Streetwise Professor

In the ongoing European crisis, everyone is looking at the European Central Bank to ride in to save the day.  The ECB is to serve as the lender of last resort (LOLR) for sovereign borrowers suffering liquidity problems.

There are two major problems with this.  First, lending to sovereigns is very different than lending to private institutions.  Second, there is a substantial probability that there are solvency problems for many European sovereigns.

The idea of an LOLR is that it can provide liquidity to financial institutions that cannot fund themselves on the market due to runs or the unwillingness of creditors to roll over debt.   These funding problems can arise due to a coordination problem among depositors/creditors.  The LOLR can prevent the coordination on an inefficient “run/don’t fund” equilibrium, meaning that just its existence can prevent the occurrence of runs, and if a run does indeed occur, it can mitigate its adverse effects.

In the 19th century Bagehot described the basic rules for the LOLR: lend against good collateral, at penalty rates.  This has been the mantra of central bankers ever since, although in the crisis both of these principles were pushed to their limit–and perhaps beyond.

The penalty rates aspect of the Bagehot formula is to ensure that healthy institutions do not attempt to get cheap funding at the central bank’s expense.  The collateral aspect is intended to increase the likelihood that the borrower is in fact solvent–it has assets sufficient to back the loan that is being extended to it.  Of course, valuing that collateral is a challenge, particularly in times of market stress when fire sale problems can cause the market values of assets used as collateral to plunge.

The Bagehot formula doesn’t work well with sovereigns.  What collateral will Italy pledge, for example?  The Uffizi Gallery?  The Coliseum?

But there is a more fundamental problem.  It has long been known that sovereign debt is different than private debt because of the higher cost of enforcing payment on sovereign debt.  Indeed, it is something as a puzzle as to how sovereign debt can exist in the first place: why would the sovereign ever repay?  One answer is that reputational concerns lead to repayment.  But it is prohibitively expensive to rely on reputation to enforce every debt contract in every state of the world: sometimes the benefits of avoiding existing debts exceeds the cost of not being able to borrow more in the future.

Since sovereign debt is different, and far more difficult to collect on–due to the lack of collateral and the high cost of enforcement of the debt contract–an LOLR to a sovereign is in an entirely different position than an LOLR to a private entity.   One should therefore be very cautious about extending the LOLR model from banks to countries.

This likely explains the ECB’s reluctance to commit to serving as the LOLR for Eurozone countries.

The European governments are trying to entice the ECB by providing political promises and ad hoc treaty changes to serve as a substitute for collateral, and as a way to enforce the payment of sovereign debts.  Last Friday’s “deal” was just the latest attempt at this–and the latest failure.  It is evident that the mechanisms advanced by Sarkozy and Merkel are inadequate.  First, they are just a variant on the pie crust promises made–and broken–in the past.  They will be, for instance, just another invitation to engage in Greek-style accounting and financial engineering.   Second, the mechanism of a “fine” for violation of deficit limits is something of a joke.

And consider the full game tree.  Let’s say that based on the promises of big borrowers to behave in the future, the ECB buys huge amounts of Greek, Italian, Portuguese, etc., debt today.  It now faces tremendous credit risk, and is at serious risk of holdup.  For example, if the ECB holds several hundred billions in Italian debt, and a year from now Italy has not made serious progress on restoring its fiscal balance and as a result is facing continued difficulty in rolling over its debt, what is the ECB going to do?  Will it say to Italy: you didn’t live up to your commitments, so you’re on your own?  Then Italy spins into the abyss and the ECB suffers a huge credit loss–and almost certainly becomes insolvent itself.  It can’t seize and sell collateral (see above).

No, instead, the ECB is likely to throw good money after bad.  Knowing this, Italy can play hardball with the ECB, and fade its commitments to fiscal probity.

