Counterparty Risk Trips Up MF Global

The New York Times DealBook blog just put out a fine piece on the collapse of MF Global: A Romance with Risk That Brought on a Panic by Azam Ahmed, Ben Protess, and Susanne Craig (December 11, 2012). It’s the most comprehensive summary of the events that led to the firm’s bankruptcy that we’ve seen so far. Until the investigations are done and the books are written, it’s a good source for thinking about the credit risk lessons to be learned in MF Global’s sad story. MF Global seems to have made a lot of risk management mistakes. It took on a big dose of market risk with its $6.3 billion exposure to the European debt crisis – over the objections of its senior risk manager. With only $1.4 billion in capital, the company could barely afford to take any losses. There may have been operational risk issues at the firm as well. About $1.2 billion of client money has gone missing, and after weeks of searching the company’s records it’s still not clear where most of it is. At best, this is a serious systems failure; at worst, it could be a lot more sinister. But the fatal risk at MF global was a form of credit risk called counterparty risk. That’s the risk that a firm involved in a trade fails to pay what it owes. Counterparty risk is where market risk and credit risk intersect: as a company’s trading losses grow, its ability to pay decreases. Moody’s downgraded MF global from Baa2 to Baa3 in October, citing exposure to European sovereign debt, a regulatory capital shortfall,...

Misgovernance at Olympus

Michael Woodford lost his job on October 14. He had been CEO of Olympus, the Japanese maker of medical systems and cameras, only since last July; and as recently as September, the company’s Chairman had said he was “extremely pleased” with Mr. Woodford’s performance. But then the board fired him for “causing problems for decision making.” He definitely was causing problems. He kept asking embarrassing questions about the Olympus’ 2008 acquisition of Gyrus, another medical equipment company. Olympus paid $2.2 billion for Gyrus, including $687 million in advisory fees to AXAM, an obscure Cayman Island firm that vanished from the trade register a few months after the deal. See this interview of Mr. Woodward in the Financial Times for more information. The Olympus case reveals big weaknesses in Japanese corporate governance: unaccountable senior executives, weak disclosure standards, and dangerously passive shareholders. At the heart of these is an issue behind many failed companies and damaged lenders — poor governance. Board Strength Many things contribute to good governance, but the key factor is a strong board of directors. We think there are three dimensions to board strength. Independence. The majority of directors on any board need to be independent of management. There are different standards of independence in use around the world, if not in Japan. Among the most rigorous is one from the Council of Institutional Investors, which defines independence this way: “An independent director is a person whose directorship constitutes his or her only connection to the corporation.” Expertise. Directors of an effective board have relevant industry and management experience. They are well equipped to evaluate the company’s...

Risk Mismanagement Timeline

There are a number of worthwhile accounts of the firms that failed or nearly failed in the great financial market collapse of 2007-2009. Too Big to Fail by Andrew Ross Sorkin and All the Devils Are Here by Bethany Maclean and Joseph Nocera are two strong general accounts. House of Cards by William D. Cohan tells the Bear Stearns story very well, and Fatal Risk by Roddy Doyle does the same for AIG. But the stories they tell are mainly about the personalities of the men who led those companies and the blunders they made in strategy and funding. None of them focus closely on risk management. So to correct that, we thought we’d start building a timeline of major risk management mistakes made in the run-up to the crisis. It’s not comprehensive. It’s just a series of anecdotes drawn from books, press coverage, government reports, and other sources. Please help us build it up by contributing more stories. We’ll add them to the timeline as you do. Sometime in 2005 Stan O’Neal, CEO at Merrill Lynch, puts Ahmass Fakahany, his Chief Administrative Officer, in charge of risk. Over the next two years, Fakahany dismantles Merrill’s risk organization, firing senior managers and moving the remaining risk managers off the trading floor. Merrill’s exposure to the mortgage market grows to $55 billion, and the company is forced to merge into Bank of America in 2008. June 2006 Citigroup demotes Richard Bowen, a senior risk manager for raising the alarm over the decline in underwriting standards in its mortgage business. His report reaches Vice-Chairman Robert Rubin, but Rubin fails to act...

Early Warning Signs at Borders Part 2

It may be disappointing, but it can’t be surprising that Borders Group went bankrupt this week. It was clear some time ago the company was heading deep into distress. What made it so clear? The six classic early warning signs of financial distress. We covered the first three in our last blog post. Here’s a brief video about the last three. [youtube...

Early Warning Signs at Borders Part 1

We blogged about Borders Group back on January 4. Even though the company has a new financing commitment, it continues to have problems paying suppliers. It looks like Borders is still circling the drain. Borders’ survival is questionable, but for us the more interesting question is, “How could we have have seen the trouble at Borders coming?” What were the warning signs of Borders’ distress? In this video post we talk about three of the six early warning signs of financial distress and see how they apply to Borders. We’ll talk about the other three in our next post. [youtube SXjauKH5s7c] Early Warning Signs Part...