Leverage is still a ticking time bomb

November 03, 2011

Monday’s announcement that MF Global filed for bankruptcy came as no surprise to those in the financial world. To those outside of it, this filing is another sad reminder of what happens when smart men do stupid things.

MF Global held distinction in the financial community as one of only twenty two firms who were primary dealers for the U.S. Treasury—meaning they had special permission to bid directly on behalf of their clients during Treasury auctions, as well as help the Federal Reserve carry out monetary policy.

Now, they are no more. Their $41 billion bankruptcy makes it the eighth largest in U.S. history.

At the heart of the bankruptcy filing is the fact that Jon Corzine, MF Global's CEO made a large bet that would pay off handsomely if Greece and other European countries selectively defaulted on some of their debt obligations to other nations.

Fundamentally, we agree with Corzine’s logic—Greece should be in bankruptcy as we speak.

However, unexpected things often happen with even the best laid plans.

Instead of Greece selectively defaulting, all of the countries that have lent Greece money have voluntarily agreed that Greece should only pay back about half of the money that is owed.

Because this is a “voluntary” agreement amongst the lenders to Greece, the technical definition of default has not triggered and therefore the investment that MF Global made did not pay off.

Why then would this cause MF Global to file for bankruptcy? One word answers it all: debt.

Notonly did Corzine bet big, but he did so with borrowed money--so much so that for every dollar of equity they had in their firm they had another $40 dollars of borrowed money.

This is massive leverage-- reminiscent of the magnitude that Lehman Brothers had prior to their collapse in 2008. In our opinion, 2008 should be fresh in our collective memories. Furthermore, Mr. Corzine—who was also the former head of Goldman Sachs and the former Governor of New Jersey--should have known better.

This brings us back to some lessons on debt that should never be forgotten:

  • Debt does not make a person right or wrong--it simply magnifies the extent to which we are right or wrong.
  • No matter how solid our logic is, short term disruptions can derail even the best of plans when we borrow too much money.
  • You should never borrow money in such an extent that it can wipe out everything that you have worked a lifetime to earn. In other words—in order to finish first, you must first finish the race.
  • As an investor make sure the investments you have can honor their commitments--not only interest payments, but also principal payments.
  • As a borrower, don’t borrow more than you can easily cover. Don't borrow the absolute maximum allowable as that requires that things always work perfectly--which they never do.
  • Often, companies that borrow large sums of money get their credit lifeline yanked out from under them at the worst possible time. Once this happens, the game is over.

Mr. Corzine is a rather wealthy man--and a supposedly intelligent man too. Unfortunately, he got greedy playing with other people’s money and bet the farm. Not only did he drive his company into bankruptcy, but now many innocent employees of MF Global are severely affected by Corzine’s foolishness.

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Topics: Blog Posts, Strategic Planning, Risk Management, Accounting & Finance

Dave Sather

Sather Financial Group

Dave Sather is a CERTIFIED FINANCIAL PLANNER and President of the Sather Financial Group, Inc. Sather Financial Group is a $400 million “fee-only” wealth management firm based in Victoria. Sather Financial is ranked as one of the top independent wealth management firms in the country according to Financial Advisor Magazine. Dave was raised in El Paso, received his B.A. in Business Management from Texas Lutheran University and received his M.B.A. from Texas A&M University. He has spent the past twenty years in the financial analysis, investment and banking industries. Dave is an adjunct professor in the business program at Texas Lutheran University. Additionally, Dave is a director of Business Bank of Texas as well as the Chairman of the Finance and Investments Committee for the Brownson Children’s Home and is a member of the Executive Advisory Council at Texas Lutheran University. He resides in Victoria, Texas.
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