Blogs & Comment

The primary reason MF Global collapsed: Primary dealer supervision

America's primary dealers are seen as too important too fail. So why is the U.S. Federal Reserve not keeping an eye on their books?

(Photo: Mario Tama/Getty)

MF Global was admitted to an exclusive club in February, when the brokerage firm run by former New Jersey governor Jon Corzine was handed primary dealer status.

Landing the right to serve as one of just 20 New York Federal Reserve Bank counterparties was an official vote of confidence in the company. MF Global naturally used the news to promote itself as a rising player.

“Being designated a primary dealer by the Federal Reserve Bank of New York is consistent with our global strategy of expanding our broker-dealer activities, as we seek to serve our clients with broader execution services and greater market insight and ideas,” Corzine said in a press release statement at the time.

“We are delighted to join the group of dealers trading directly with the Federal Reserve Bank of New York,” added Peter McCarthy, then head of fixed income. “This designation is a natural next step as we continue to build our fixed income platform to provide broad access and liquidity to global markets.”

Exactly 35 press releases later, on Halloween, the company scared away a little bit more investor confidence by announcing the New York Fed had suspended its designation as a primary dealer. The same day, of course, the firm issued a filing under Chapter 11 of the U.S. Bankruptcy Code that put an end to the expansion of its activities.

The FBI is now investigating. Client money has ended up in strange places. Corzine has resigned and retained counsel as he awaits fallout from the collapse.

Primary dealers deal directly with central banks. They act as market makers for government debt and dominate currency exchange trading. They are even consulted on monetary and fiscal policy issues. As a result, primary dealers are the most influential non-governmental players in global financial markets, which is why they supposedly must meet certain liquidity and quality requirements and provide central banks with analysis and market intelligence on the state of the worldwide markets.

Now, with the relatively recent string of primary dealer failures (Countrywide, Bear Stearns, Lehman, Merrill, and now MF Global), a rational observer might think the NY Fed had moved to beef up surveillance activities designed to protect the financial system from excessive risk taking at primary dealers. But that only makes sense in a rational world. What passes for logic on Wall Street is the January 1992 Fed decision to kill its primary dealer surveillance program. “It was, to some Fed officials, a dangerous delegation of an important duty that had given the central bank access to crucial information about the soundness of the Wall Street firms it was dealing with,” write Gretchen Morgenson and Josh Rosner in Reckles$ Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon.

According to U.S. fund manager David Kotok, who runs Florida-based Cumberland Advisors, the failure of Drexel Burnham Lambert in February 1990 highlights the importance of keeping tabs on primary dealers. In a market commentary on the matter, he points to a 2010 letter from Fed Chairman Ben Bernanke to the U.S. Senate Banking Committee. In it, the top U.S. central banker writes: “Drexel’s rapid collapse posed a risk of gridlock in the financial markets. Notably, because of their parent’s failure, Drexel’s solvent broker-dealer and government securities dealer subsidiaries experienced serious difficulties liquidating their positions. Because of its ongoing supervisory relationships with the banks that provided settlement services to Drexel’s subsidiaries and its knowledge of the payment and settlement system’s infrastructure, the Federal Reserve had the access, contacts, and in-depth knowledge that enabled it to obtain the information it needed to evaluate this complex problem and formulate a plan to address it.”

America’s regulatory framework has been overhauled since the start of the so-called Great Recession. Nevertheless, among the rules of the NY Fed, you can find the following sentence. “The Bank expects primary dealers to submit accurate data, but the Bank itself does not audit the data.”

Simply put, that’s nuts. Today, despite all the financial trouble the world has seen with primary dealer risk taking, the NY Fed still relies on its counterparties to be transparent and accurate in reporting their health—and do it voluntarily.

As Kotok points out, “The great sage Albert Einstein suggested that repeating something and expecting a different outcome is insanity.” The 1992 policy change, he adds, “has been and is a disaster.”

The fund manager insists it is time for the Fed to address this issue by requiring compliance with a Fed surveillance team as a condition of primary dealer status. “What are you waiting for,” he asks.

Good question.