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) 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) 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) 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) and Bank of
America (BAC)...
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
Yasuo Hamanaka -- Sumitomo Corp. 1996 Copper $2.6
billion
Peter Young -- Morgan Grenfell 1996 Speculative
Stocks $700 million
John Rusnak -- Allied Irish Bank 2002 Japanese Yen
$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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