It’s like the old joke.  If you owe the bank $1000 and you can’t pay, you have a problem.  If you owe the bank $1,000,000,000 and you can’t pay–the bank has a problem.  (Cf. Donald Trump’s bankers.)   And if you, sovereign borrower, owe the ECB on the order of 100 (or 500 or 1000) times that, the ECB has a big problem.  Lending today effectively commits it to lend more and more and more in the future.

Given this reality, the ECB’s response to the “deal” has been equivocal.  It understands the game tree.  It understands that the mechanism proposed by Sarkozy and Merkel does not overcome the fundamental problem with sovereign debt.  It understands that lending huge amounts to Italy or another European government today will put it in a position where it will feel compelled to lend even more in the future.

The markets’ response to the ECB’s equivocation has pretty brutal: European credit spreads widened, the equity markets have sold off, and the Euro is down about 1.5 percent.

Sarko in particular is panicking.  Here’s all the evidence you need: given that the ECB won’t lend to countries directly, he is proposing to launder the money through European banks:

At its monetary policy meeting on Thursday, the ECB offered ultra-long 3-year financing to banks and eased rules on the collateral it requires from them to tap its funds. It also cut its interest rates to a record low of 1.0 percent.

Euro zone leaders seized on the increased liquidity provision as a means to help fight the debt crisis, which has pushed up borrowing costs for countries on the periphery of the bloc – including G7 economy Italy – to unsustainable levels.

French President Nicolas Sarkozy said the ECB’s increased provision of funds meant governments in countries like Italy and Spain could look to their countries’ banks to buy their bonds.

“This means that each state can turn to its banks, which will have liquidity at their disposal,” Sarkozy told reporters at the summit in Brussels.

No problems with that plan. None whatsoever.

Well, other than the fact that European banks are hugely leveraged; have been under pressure to increase capital which they have done by shedding assets, including the debt of the riskier European countries; and are effectively backed by the very sovereigns whose debt they are supposed to buy.  Sarkozy’s “plan” that undercapitalized banks buy more government debt and then use it as collateral for ECB loans creates the very same problem for the ECB as it would face if it lent directly to Italy or Spain: a huge exposure to European sov debt credit risk that would effectively force it to continue to buy, buy, buy in the future even if the fiscal condition of these countries stays bad or gets worse.

And it is beyond satire that someone like Sarko, who has conniptions over banks taking on sovereign credit risk via CDS, thinks it’s perfectly copacetic to take it on by buying the actual bonds.

The basic problems with sovereign debt and the parlous condition of European sovereign borrowers means that if the ECB intervenes aggressively today, either directly or indirectly via the Sarko cutout plan, it will likely be doomed to monetize in the future.  A LOLR to sovereigns can’t do the same things that a LOLR to private debtors can.  Sovereign debt is different.  If reputational effects, or different mechanisms, don’t induce governments to do today what they need to do to get the markets to fund them, why would these mechanisms get them to do that in the future?  Indeed, the problem is all the worse once the LOLR provides the funding today because those that it lends to can threaten to bankrupt it in the future if it doesn’t.

The ECB may capitulate.  It is under tremendous pressure.  But that won’t make the problem go away: it will just defer it and likely make it worse. We’ll just proceed down the game tree until the ECB prints like crazy.

What are the alternatives?  Relatively flush governments agree to assume some of the debts of the weak sisters?: but the willingness and ability of Germany, etc., to do that is limited.  An agreement that credibly commits borrowers to perform, and take measures that ensure their ability to do so in the future?:  given all the problems with negotiating and enforcing such an agreement, this seems farfetched.

No, the fundamental problems with sovereign debt seem to put all the conventional solutions out of reach.  Sovereign debt contracts have to be self-enforcing, and current conditions have put those contracts outside of the self-enforcing range, or at the very edge of it.  Making the ECB a sovereign LOLR won’t address these fundamental self-enforcement problems, and indeed, it may make them worse.

