Thursday, November 3, 2011

The MF Global Debacle

Prior to the collapse last week, MF Global (MF) appeared to be an excellent candidate to take market share in the financial sector. MF was already a respectable commodities trader and primary broker dealer. On top of that, it hired prominent figure John Corzine with experience at both Goldman Sachs (GS) and the political arena to expand into the investment banking sector.

The combination provided a catalyst for a what could be a game changer. Unfortunately last week the concept completely collapsed as MF couldn't handle the high leverage of European Soveriegn debt. Debt that likely will payoff as expected, but debt that unfortunately scared the market into a panic.

Lesson revisited that perception trumps reality at least in the short run.

Last week we wrote about the thesis for buying into MF prior to the earnings report and even after [See Wild Times at MF Global Holdings]

At the time, the trade seemed to have a good risk/reward thesis. The stock had already been cut to half of book value. Unfortunately it didn't work out for investors. Luckily though we sold the 2nd investment prior to closing on Friday at just a small loss.

As mentioned in our original write up, only half a position (actually closer to a third) was purchased as the risk was extremely high. This greatly reduced the exposure even in the case of the collapse.

The Jefferies (JEF) news today further highlights this concept of perception versus reality. It came to light that JEF has exposure to European debt and investors panicked. It doesn't appear to matter whether the debt is to Italy or Greece. Whether it matures in 6 months or 6 years. Or whether JEF has short positions to hedge the longs. The market doesn't appear to care. European debt is basically deemed worthless though most of the countries involved won't ever come close to defaulting.

This leads us back to our trade made last week. MF was plunging based on what appeared to be over stated fears. Sure MF had a ton of leverage. Sure MF had exposure to Italy, Spain, and Portugal debt. The debt though has an average maturity of 12 months. Anybody expect Italy or Spain to blowup in the next year? Greece was worse off 12 months ago than Italy is now and the Geek debt hasn't defaulted yet. Close, but not yet.

The Opportunistic Arbitrage model is very risky and these trades don't always pay off. This might go down as the quickest blowup in my investment career. Yet, by limiting position size it didn't have a major impact to the model. It still gained 47% in October when most of the MF losses were taken. The remaining hit the November numbers as the original purchase was sold shortly after the stock opened on Monday.

Ultimately, the outcome was unfortunate, but nothing devastating. Other blowups will occur in this model, but the key remains to stay diversified so that any one such event doesn't destroy the model.


Disclosure: No remaining positions. Please review the disclaimer page for more details. 



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