Dexia and MF Global Holdings: Canaries in the Financial Markets?

Financial market volatility as we've had in recent months inevitably takes a toll if it continues long enough. A few weeks ago, a large Belgian-French bank, Dexia, was bailed out and partially nationalized after sustaining heavy losses from the European sovereign debt crisis. This weekend, news services report that MF Global Holdings, a financial services firm, is on the ropes because of sizeable losses in proprietary holdings of European sovereign debt. MF Global and its advisers have reportedly been seeking to sell part or all of the firm, but no transaction appears imminent. This evening (Sunday, Oct. 30, 2011), we now learn that the firm has hired bankruptcy lawyers. http://www.marketwatch.com/story/mf-global-hires-bankruptcy-lawyers-wsj-2011-10-30?link=MW_home_latest_news, and http://www.reuters.com/article/2011/10/30/us-mfglobal-idUSTRE79R4YY20111030?feedType=RSS&feedName=topNews&rpc=71.

Because Dexia is a bank, its bailout was not a particular surprise. The EU could hardly allow a major bank to collapse at this moment of crisis, lest its entire financial system nosedive.

MF Global, however, isn't a bank and doesn't have a hovering government Sugar Daddy waiting to hand over a blank check. It brokers derivatives transactions, and its operations include the clearance and settlement of derivatives trades. It also trades for its own account. The firm reportedly held about $6.3 billion in hinky European sovereign debt, and disclosed a quarterly loss of $191.6 million on Oct. 25, 2011. Moody's and Fitch have lowered MF Global's credit rating to junk, which could disrupt its normal access to credit. Some brokerage customers have apparently been exiting, stage right. Press reports indicate that, to maintain liquidity, MF Global has drawn down two bank lines of credit. Its banks include Citigroup, Bank of America and J.P. Morgan Chase. That these big boys would allow MF Global to tap out its lines of credit indicates a difficult situation. One surmises that MF Global may be facing a potentially major run by customers and, with its banks' assistance, is doing whatever it can to buy time to find an acquirer.

MF Global hired three of the largest law firms in New York to assist in a possible bankruptcy: Skadden Arps Slate Meagher & Flom, Weil Gotshal & Manges, and Sullivan & Cromwell. Chances are it wouldn't hire firms of this size and stature unless something very big might happen very soon. These firms can, on a moment's notice, throw legions of lawyers onto a matter such as a bankruptcy of MF Global. The retention of such massive potential legal resources doesn't signal a bright near term future for MF Global.

What's unclear from news stories is the condition of MF Global's derivatives clearance and settlement operation. Such operations typically are protected by the capital of the settlement and clearance firm, which may also hold collateral from counterparties. A crucial question is whether losses from the proprietary trading could spill over into the brokerage operation and impair its ability to honor its brokerage and clearance and settlement obligations. If so, the value of an unknown quantity of derivatives transactions could be thrown into doubt. Were that to happen, a pathway for financial contagion could open up and spread outward into the larger financial system. If there is a potential for financial contagion to spread, expect the Federal Reserve to open the monetary floodgates.

The MF Global situation provides yet even one more reminder that we really need to implement a new regulatory regime for derivatives. The possibility that a derivatives broker, that provides clearance and settlement services, might put customers at risk from its proprietary transactions is simply unacceptable today. For many decades now, clearance and settlement in the stock markets have been legally insulated from proprietary trading, and separately capitalized. Mistakes and misjudgments at proprietary trading desks shouldn't be able to blindside clearance and settlement customers. The Dodd-Frank legislation provides a framework for making clearance and settlement in the derivatives market much more rigorous and secure. With all the volatility we've had, it's entirely possible that more financial firms beyond Dexia and MF Global are headed for the shoals. How many more canaries in the financial markets need to stop tweeting and fall over before we have reform?