Coverage of MFer John Corzine’s House testimony yesterday has focused on his repeated denial of any intent to dip into customer seg funds.  That’s walking a thin legal line, and it’s unclear that lack of intent would be sufficient to evade time in the pokey.  That part of his testimony seemed weasely, at best.

But this piece suggests idiocy:

Why did you bet the survival of the firm on European sovereign debt?

“We looked at the ratings, but they were not the only consideration. We looked at what counterparties would charge for initial margin. We would look at how individual securities were looked at by regulatory authorities around the globe – what they were able to use as collateral. We look at prices in markets to determine whether people thought the default or restructuring risk was being priced into it.

“There were many considerations along with the ongoing dialog that, which after the fact clearly can be second guessed, that the European community was going to take a much more forceful steps to avoid bankruptcy or insolvency.”

Looked at initial margins?  What about the risk of variation margin or the equivalent?  What about the risk of ratings trigger-induced increases in haircuts?

Initial margin isn’t what killed the trade.  It was increases in margin–additional collateral calls based on adverse movements in the price of the European debt, and perhaps collateral calls based on the downgrade–that sunk the company.

In other words, what killed the firm was its inability to fund the trade over its life in the face of adverse price moves.  Note that nowhere in Corzine’s answer does he mention mark-to-market risk, funding risk, haircut risk, variation margin risk, or anything related.  Given the firm’s leverage and the leverage in the trade, that oversight is beyond idiotic.  The main risk of a trade like that to a firm like MF was that prices would move against it and it wouldn’t have the resources to fund the additional collateral calls.

That’s exactly what happened–and per Corzine’s answer, that risk played no role in his decision to make the trade.  None.  That is just beyond belief.

Could he really have overlooked that risk?  Or was he just weaseling again, leaving out the crucial risk of the trade from his account, in the hope nobody would notice?

The coordinated intervention of central banks calmed the European situation in the runup to 9 December EU summit, but the fundamentals of the situation have not really changed.  To get a handle on how things might play out, it’s worthwhile to lay out the basic facts.

1. Some countries on the Euro will never be able to pay back what they owe.  Greece is clearly at the top of the list, but Portugal is likely in the same boat.
2. Other countries, notably Italy and Spain, are not clearly insolvent, but they are in a sufficiently parlous fiscal condition, and have enough short term debt that must be rolled over, to make them vulnerable to speculative attacks that make these rollovers impossible.  In the event, this would result in default.  Put differently, these countries are sufficiently dodgy fiscally that they are at serious risk of a shift from a rollover equilibrium to a run equilibrium.
3. The European Central Bank is not supposed to print.
4. The ECB is not supposed to serve as a lender of last resort (LOLR).
5. In terms of the insolvent countries, default would be very costly not just for the debtors, but the creditors.  Some highly leveraged European banks with huge balance sheets would likely become insolvent, likely requiring government bailouts.
6. Given the price stability mandate of the ECB, the debts of Greece, etc., can’t be inflated away.  Even if the ECB mandate was abandoned, inflating away the problems of the Greeks, etc., would have huge distributive effects in a single currency. The real value of all Euro-denominated sovereign debts would decline.  (As would the real value of Euro-denominated private debt.)   This would lead to huge transfers of wealth across the Eurozone and worldwide.  It could cause S&L-like problems with European banks, as the real value of their long term assets would decline more than the value of their shorter term liabilities, making them insolvent on a mark-to-market basis.  German fear of inflation is not just a Weimar neurosis.
7. There are various means of allocating losses as a way of avoiding default.  Some of the obligations of the insolvent countries could be assumed effectively by richer countries through Eurobonds, for example.  Some of the obligations could be written off “voluntarily” by holders of the debt of insolvent countries.
8. The liquidity problems of Italy could potentially be addressed by allowing the ECB to act as LOLR, but this exposes the ECB to substantial credit risk.  Realization of credit losses could result in inflation (with the implications discussed in 6) or the recapitalization of the ECB, with the cost paid by the taxpayers of the more fiscally solid countries.
9. Any mechanism (e.g., Eurobonds, closer fiscal union) to address the debt problems of insolvent or illiquid nations will likely create substantial moral hazards.
10. The bargaining problem is a multi-lateral one.  Moreover, the bargainers (heads of government) are agents for disparate interests that will be impacted very differently by alternative outcomes.
11. Multiple issues/alternatives are up for negotiation.
12. There are serious problems with enforcing any deal that is negotiated.  For instance, if Germany prevails in its insistence that any fiscal transfer mechanism be accompanied by fiscal reforms in the debtor countries, its ability to enforce this agreement is highly limited.
13. Germany and the other relatively fiscally sound states could afford to bail out Greece, and maybe Greece plus Portugal.  Those plus Italy, or Spain, or Spain and Italy–no.
14. A deal extended to any state (e.g., a substantial writedown of Greek debt) becomes a precedent (or focal point) in negotiations with any other state.

