MF Global: What Were They Thinking? Brad DeLong Explains

You just know that James Man is rolling over in his grave.
What started out as an honest business selling rum to the British Navy ended up as Corzine's Folly.
From Grasping Reality With Both Hands:

What Went Down at MF Global?: I Think I Am a Bear of Less Little Brain Today Than I Was Yesterday…

Okay. I think I have got it. I seem to be smarter, with a better-functioning brain, this morning then I was last night in analyzing what may be the eighth-largest bankruptcy in U.S. history:
We need a three-stage model:

• In stage zero MF Global sets up the financing with its counterparty and buys southern Europe's bonds.
• In stage one we learn whether the market is tolerant or intolerant of southern Europe risk: if the market is tolerant the bond prices stay high; if the market is intolerant the bond prices collapse.
• In stage two southern Europe either pays off its bonds or defaults.

We have four possible outcomes: 1--market risk tolerance and bond payoff; 2--risk intolerance and payoff; 3--risk tolerance and default; and 4--risk intolerance and default.

MF Global wins substantially in Outcome (1), if the market remains risk-tolerance and if southern Europe pays off. They have then made a large leveraged bet on southern Europe and on the market's risk tolerance, and have won.

The counterparty also wins in Outcome (1), the tolerance-payoff scenario. But it does not win as big as it would have won had it simply bought the bonds out right.

In the other three outcomes MF Global is toast....MORE