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Daniel Nestlerode: MF Global's Failure an Avoidable, Human Tragedy

by on November 06, 2011 8:01 AM

We were recently greeted with news of the financial failure of MF Global, a fairly large broker-dealer firm ($41 billion in assets, apparently) dealing in commodities and securities and run by former-New Jersey Gov.-New Jersey Sen.-Goldman Sachs-CEO Jon Corzine.

The failure, even with the heightened regulatory oversight of Sarbanes Oxley and Dodd-Frank legislation, included the apparent misappropriation of $633 million in customer funds. According to news reports, approximately 150,000 customer accounts are frozen -- 50,000 of which carry commodities positions that customers are unable to close. When these accounts are frozen, clients cannot retrieve their funds from their accounts or limit their losses from deteriorating investments.

That's the news. Here's the reality:

Why would you trust any Wall Street firm with your money? Further, do you trust the regulators, the attorney general and the various state attorneys general to make this situation right from the customers' point of view?

Just to be clear, it is a cardinal rule on Wall Street that customer funds are never to be commingled with the capital and funds of the brokerage firm. It has come to light that MF Global executives removed $633 million from customer accounts to pay for investment positions of the firm. Their gamble, a concentrated investment in European bonds, failed miserably as Europe moved from one financial breakdown to another.

Given this turn of events, it would seem to me that Bernie Madoff should be getting some company rather soon. We will have to wait and see how the legal and regulatory issues play out. The Main Street investing public is waiting to see if there are any consequences to very bad behavior, perhaps even criminal, by MF executives.

At issue is the trust Main Street has in the system to treat investment customers fairly and to remove those who violate that trust from the industry and perhaps from society at large. So while the wheels of regulation and justice turn, we watch with interest as to the outcome and consequences of this financial tragedy.

Keep in mind that this is a human tragedy, ultimately avoidable by holding to sound investment standards and principles and by simply obeying the rules of running an investment firm.

Trust is a matter of belief that those you are dealing with have the ability and the intent to perform as they say and as you expect. When Main Street loses trust with Wall Street, the ordinary investor withholds money that could be invested, and instead places funds in more trustworthy institutions like deposit accounts in local banks, even though such accounts offer nearly no return. It is better to have your funds safe than to reach for returns, only to get involved with untrustworthy investment firms like MF Global.

The SEC recently did a study (required under Dodd Frank legislation) inquiring about the understanding the investing public has about brokers and investment advisors. The investing public makes little distinction between these two, but in fact they are two very different investment businesses. Brokers are salespeople for their firms and are remunerated by making transactions. Wall Street brokerage-firm investment research was long ago determined to be sales material designed to produce transactions, the commission life blood of the brokerage business.

Investment advisors, by contrast, are fiduciaries whose business it is to help their customers reach their financial goals. Many, perhaps most, investment advisors are not remunerated by commissions for transactions, but charge a percentage of the money under management. The primary difference is that the investment advisor wants to make your account grow; the broker just wants you to make trades. Further, no investment advisor worth his or her salt would have had any clients with accounts at MF Global.

Investing on Wall Street in the securities markets is a voluntary endeavor. No one has to invest with a brokerage firm or an investment advisor. Investing is an endeavor based on the notion that you will be better off buying stocks, mutual funds, municipal, government or corporate bonds or even perhaps commodities than you would be placing the money on deposit with your local bank. The credibility and regulatory compliance of your investment person and the firm he or she works for is crucial to this process.

Let's see if the legal machinery and the regulatory bodies add to the credibility and trust of the industry or detract from it as they deal with the MF Global bankruptcy.

Dan Nestlerode was previously the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. He retired in 2015 after 50 years in the investment business. A graduate of Penn State University, Nestlerode became an investment advisor in 1965. He can be reached at [email protected]
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