In other words: a fine mess.

The costs of default or inflating away debts are large for the creditor countries.  This gives the big debtors substantial leverage in negotiations: it is well know that it corporate bankruptcies, equity can often extract substantial amounts from creditors, and something analogous is true with spades here.

Also, these costs give rise to a huge bargaining range, which in turn encourages all sorts of opportunism and gamesmanship, and which can result in failures to come to agreement.  EU political mechanisms, and the large number of parties involved, increase the likelihood of such a bargaining failure.

It’s hard to see this ending well.  If I had to guess, I’d say it will go something like the following.  The costs of default, or of inflating away insolvent countries’ debts, are so large that the debtors will have substantial bargaining power. Germany et al will have to find some way of writing off or absorbing a big chunk of these debts, but will demand in return some mechanism to ensure that the debtors adhere to fiscal discipline, to which the debtors will grudgingly promise to implement.  Given such a deal, the ECB will find its way to serve as an LOLR, mitigating the liquidity problem for Italy.

But the debtors’ promises to get their fiscal houses in order will not be credible, and will not be enforceable.  So even if the Euros successfully escape their immediate predicament, it will return with a vengeance before too long.

And even this not-so-rosy-rosy-scenario (in which reckoning is merely postponed for a bit, rather than banished for all time) is not a sure thing.  The bargaining problems–huge bargaining range; the massive distributive effects of any deal, and the fact that different deals could have very different distributive effects; large numbers of participants in the negotiation, with the negotiators being subject to conflicting demands from their diverse domestic constituencies; the difficulty of enforcing any deal–are ugly individually, and arguably intractable collectively.  Failure is a very real option.

And in the event of failure, the various amputation options become much more likely.

I could perhaps see some kind of relatively stable, long-term deal coming out of this process if there was a robust enforcement mechanism, and if political commitments made today were credible and binding on future politicians.  But there isn’t, and they aren’t.  From which I conclude that the ultimate demise of the Euro is a matter of when, not if.

The Bank of England’s most recent Financial Stability Report includes an extended discussion of the various systemic risks posed by CCPs.  For SWP readers, the analysis will be familiar.  It focuses on the margin mechanism as a channel of contagion, procyclicality, and wrong way risk.  It emphasizes the risks arising from the pivotal role of sovereign debt in the clearing system.  Adverse shocks to sovereign debt prices can initiate the destabilizing margin cycle.  Moreover, given the correlation between the financial condition of CCP members and sov debt prices, sovereigns are a source of wrong way risk in teh system

Recognizing the very real possibility for a CCP failure, the BoE recommends the implementation of a resolution regime for CCPs to ensure that the market can continue to operate even if a CCP exhausts its financial resources.  I recommended this in  my ISDA white paper.

