Latest crisis only of confidence as finance stocks cop a hammering

THE markets were haunted this Halloween by the ghosts of the past financial crisis.

By InvestSMART · 2 Nov 2011

By InvestSMART ·
2 Nov 2011

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THE markets were haunted this Halloween by the ghosts of the past financial crisis.

With MF Global filing for bankruptcy on Monday, investors pummeled many financial stocks, fearful that problems were lurking on the books of other Wall Street firms. It was a crisis of confidence, not unlike in 2008 when the markets punished stocks on mere speculation of trouble.

On Monday, companies with perceived exposure to MF Global bore the brunt of the pain. The Jefferies Group, which issued a statement saying it had a minimal stake in the brokerage, fell by nearly 10 per cent. The Fortress Investment Group, which proactively disclosed that it had "literally zero" exposure, dropped more than 11 per cent.

"Investors across the financial sector are definitely on high alert trying to avoid or minimise these sovereign debt exposures," said Ed Ditmire, an analyst at Macquarie Capital.

MF Global made a risky bet in a tumultuous market. Recently, the firm revealed that it had $6.3 billion of sovereign debt in troubled countries such as Italy and Spain. The position was nearly five times the firm's equity of $1.2 billion. As the sovereign debt crisis reached a peak in October, two rating agencies cut the grades on the company's debt, saying they questioned the firm's risk controls given the size of the position.

The downgrades sent the company into a tailspin. Trading partners asked the firm to post more money against their portfolio. Adding to the jitters, MF Global reported a third-quarter loss, which further eroded its stock and made its capital position even more tenuous. The firm drew down a $1.3 billion credit line as it fought to stay afloat. But it proved insufficient and MF Global was forced to file for bankruptcy.

After the Moody's downgrade last week, MF Global sent a letter to clients trying to reassure them of the firm's strength. On Monday, as some clients called to ask questions and liquidate their accounts, MF Global was not picking up the phone.

Some financial exchanges prevented MF Global employees from entering Monday, while others, including the Chicago Mercantile Exchange and the Intercontinental Exchange, halted the firm's trading in the morning. That forced clients of MF Global to sit tight or liquidate their holdings.

It is difficult to know what other firms could face the same pressure. Most of the small brokerages that clear futures trades like MF Global are private companies, so their capital positions are not as vulnerable to the whims of the public markets. The rest of the industry is dominated by large banks, which analysts say have sufficient capital.

The irony is that MF Global's sovereign debt may turn out to be right eventually. The firm was ostensibly making the wager that Europe would come to the rescue of its troubled economies and the countries would not default on their debt.

In such an event, MF Global's holdings would most likely have paid off. But investors and others just did not have the patience to wait.

"The positions still have not caused any losses to the best of my knowledge," said Richard Repetto, an analyst at Sandler O'Neill. "But this risk-taking is just excessive compared to the size of the balance sheet."

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Frequently Asked Questions about this Article…

What caused the MF Global bankruptcy and why should investors care?

MF Global filed for bankruptcy after taking large bets on sovereign debt — about $6.3 billion in troubled countries like Italy and Spain, nearly five times its $1.2 billion equity. Rating downgrades, a third‑quarter loss and margin demands from trading partners forced the firm to draw down a $1.3 billion credit line and ultimately file for bankruptcy. Everyday investors should care because the collapse sparked a wider loss of confidence across financial stocks and highlighted counterparty and market‑confidence risks.

How did MF Global’s sovereign debt exposure lead to market turmoil?

When rating agencies cut the firm’s debt grades and markets questioned MF Global’s risk controls, trading partners demanded more collateral and some exchanges restricted the firm’s trading. That sequence — big sovereign debt positions, downgrades, margin calls and a loss of confidence — amplified market fears and contributed to sharp falls in other financial stocks.

Which financial stocks were hit after MF Global’s problems emerged?

Companies perceived to have exposure were punished by the market. The Jefferies Group fell by nearly 10% despite saying it had minimal stake in MF Global, and Fortress Investment Group dropped more than 11% even after proactively disclosing “literally zero” exposure. The article notes that firms with perceived links bore the brunt of the pain.

What role did credit rating downgrades and Moody’s play in the MF Global story?

Two rating agencies cut MF Global’s grades, raising questions about the firm’s risk controls given the large sovereign debt position. After a Moody’s downgrade the prior week, MF Global tried to reassure clients with a letter, but the downgrade contributed to loss of market confidence and subsequent pressure on the firm.

Were MF Global clients able to access their accounts or trade during the collapse?

The article reports that some clients calling to liquidate accounts couldn’t reach MF Global by phone. Several exchanges prevented MF Global employees from entering, and exchanges including the Chicago Mercantile Exchange and the Intercontinental Exchange halted the firm’s trading in the morning, forcing clients to either sit tight or liquidate holdings under difficult conditions.

Could other brokerages face the same pressure as MF Global?

The article says it’s difficult to know. Many small futures‑clearing brokerages are private and therefore not as exposed to public‑market pressures, while the rest of the industry is dominated by large banks that analysts believe have sufficient capital. Nevertheless, investors were put on high alert to avoid or minimise sovereign debt exposures.

Was MF Global’s bet on European sovereign debt necessarily wrong?

Not necessarily. The piece notes the irony that MF Global’s sovereign debt positions could pay off if Europe ultimately rescues troubled economies and countries don’t default. However, analysts cited in the article said the risk‑taking was excessive relative to the firm’s balance sheet, and the positions had nonetheless triggered rating downgrades and market panic.

What practical lessons does the MF Global collapse offer everyday investors?

The article highlights a few clear lessons: market confidence matters and can cause fallout beyond the firm at risk; investors and analysts are especially wary of sovereign‑debt exposures; and even firms that claim minimal exposure can see big stock moves in a crisis. Staying informed about counterparty risk, rating changes and concentrated positions can help investors understand where contagion risk may arise.