Could Smarter Rules Have Protected MF Global's Clients?

There are some kinds of problems that seem like an indictment of the system--like, say the 2008 mess.  No matter what your political persuasion, you probably think that the chaos of 2008-9 indicates that we need to somehow change the rules that goverened those markets.  (How you think they should change probably varies.)

Then there are the kinds of problems that you just have to chalk up to, well, these things happens.  Unfortunately, the most explosive potential problem at MF Global--the fact that hundreds of millions of client money seems to be somehow missing--fall into this category.

To repeat what I said yesterday: we don't yet know what happened, and this may be simply sloppy bookkeeping.  The company is apparently claiming that it was simply caught short, unable to complete trades when liquidity dried up.  I don't know how regulators could have prevented that, and in any case, if it's true, it's not something they need to prevent; the money will eventually be moved to the right place and clients will be made whole.

But what if the rumors are right, and MF Global did in fact use client funds to cover its own trading losses?  Don't we need tighter regulations to prevent this from happening again?

No.  Or at least, probably not.

To start with, this is really illegal.  There are no "loopholes" that allow you cover your losses with client funds.  There is only the fact that it's actually pretty difficult to catch embezzling, even if you're looking really hard.  As I understand it, despite fairly tight internal controls and obvious incentives to prevent it, banks suffer quite a lot of embezzling every year, and hush much of it up rather than suffer the bad publicity.

The problem is that the embezzler knows where to look, and you don't.  There are all sorts of ways to remove money from an account so that it will look fine to an auditor.  (A favorite, especially with bookkeepers, is simply writing a check to a shell company).  Eventually, of course, something won't add up--the client will realize their statement is off, corporate accounts will run dry, or in some other way, reality will expose the fraud.  As accountants like to say, "recessions uncover what auditors can't."  Hello, Enron.

But the thieves always have a head start--which means that for a while, they'll usually get away with it.  Reality is tireless, and eventually she almost always catches up with her quarry.  But she is not necessarily speedy, and the denouement may be a long time coming.  Even seemingly stupid embezzling schemes frequently go on for years.

I doubt that, um, whatever did happen at MF Global, has been going on that long, however. Not if a potential buyer could catch it in a weekend.  Which is another problem: regulators can't scrutinize the books on a daily basis--companies don't even reconcile over such short time frames.  So a desperate firm has a little window in which they can divert funds to cover their own emergency.

A friend and former CPA once observed to me that what people who are not auditors think happens in an audit is very different from what auditors actually do.  What people seem to think happens (or should) is that every transaction is checked, scrutinized, and reconciled to the books.  But as she pointed out, this would require a mirror organization at least as large as the client's finance and accounting departments.  This would be obviously unworkable, and incredibly expensive.

What auditors actually do is look for red flags, and perform spot checks.  In this case, the red flags were apparently pretty large and, um, red.  But if they're not, the auditors may miss them.

In other words, no amount of "strengthening regulation" could have prevented MF Global from misplacing those funds.  If it's a harmless bookkeeping error, then it's not worth spending much more regulatory energy on--I mean, absolutely, punish those who make such mistakes pour encourager les autres, but don't plow more limited resources into looking over the shoulder of the bookkeepers.

And if it's not a harmless mistake, then at some level we have to recognize that there are practical limits to how much embezzlement oversight can prevent.

That's not to say that MF Global doesn't raise questions.  Was Jon Corzine right to try to turn a sleepy dealer into a sort of mini-Goldman?  Should the Commodity Futures Trading Commission have lowered clearinghouse capital requirements so that firms like MF Global could be members?  Should we insure these sorts of account against fraud?

But these aren't really questions about the improper accounting for client funds.  I mean, I'm sure it's actually true that we'd have fewer such problems if small dealers never went spectacularly bankrupt and got tempted, en route, to dip into the till.  But the issues are at best tangential to each other--you don't focus on stabilizing the economy because hey, I bet fewer business owners will be tempted to cheat on their taxes if they make enough profits to cover their school fees.