Wednesday, November 2, 2011

The More Things Change, The More They Stay the Same

French diplomat Charles Maurice de Talleyrand once famously said that the Bourbon family dynasty that "had learned nothing and forgotten nothing."

This quote came to mind when reading about the fall of MF Global.

The investment "bets" that MF Global had made were not on the surface particularly aggressive. From what I read, the firm had amassed huge positions in short sovereign debt of countries like Italy which are trading at a modest discount to par in the secondary market.

The idea was simple: at the end of the day, it seems very likely that all of most, if not all, of the debt would be repaid in a year or so.

The problem is the fact that MF Global borrowed heavily to buy as much of the sovereign debt as it could. When its creditors turned skittish, and pulled their credit lines, MF Global tried to get out of its positions, but there is obviously not a particularly strong bid for euro bonds these days.

Exit MF Global.

This strategy seems very similar to the ones followed by Long Term Credit Management (LTCM) back in the late 1990's. There again, a group of very smart investors decided to leverage up their investments in sovereign bonds issued by countries like Russia. When Russia defaulted, LTCM collapsed.

Ironically, one of the firms that helped liquidate LTCM was Goldman Sachs, headed by none other than Jon Corzine. Corzine, of course, is the head of MF Global, and pushed MF Global to make the same type of leveraged bets on sovereign debt that LTCM had done.

And now MF Global has reached the same fate as LTCM.

Roger Lowenstein wrote an excellent book about the hubris that ultimately lead to the demise of LTCM called "When Genius Failed: The Rise and Fall of Long Term Capital Management". He wrote a column for Bloomberg yesterday which discussed the similarities of LTCM and MF Global:

MF Global was leveraged 30 to 1, shades of LTCM. And of MF Global’s roughly $40 billion in assets, more than $6 billion were in volatile European sovereign debts. Corzine was the author of the firm’s strategy of risking its own capital. He wanted a firm like {LTCM}, and he got one. Corzine also approved the strategy of loading up on European debt. According to the Wall Street Journal, he told a company executive that “Europe wouldn’t let these countries go down.” Just as, 13 years ago, traders believed that Russia wouldn’t default.

Corzine’s bet may still prove correct; “these countries” -- Italy and Spain, for instance -- may emerge from the current crisis solvent. But if they do, MF Global will not be around to reap the gains. Because the firm was so highly leveraged, and because it was dependent on short-term financing, its liquidity dried up and it failed. This seems to be the lesson that Wall Street never learns.

As Talleyrand might have said: Plus ca change, plus c'est la meme chose (the more things change, the more they stay the same).