The red lights were flashing in August when the giant commodities broker Refco first sold its shares to the public. The company admitted in its initial public offering that its internal financial controls were so weak it lacked “formalized procedures for closing our books.”
Translated into plain old English, Refco was telling potential investors that its numbers could not be trusted. They should have listened. The IPO’s warning turned out to be understating the risks. Even so, the investment bankers and accountants signed off on this IPO, and many supposedly savvy institutional investors bought the stock. Now they’re all taking a bath.
Refco imploded this month after it was revealed Chief Executive Officer Phillip Bennett hid the fact that an entity he controlled owed Refco $430 million–a secret debt that may have been artfully hidden on the books at least since 1998. When the news broke, the stock plunged and investor confidence evaporated. Refco has filed for bankruptcy protection and Bennett faces criminal charges.
Though Refco was an enormous force in the world of commodities and financial futures trading–it accounted for about 30 percent of Chicago Mercantile Exchange volume–its rapid fall so far hasn’t shaken markets. Refco’s parent company operated three businesses. Two of those–exchange-based futures trading and stock and bond trading–came under government regulation.
But Refco was also a major player in off-exchange derivative trading–its third business. That involves trading complex, often customized, financial securities devised to serve the financial needs of two consenting private parties. It’s carried on away from the scrutiny of regulated exchanges. Many customers of Refco’s off-exchange business were hedge funds, unregulated private pools of money that now hold an estimated $1 trillion in assets from big mutual and pension funds and wealthy individuals.
Refco’s collapse comes on the heels of the failure this summer of the Bayou Management hedge fund and as questions fly over yet another hedge fund, Wood River Capital Management. It’s likely to reignite the controversy over whether the government should regulate derivative trading. That debate last flared up when the giant hedge fund Long-Term Capital Management nearly collapsed in 1998, shaking financial markets. LTCM survived only because the Federal Reserve engineered a private bailout, sending the wrong signal to investors who ignore red flags. In Refco’s case, the investors are on their own and that’s how it should be.
There is a persistent worry that derivative trading risks could cascade into the overall economy, sending it into a tailspin. But Fed Chairman Alan Greenspan has argued that derivative trading does the opposite–it helps diversify overall risk. This page shares that view.
As for the belief that wealthy people and big institutional investors are sophisticated enough to look after their own interests and don’t need government regulation, those investors look far from sophisticated now. It’s an open question whether regulatory oversight would have uncovered this CEO’s lies, but those big investors may need to have their eyes examined.
When the red lights are blinking that brightly, savvy investors need to demand more information, not put on shades.
