The futures industry is reeling over the latest theft of segregated customer funds, this time by Peregrine Futures’ Russell Wasendorf. Wasendorf admitted to stealing seg funds in a note left at his side when he attempted suicide after it looked like his scheme was unraveling. He has been indicted for fraud committed over the 2010-2012 period. Over $200 million is missing, and his company is undergoing Chapter 7 liquidation.
Following hard on the heels of the MF Global (MFGLQ) disaster, the Peregrine revelations are raising further fears about what had once been considered sacrosanct: that customer funds are inviolate. Even the CME Group, which has historically been a stalwart defender of the traditional segregation model in which FCMs are the custodians of customer money, has suggested that changes may be necessary:
Without question, the current system in which customer funds are held at the firm level must be reevaluated.
CME Group (CME) recognizes that the demand for its services is reduced to the extent that suppliers of complementary services-such as brokerage-are deemed untrustworthy.
I consider it virtually inevitable that this will be the last nail in the traditional segregation model. This will lead to a dramatic change in the organization of the FCM industry. Though (as I discuss a below) that industry was already under tremendous strain. Peregrine and MF Global are symptoms of that strain.
Other big news this week was JP Morgan’s (JPM) reporting of a $4.4 billion dollar Q2 2012 loss, and a $459 million restatement of its Q1 results-along with an admission that the “integrity” of the marks in the CIO books.
Do Peregrine, MF Global, and JP Morgan’s travails have anything in common, except for bringing further discredit onto the finance and banking industry? I think they do. I think they are all consequences of near-zero interest rates.
The traditional FCM revenue model relied on interest income from customer funds invested by the FCM. Very low interest rates make that model unviable. That is a major reason why Corzine felt it imperative to transform MF Global-and to take on more risk. I conjecture that similar pressures led Wasendorf to commit fraud. (Though his admission that he had been doing so for 20 years cuts against that interpretation. A hypothesis: Wasendorf had been engaging in this activity on a smaller scale for years, but escalated it sharply as the financial pressures on Peregrine grew in the low interest rate environment.)
The Morgan story is different, but the extraordinary monetary policies that have driven interest rates to extremely low levels are at the center of the story. Morgan had about $360-$500 billion in deposits that it needed to invest, but traditional investments such as Treasuries offered such low yields that the bank went hunting for yield, and invested in more risky securities and derivatives to get it. Yield chasing in Fed-created low interest rate environments has contributed to previous big losses, such as Orange County’s in 1994.
Bernanke and the Fed initially pursued a low interest rate policy in an attempt to prevent another depression, and have continued it in attempt to spur growth. These are the justifications for these policies, and they are defensible ones. But these policies cause collateral damage. Financial blowups-from MF Global to Peregrine to the Whale-are plausibly just that.