Banking or financial services tends to involve big numbers. Lots of zeroes; things do go wrong and often in spectacular style. Most recently, that nice Mr Corzine, Goldman Sachs alumnus and over achiever extraordinaire, came a little unstuck at MF Global. With every risk of over simplifying, the mess was what football fans call a game of two halves. One half was being “long & wrong”; once more the markets proved that they could stay against you longer than you can stay solvent. Those margin calls mounted up and the credit downgrade did the rest. I am no trader and even though Mr. Corzine has been long and wrong before, at his alma mater, Goldman Sachs, in 1994, I will leave it to wiser heads than mine to judge his trading skills. The other half of this unholy mess is the apparent shortfall in customer funds or client money of some $700 million This is the stuff of operations; the plumbing and the daily routine. When I read the story, I had a huge sense of deja vu.
Although this story dates way back to the late 1990’s, the lessons from it are as relevant today as they were then. The rules in the US around client money are actually long-established and good. Not something you can say about much legislation and even less so of recent US attempts to regulate the world. The SEC Act of 1934 sets out in the eponymous section 15C3-3 the rules around how broker-dealers have to protect client assets. In short, the broker-dealer have to have all the securities that clients have fully paid for and their free cash (see: http://taft.law.uc.edu/CCL/34ActRls/rule15c3-3.html
, for more detail). If all clients together have 100’000 shares of Apple, then the firm has to have those securities in a separate depot or the cash at current market prices to buy any missing securities, also in a special account. All of those assets are protected in a bankruptcy. Normally, every week, the firm will calculate “the formula” and then adjust the amount of cash in the special cash account. Differences are inevitable and not, in and of themselves, a bad thing. This job is an important one and more likely to be done by “Steady Eddie” character with 25 plus years of service and whose jobs are this and the football pool.
On the day in question, sometime in 1997 or so, as ever it is a Tuesday at Goldman Sachs and, as ever, Steady Eddie does the formula. “Firm owes clients $700 million”, so says the report and so it is. 700 million may be a big number to the man on the street, but on “the Street” it is not. So, ever eager to get back to the football pool, Steady Eddie logs in to his special Bank of New York on-line terminal. “Debit the firm, credit the clients $700 million, Enter”, “Are you sure?”, “Yes, Enter”. Job done, or is it? “F@#§!”. Steady Eddie realises he has included one zero too many and sent $7 billion dollars to the clients. A couple more expletives and then it is back to the terminal: “Debit the clients, credit the firm $6.3 billion”, “Are you sure?”, “Yes, Enter”. Job done time for a coffee.
A couple of minutes later, Steady Eddie is back at the desk, coffee in hand, ready to deal with the football pool. No sooner has he sat down, then a firm hand descends on his shoulder and a voice booms: “What the hell is happening here?”. Standing over his shoulder is Goldman’s head of compliance, Mark Holloway. Mark was at the time one of the most senior people at the firm who was not a partner. Within a couple of minutes of that movement of $6.3 billion out of the client account, alarm bells had rung at the SEC and they had picked up the “Batphone” and called over to the hallowed halls of 85 Broad Street to ask if Goldman’s regulatory guy had a clue about what was going on. Now Mark is one of the real gentlemen of Wall Street and cool enough to give the indomitable Sir Humphrey Appleby (see: http://en.wikipedia.org/wiki/Humphrey_Appleby) a run for his money. He is though, pretty apoplectic about being caught on the hop by the folks at the SEC.
Having been intimately involved in the drains up exercise that followed (think Spanish Inquisition) I can assure you that Goldman Sachs takes their client obligations very seriously indeed. Also worth a thought, that even as long ago as 1997, it took the SEC just minutes to get on top of the issue.
Lessons Learned: Once we had analysed this one, it was hard to really fault Steady Eddie; he made a mistake, he corrected it. What did not occur to him was that $6.3 billion coming out of the client account was such a huge amount and out of proportion by a multiple factor versus any other movement, ever, and just maybe somebody might be watching. When things go wrong, or even if you are just monitoring activity, do you know what normal is? “Normal” is not a magic number on page 23 of the textbook. it will vary depending on the legal entity, the business, the currency and even the day of the week. That small private banking entity in Switzerland with just CHF 30 million in capital is going to be more sensitive to a 25 million CHF problem than the heavily capitalised Credit Suisse down the road. ZAR 1 billion, may be just about $120 million or so, but in ZAR, that is a big number. A $10mm problem on a Friday will cost you 3x what it will cost on a Thursday. if you are in financial services, you need to understand normal. When things are not normal, then it is probably time to apply lesson #2; get the best brains on the job. Escalate up, to your manager or beyond. Do not be frightened to be frank: “I made a mistake, or this seems not to be normal”.
some readers will have some Goldman insight and realise that when this went wrong, one John Thain was COO and one Jon Corzine was CEO or senior partner. That $700mm is no coincidence and I am not making it up. Whilst I can assure you that there were lessons learned and Goldman Sachs took the incident very seriously, when it comes to Mr. Corzine and the missing funds at MF Global, I could not possibly comment.
Mark Holloway passed away after the original article was written.