So I concur wholeheartedly with this BoE analysis.  But as was the case with Bernanke’s warnings about the systemic risks of CCPs, I ask: where the hell was the BoE  when everyone was drinking the clearing KoolAid?  Some of this realism would have been much more constructive before Frankendodd, the G-20 clearing commitments, and other moves to mandate clearing around the world.   Right now, the BoE, the Fed, and more than a few financial journalists remind me of someone who stood on the platform waving goodbye to a departing train, but are now running down the track screaming that its brakes are defective.

So regulators are no scrambling to figure out how to buttress the much expanded clearing system against its inherent vulnerabilities.  Would that as much thought and effort had been expended to identify, anticipate, and mitigate these vulnerabilities before regulation and legislation imposed such heavy reliance on CCPs.

Clearing was mandated in haste.  Unfortunately, given the current tumult in world financial markets, we may not have the luxury of mitigating the risks of these mandates at leisure.

Equity markets around the world are spiking on news of Le Plan du Jour/Der Plan des Tages being floated by the French and the Germans.

Basically, it is just a variant on an old theme: fiscal integration, but with teeth this time:

Angela Merkel and Nicolas Sarkozy . . . are said to be putting together a framework for a rapid move toward greater fiscal integration. Such a plan would likely entail oversight of member-state budgets—and a corresponding loss of sovereignty—with the understanding that such ties would facilitate the way toward sovereign risk-sharing, as through euro bonds. The prospect of fiscal submission to the will of the euro zone’s big powers is unlikely to appeal to peripheral countries, but many have already accepted some degree of oversight in exchange for emergency assistance, and the alternatives are likely to be far worse. To get around the need to go through a lengthy and uncertain treaty-change procedure, the plan may be drawn up along the lines of the Schengen agreement on geographic mobility. Countries may be able to sign on on a voluntary basis; it will not be an all or nothing approach. Given the scale of the current debt crisis, mutualisation of fiscal responsibilities won’t fix the mess. The main hope for the plan is clearly that a major step toward better fiscal institutions will encourage the European Central Bank to substantially step up its intervention in bond markets.

But the teeth are the problem.  Or, put differently, the lack of panzers is the problem.

The Economist piece is right to recognize that “mutualisation”–i.e., having Uncle Fritz pick up the tab–won’t work.  It won’t work because Fritz (or, more accurately, German taxpayers) aren’t willing to do it, and even if they were, it is doubtful that even Germany has the financial wherewithal.

But if Germans aren’t willing to tax themselves more to pay for what they perceive to be Greek, Italian, Portuguese, and Spanish profligacy, why should anyone expect that Greeks, Italians, Portuguese, and Spaniards are willing to tax themselves much more to pay for what they perceive to be German miserliness?  Which leads to a focus on one of the italicized sentences: any voluntary agreement requires Greek, etc., consent.  How likely is that?  And even if they consent now, are their promises credible?  Will southern Europeans agree to be bitten, and will they stand still to be bitten?  Can Germany et al really bite?  Color me extremely skeptical on each count.

Although the plans themselves have huge holes, as the rapid sequence of announcement and fading away demonstrates, the announcements and leaks (e.g., the completely unsourced story in an Italian paper that the IMF was going to finance Italy) serve a purpose.  The rumor mill will keep on grinding as long as the rumors have even a temporary market impact.  This buys time, which suits the natural proclivity of politicians to procrastinate, but which also does make some miraculous outcome possible.  Time to pressure the ECB into becoming the lender of last resort–or, more aptly, debt monetizer of last resort (because although a liquidity crisis is the current symptom of the problem, it’s much more than that); or time to pressure the Fed into becoming the European lender of last resort.

Which means that today’s market bounce will produce a bounty of new rumors and plans.

Just in time for Christmas.

Two headlines in today’s WSJ.  German Bond Auction Flops.  Pressure on Merkel Intensifies:

The German chancellor faces calls to soften her resistance to euro-zone bonds that would increase investor appeal but also make euro nations liable for each others’ debts.

