Refco will be looked back on as one of the most incredible puff stories in financial history. Investors, in their greed, were prepared to ignore the company’s patchy record with the regulators. Scarcely a year has passed since the company’s creation in 1969 without the regulators hitting the firm with a financial penalty. From illegal front-running on Liffe to inappropriate cattle futures trading in Arkansas, Refco has transgressed rules and regulations in many of the locations in which it has operated.
Nonetheless, Refco helped satisfy a huge appetite for financial stocks in the US, especially in companies with a strong presence in derivatives. The Chicago Mercantile Exchange kicked off the trend when it became the first US exchange to demutualize and then go public in 2000. Since then, the CME’s shares have risen from an issue price of $35 to a recent high of $346.50. The CME’s stratospheric P/E ratio of about 42 illustrates the demand. Not surprisingly, other exchanges, brokers and niche players, including Refco, have looked to get in on the act.
Many of these companies’ shares took a hit as the Refco news broke, including the CME’s. The fact that Refco was one of the CME’s largest customers made this inevitable and the exchange’s stock plunged by more than 15% to about $285.
But reality soon returned as investors realized the fundamental difference between the CME and Refco. One is a good business with a few dodgy customers; the other was a dodgy business with many good customers.
As Refco looks set to wither and die, many have focused on the impact on the hedge fund industry. Ultimately, the fallout will probably be minimal. Those hedge funds that have Refco as their prime broker clearly have a problem in managing their risk. However, most still have access to the markets through other counterparties. The trouble will soon pass and the hedge fund business will continue as normal.
But the victims of Refco are numerous. They include the investors in the IPO, individual traders, hedge funds, employees and even those whose stakes in companies purchased by Refco have been declared virtually worthless (such as EasyScreen Inc).
One investor few will feel sorry for is Refco chairman Phillip Bennett, who borrowed A425 million from Austria’s Bank für Arbeit und Wirtschaft (Bawag) against his stock. The equity was apparently worth $500 million at the time of the loan. Bennett’s move was a futile attempt to dig himself and Refco out of the hole it had fallen into as a result of its false accounting.
Bawag will clearly have to take a big loss as well, but at least it should have had some idea of what it was letting itself in for. The bank has had a long relationship with Refco and purchased a 10% pre-IPO stake as far back as 1999. At the time, Bennett was quoted as saying: “Our objective is to provide Bawag with insights into non-bank financial markets in which we have expertise...” He has certainly done that.