF Global chief executive Jon Corzine's decision to use the firm's own capital to buy the spurned debt of some peripheral European countries generated losses, drew credit-agency downgrades and spooked trading clients, many of whom withdrew their funds before the bankruptcy, which stranded $1.6 billion in customer money within MF.

Financial controls also appear to have been lacking for years before MF's undoing, according to retrospective accounts, with the broker's accountants unable to get a firm handle on its cash balances in a timely way.

Civil action against MF Global, charging that the firm mislead investors about the risky bets it was making with European debt, is going forward as of now, despite Corzine's efforts to get these charges dismissed. Back in August, it became clear that criminal charges were unlikely to emerge from this case.

Operating in a Zero-Interest-Rate Environment

Less obvious and yet more broadly significant is the role the Federal Reserve's zero-interest-rate policies played in the chain reaction that sank MF. These policies are also pressuring other brokerage firms, from discount derivatives specialist Interactive Brokers Group (IBKR) to Main Street investment providers Charles Schwab Corp. (SCHW) and TD Ameritrade Holding Corp. (AMTD), to your local community bank.

[See related: John Corzine Taken to Task for Excessive Chutzpah]

So-called futures commission merchants such as the former MF, and discount brokerage houses such as Schwab, hold customer cash balances along with their trading and investment portfolios, and are allowed to invest excess cash not pledged against margin loans in safe, yield-bearing securities.

The interest collected by the brokers in times when rates were at more-normal levels acted as a kind of low-risk subsidy to the financial middleman industry. This supported revenue and emboldened brokerage firms to compete aggressively with cut-rate commissions and investments in high-speed trading technology. The reigning philosophy in the discount brokerage and futures-trading business was that ultra-low commissions would pay for themselves, and then some, by encouraging heavier trading volumes.

It worked exactly that way from the mid-1990s until the financial crisis of 2008. When the Fed rushed to set short-term interest rates just above zero in response to the credit-market collapse and brutal recession, this equation was upended. Denied the automatic stream of interest income, brokers have had to face the reality that their core operating businesses don't generate adequate profit levels to satisfy their investors. Their choice: Suffer weak profits and wait, try to raise commissions and other fees in a slow trading environment, or stretch for more investment income by plowing cash into spicier securities.

Risky Moves

MF took the latter tack. As its bankruptcy trustee concluded in a report over the summer, "In the face of declining interest rate revenues, MF Global's proprietary investment strategy shifted from short-term, low-yield investments to longer-term, high-yield and highly leveraged investments."

It now provides no comfort that the European debt instruments MF bet on eventually came back in value; during the broad Euro-debt scare of mid-2011 their presence on MF's books spurred a flight of enough clients to imperil the firm.

More nagging than cataclysmic for most other brokers and banks, the struggle to earn a decent return without help from decent interest income has depressed the stocks of many affected companies while leaving in place the temptation among management to move out on the risk spectrum to goose returns.

The share prices of Interactive Brokers, Schwab and TD Ameritrade are all down appreciably over the past two years, underperforming the Standard & Poor's 500 index by between 25 and 45 percentage points. Not only do the retail stockbrokers suffer the absence of a respectable net-interest margin, but the low-rate environment has forced those that manage money-market mutual funds to waive management fees that would otherwise exceed the funds' yield. Schwab is on pace to subsidize its funds this year by about $200 million, a sum equal to a quarter of the company's 2011 net income.

The Fed's decision to keep rates near zero indefinitely and at least until 2015 has kicked up plenty of complaints that the policy punishes individual savers, including many retirees, who now can't support their spending needs with a safe yield. This is true but not particularly relevant to the Fed's priorities of sparking risk-taking and consumption levels in a country where many more are net debtors than are savers.

Yet the fact that these same policies have deprived the financial industry of a secure revenue stream for its role in handling client cash balances and trading needs brings its own potential unintended consequences.

We may not see many more outright meltdowns of the sort that befell MF Global, although the collapse of much smaller firm PFGBest only months after MF's had some similarities (but seems to be a case of pure fraud rather than an interest-rate-related implosion in any sense) . But zero rates distort behavior and incentives among financial intermediaries. They threaten to spawn new fees and lower the threshold for traders and executives at these companies to consider getting more aggressive with client cash -- and their own -- than is desirable for the health of the system and the good of investors who provide it with the capital it needs.