The connection between the two stories is clear, though the stories don’t make it: nor have any of the other stories I’ve read about the auction debacle.  All the down-at-the-heels Euronephews are looking desperately at rich Uncle Fritz to bail them out.  The more likely that becomes, the weaker the German fiscal position becomes.

And let’s face it.  Fritz is pretty wealthy, but not nearly wealthy enough to pay for Europe’s past profligacy.  The failed auction is a harbinger of things to come.

This will make the amputate-or-gangrene decision all the more pressing for Germany.

There’s an old blues song, Goin’ Down Slow.  That’s not what’s going to happen in Europe: they’re going down, but the descent is accelerating.

The lyrics of the song, though, do resonate:

I did not say I was a millionaire…
But I said I have spent more money than a millionaire!
Cause if I had kept all my money that I’d already spent,
I would’ve been a millionaire a looong time ago…

The money’s already been spent, and there ain’t no mo’.

Hit it, Wolf:

There are many misconceptions about the CME’s responsibilities in the MF Global situation, and the implications of this situation for the CME’s longstanding claims that no customer has lost money as a result of a clearing member default.  These misconceptions are epitomized by this Sun Times article:

CME owns the Chicago Mercantile Exchange, Chicago Board of Trade and the New York Mercantile Exchange, where much MF Global business took place. It legally clears, or guarantees, the trading on its markets and often boasts that no customer has ever lost money because a trading firm failed.

That more than 100-year record may be in jeopardy with MF Global, one of the largest brokerages on the Chicago and New York commodity markets. Former New Jersey governor and Goldman Sachs Group Inc. chairman Jon Corzine led the firm but made a disastrous investment in European debt.

The claim is true, and regardless of what happens with MF it will remain true.  The clearing guarantee is not in play here.

If clearing firm A defaults, customers of clearing firms B, C, etc., will get paid as long as the clearinghouse is solvent.  That has always been the case in the past, and it is true now.

It is possible that customers can lose money under the omnibus account system employed in the US, if there is a default on A’s customer account, and A cannot cover it, then A’s customers bear some of the losses.  As an example of this, the London customers of Griffin trading lost money when that firm went bust in 1999: no US customer customer lost.  (Customers of a COMEX member, Volume Investors, did lose when that firm went under).

There was no default in either MF Global’s house or customer accounts, so the clearinghouse guarantee never came into play.  So the Sun Times account–like many others–is fundamentally misleading.

Moreover, 60 percent of customer margin associated with open positions was transferred to other clearing members.  Most of the missing money in question, from what has been reported, was customer money on deposit at MF Global but not margin associated with open positions.  (That is the case with two MF customers I know personally.)  The CME clearinghouse guarantee has nothing to do with that money.

CME has raised the amount that it is willing to commit to cover any shortfalls from the bankruptcy trustee’s distribution of cash to customers.  This is not the CME’s legal obligation, but is, as I said in an FT article a couple of weeks ago, an indication of the importance of this situation to CME’s reputation.

CME will be subject to scrutiny primarily for its role as the MFer’s Designated Self-Regulatory Organization (and hence responsible for auditing it) prior to the firm’s rapid implosion.  Moreover, as Jeff Carter (a one-time CME floor trader and board member) writes, CME has not done itself any favors with its handling of the “public perception of the crisis.” (Though I have also heard that CFTC is attempting to control what the exchanges–CME and ICE–are saying.  As well it might, as it will also come under considerable scrutiny.)

A big question in my mind is why Corzine isn’t getting the Madoff treatment from the Feds and the media.  He has been called to testify in front of a House committee.  I wonder if he’ll invoke the amendment that comes right after the one about unreasonable searches and seizures.  But it is amazing to me how little critical coverage he has received.  Especially given the bad press that rich bankers are getting these days.

Oh, I forgot.  He’s a progressive Dem in good standing.  What was I thinking?  My bad.

So there are two major things wrong with coverage of the MFer’s tale.  The first is that the role of the CME’s guarantee to its customers is being misrepresented with some regularity–including by the home field rag.  The second is that the most likely culprit–and certainly the person ultimately responsible for the firm’s collapse, and anything that occurred as the firm crashed and burned–is all but invisible.

