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(Reuters) - U.S. regulators started raising concerns about MF Global's European sovereign debt exposure as early as June, according to a source familiar with the matter, four months before the company's collapse into bankruptcy.
The revelation comes as MF Global tries to account for hundreds of millions of dollars in client accounts that are still missing, according to a federal official. While the size is down from an initial $900 million that was missing, the source told Reuters that regulators are not sure where the money went, and why they can't find it.
The meltdown of Jon Corzine's firm after high-risk bets on European debt should spark reforms to separate retail from investment banking operations, according "Bond King" Bill Gross, who says it marks another example of how Wall Street has "lost its way."
Not long ago, Wall Street was witnessing the comeback of Corzine, the ex-Goldman Sachs chief and former New Jersey governor, when he took the helm of MF Global. But the recent revelation of $6.3 billion of European bond positions caused the ratings agencies to cut to MF Global's debt to junk status, speeding its descent into bankruptcy.
The implications for the broader market so far, however, are limited, according to U.S. Federal Reserve Chairman Ben Bernanke.
"It appears to be an idiosyncratic case," Bernanke told reporters. "We are monitoring the possible impacts on funding markets and elsewhere, and so far we have not seen any significant impact on financial stability."
Though the firm's failure played out in a matter of days, regulators started turning the screws on MF Global months ago.
Around June, the Financial Industry Regulatory Authority (FINRA), one of many regulators that policed the firm, became concerned that MF Global had a substantial position in European sovereign debt and was not appropriately holding capital against it, the source told Reuters.
FINRA began conversations with MF Global about whether it was appropriate under Generally Accepted Accounting Principles to consider the exposure to be off balance sheet, according to the source, who was not authorized to speak publicly.
FINRA felt that regardless of GAAP, MF Global should recognize how much the market value of the sovereign debt-related holdings had declined, and consulted with the U.S. Securities and Exchange Commission, the source said.
After lengthy conversations with FINRA and the SEC, MF Global yielded and infused the additional capital called for, something the firm disclosed on September 1.
Those deals were attractive because they were financed in the repo market, according to Thomson Reuters columnist Bethany McLean. The company was essentially earning money by receiving more interest on the bonds than it was paying to finance the instruments.
When the bonds matured, MF Global planned to pay back the money it borrowed. The repo transactions were treated as off balance sheet assets and liabilities, even though MF Global still bore the risk that the issuer would default.
The exposure to sovereign debt was not included in MF Global's calculation of value-at-risk, according to its filings. That means MF Global recognized a gain or loss on the transaction at the time of the sale.
The filings do not say how much of the gain was recognized upfront, McLean wrote. But if it were a substantial portion, then these transactions would have frontloaded the firm's earnings. That, in turn, may have helped cover the fact that MF Global's core business was struggling.
It all points to the fact the Wall Street model is broken, according to PIMCO's Gross.
"Do we have a better example today than MF Global in terms of the mingling of those two particular aspects of capital allocation?" Gross, who runs the $242.2 billion PIMCO Total Return portfolio, said at a Charles Schwab Corp conference in San Francisco.
"So the closer we get back to separating the two, I suppose the better from the standpoint of reform."
The European debt trades pushed the company into bankruptcy, but the heat on MF Global now is around why it cannot account for a large amount of customer money that was supposed to be kept separate from other funds, sources said.
Regulators are trying to determine if the brokerage used some of the money to support its own trades.
The U.S. Commodity Futures Trading Commission has not decided whether it is going to launch a probe into MF Global, but it remains an option the agency could consider, a source told Reuters. The agency typically does not announce when it starts an investigation.
"We don't want people to leap to any kind of conclusion that there is something criminal here, and we don't know that," the source said.
Meanwhile, Brokers at MF Global on Wednesday stopped processing liquidation orders from customers or transferring accounts to other brokerages, market sources told Reuters. While it is not clear why, the trustee in charge of liquidating he brokerage set an emergency hearing for late Wednesday to ask the bankruptcy court to approve transferring certain customer accounts to other brokers.
One piece of good news for MF Global on the money front came from IntercontinentalExchange Inc, one of the world's largest exchange and clearinghouse operators. It said Wednesday that it received all of the margin money it required from MF Global and its customers.
"The press has reported that there may be potentially a shortfall of funds in customer accounts, but in our case ICE has always been in receipt of the full amount of margin moneys that are required for the positions in our clearinghouse," ICE Chief Executive Jeffrey Sprecher said on a conference call.
He said ICE began the default process on Monday, when MF Global, a big commodities player, filed for Chapter 11 bankruptcy.
Liz Ann Sonders, chief investment strategist at Schwab, said that the MF Global situation seemed to be more a miss by the auditors than a regulatory problem.
"It may show that we don't have adults manning the regulatory store, and that to the extent that this was a miss on the part of auditors, that should have been obvious suggests that this is still a problem," she said at Schwab's San Francisco conference.
"It's another hit to the confidence certainly of individual investors who have, maybe rightly so, felt that the whole game is rigged against them."
That blow to confidence played out Wednesday in Singapore, where dozens of worried retail investors lined up at the MF Global office throughout the day seeking to recoup their money. Singapore's central bank said later in the day it would prioritize safeguarding the interests of investors who had dealings with MF Global's Singapore unit.
So far, all the investors received was a form to complete after being told no money would be disbursed until liquidators wound down the bankrupt U.S. brokerage.
"Of course I'm afraid I may not get back anything, that is why I am here," said Andre Chia, a 32-year-old pilot.
Reporting by Christopher Doering and Sarah N. Lynch in Washington DC; Jonathan Spicer in New York; John McCrank in San Francisco; Saeed Azhar, Cerelia Lim and Charmian Kok in Singapore; Writing by Edward Tobin