THE BLOG

Lessons From MF Global

11/02/2011 09:12 am ET | Updated Jan 02, 2012

The unraveling of MF Global provides a stark reminder of why we need to implement the Dodd-Frank financial reform legislation, a policy that every Republican candidate for president has promised to repeal.

Two things to look at here. First, I've been on this rant regarding the importance of capital reserves. There are a lot of moving parts to financial regulation, but at the end of the day, investors will find ways to make bets that are unregulated and systemically risky. And what we (should have) learned in the late 2000s was the extent to which leverage amplifies such risks.

MF was leveraged 44 to 1, according to the link above (leverage ratios below 20 used to be the norm).

If financial institutions have enough of a capital cushion to absorb such losses, it serves as built in insurance against the next new form of "innovative" finance that gets ahead of the regulators.

Second, there's interesting moral hazard in the MF case. The firm, and its benighted chief, former Gov. Corzine, appears to have been betting on a bailout. And it probably wasn't a crazy bet, except for the timing, which was what sunk the firm. (I know it's 20-20 hindsight, but betting on the alacrity of the European's timing in their debt crisis is really a very risky bet.)

The firm surmised that the banks exposed to troubled sovereign debt would get bailed out, and thus leveraged up to buy a lot of that debt at a steep discount. Had the bailout come sooner, MF and their investors would have made a lot of money -- at the expense of European taxpayers. A classic case of socializing losses and privatizing gains.

It's not obvious how to prevent this. Dodd-Frank has oversight provisions designed to spot trouble in systemically connected institutions before bailouts are necessary, but there's every reason to believe that we'll be back here again someday. I suspect some would say, "no bailouts ever." That's not realistic.

The answer is to provide regulators with the information to track leverage, exposure, and the risk profile of the global system. Dodd-Frank is surely not perfect by a long shot, but to repeal it without a better replacement -- to return to the assumption that markets will self-regulate -- is policy by amnesia.

This post originally appeared at Jared Bernstein's On The Economy blog.