Back in the summer I argued that sovereign CDS are acutely vulnerable to wrong way risk.  Indeed, the problem is so severe as to call into doubt the viability of these instruments.  From today’s Dow Jones News Wires:

But some market participants said that, if risk aversion from Europe spirals out of control and credit markets freeze, a large firm could fail to meet its obligations in a credit-default swap, setting off a chain reaction that threatens to destabilize the global banking system.

They are urging closer scrutiny of banks’ gross sovereign CDS positions and of the interconnectedness of the banking system.

“When there is a high degree of correlation between the underlying risk and that of the hedge counterparty [in this case, the sovereign and a bank selling CDS], can you rely on a payment from your protection seller?” asked Joyce Frost, partner at Riverside Risk Advisors LLC, a derivatives consultancy.

The correlation may be so strong, she said, that if Italy, for example, continues to deteriorate, the protection purchased from a highly correlated European bank may not be worth as much as originally thought. The value of that hedged position would be worth less than if the CDS were written by an uncorrelated counterparty–a U.S. or Canadian dealer, for example.

This is a phenomenon market experts call “wrong-way risk.”

Katy Burne goes on to argue that “[t]he lack of sovereign CDS clearing makes individual institutions more vulnerable to a messy default.”  This is fundamentally incorrect.  Clearing does not make wrong way risk go away because banks are CCP members, and would be on the hook in the event that a big loss on sovereign CDS caused a bank/clearing member to default.  In particular, the senior tranche of a CDO-like nature of CCP default funds makes them acutely vulnerable to wrong way risk.

Wrong way risk is intrinsic to sovereign CDS.  If big sovereigns are at risk of defaults that would cause payouts on CDS–heck, if even sovereigns that seem small in the scheme of things, like Greece, are in trouble–banks are likely to be in trouble.  The correlation is a fundamental feature of the instrument.  Whether banks are the ultimate counterparties in bilateral trades or via CCPs is immaterial: the problem is there.

The latest estimates of the shortfall in MF Global customer accounts have doubled, to $1.2 billion:

The trustee overseeing the wind-down of MF Global Holdings Ltd.’s brokerage said more than $1.2 billion in customer funds could be missing from the failed firm, more than double the original estimate of missing cash.That estimate of missing funds represents funds that should have been segregated in stand-alone customer accounts by MF Global in accordance with regulations, the trustee said.

Apparently the issue is that MF held about $600 million of its own capital in customer seg accounts to cover potential customer defaults (which as a clearing broker it is on the hook for).  Add that $600 million to the $600 million original shortfall estimate (which apparently was made without taking into account the MF Global capital held in the accounts), and you get to the $1.2 billion figure.

Already ugly.  Getting uglier.

When financial/trading firms implode, they do so with incredible speed. A lot of money sloshes in and out of them every day, and in the desperation and chaos of the implosion controls break down–and are sometimes deliberately broken down.  In the scramble for cash to meet incompatible demands from importuning creditors and clients, a lot of money can go out the door.  This isn’t like the collapse of a manufacturing firm with assets like machines and buildings that are hard to turn into cash quickly, and which keeps little cash on hand.  Firms like MF have mainly liquid assets, and handle large quantities of cash and liquid assets for others.  Thus, there is a much greater risk of illicit transfers in collapse of this type of firm than in others.

Interestingly, this is one reason why financial firms have fragile capital structures.  If they didn’t, it would be quite easy for managers to misappropriate assets.  Capital structure fragility and the associated potential for runs are a disciplinary device: customers and funders who suspect misappropriation can run, and destroy the firm in a trice.

But this disciplinary device is imperfect, as are all such devices.  Sometimes managers misbehave, and these firms implode quickly as customers and funders flee. We are witnessing exactly that with MF Global.